Why Context Matters (Core Post No 2)
What Can Bilbo Baggins Teach Us About Investing?
Leonardo DaVinci said, “Good judgment is born of clear understanding.” The dictionary defines context as, “the circumstances that form the setting for an event, statement, or idea, and in terms of which it can be fully understood and assessed.”
If we put these two things together, it suggests that if we want to fully understand something—in order to make good judgments—we need to put things in context.
Unfortunately, in the world of investing, putting things in context rarely happens. This ends up costing people a lot of money and unnecessary stress.
So, what do we mean by context when it comes to investing? For that, we’re going take a brief detour to Middle Earth. Specifically, a scene from J. R. R. Tolkien’s The Hobbit in which Gollum poses the following riddle to Bilbo Baggins.
This thing all things devours; Birds, beasts, trees, flowers; Gnaws iron, bites steel; Grinds hard stones to meal; Slays king, ruins town, And beats high mountain down.
If you’re a Tolkien fan, you may already know the answer. If not, take a moment and try to solve it.
Context is so important that it’s the topic that holds a key place in our financial toolbox. Much of the value of these posts will be in learning to put things in context, into a proper perspective.
We pick up the story in The Hobbit, with Bilbo in a riddle contest with Gollum and things aren’t going well:
Poor Bilbo sat in the dark thinking of all the horrible names of all the giants and ogres he had ever heard of in tales, but not one of them had done all these things. He had a feeling that the answer was quite different and that he ought to know it, but he could not think of it…He began to get frightened, and that is bad for thinking. Gollum began to get out of his boat…Bilbo could see his eyes coming toward him. His tongue seemed to stick in his mouth; he wanted to shout out: “Give me more time! Give me more Time!” But all that came out with a sudden squeal was:
“Time! Time!”
Bilbo was saved by pure luck. For that of course was the answer.
And Time is the context we’re going to return to again and again to lead us to the clear understanding Leonardo was talking about when it comes to investing.
An Investment Example
To see how this applies to investing, let’s try the following experiment. If you had $10,000 to invest and weren’t going to touch it for 20 years, which would you choose?
Note that Investment A will result in more money 100% of the time.
This is, of course, a bit of a no-brainer. Everyone will pick Investment A.
Now, answer this: which of the two investments is the least risky?
Before we reveal what A and B are, would it surprise you to know that the investment industry describes A as very risky and B as, essentially, risk free?
That probably makes no sense to you. With A, there’s no chance of losing money and A beats B 100% of the time.
So, what are they? A is a stock market index fund (we’re using the S&P 500) and B is a money market fund (based on 3-month treasury returns).
You’ve probably heard that stocks are risky; money market funds are safe. So, what gives? In a word: context. Or, more to the point, lack of context.
And the context we’re talking about, as we learned from Bilbo, is Time.
If we posed this question using the context of a 1-year investment, money market funds would clearly be the least risky. They are designed so that they don’t lose money. In contrast, stocks go down in value over any 1-year period about 24% of the time. Stocks are risky in the short term.
The accepted practice in the investment world is to use short-term volatility (how much stocks might go up or down over a 1-year period) as the standard measure of risk, regardless of the time period (or, more to the point, by ignoring the time period)
The problem is, that it makes no sense to use a 1-year risk measure when evaluating a 20-year investment period. It doesn’t just give you the wrong answer, it gives you an answer that is exactly the opposite of the correct answer. Stocks are the least risky asset, compared with money market funds, for every historical 20-year or longer period on record. And they are the least risky for the vast majority of 15-year periods. (We’re going to explore a better way to look at risk in a future post.)
A Common Mistake
One of the biggest mistakes investors make is to assume stocks are always the most risky (because that’s what it sounds like the experts are telling them) and there is a natural human tendency to panic and get out of stocks every time the market goes down. This usually happens after the market goes down and investors, inevitably, wait until it goes back up before getting back in.
The cost of this common overreaction can add up to tens or hundreds of thousands of dollars, or even millions of dollars. Most investors aren’t aware of this because they rarely measure what they could have had if they had made a smarter decision.
The other cost of this short-term mindset is unnecessary amounts of financial stress—stress that can affect both your financial and physical health.
This is the opposite of the clear understanding DaVinci was talking about. Fortunately, the solution is pretty straightforward: never make a decision about investing without explicitly considering the context. As we’ll explore in future posts, Time completely changes everything when it comes to investing. But it’s going to take some Time for that to sink in.
So, we invite you to join us in future posts as we explore ways to make the world of investing easier to understand and far less stressful to deal with. Along the way, we’ll discover that Bilbo was far wiser than he could have imagined.
And if you’re interested in all our thoughts on investing organized into one comprehensive place, keep an eye out for our upcoming book, The Practice of Investing.
Stuart & Sharon Crickmer