Choosing Your Path to Prosperity
Let's imagine for a second that there is a contest going on where you can earn a cool $1,000,000 for finding a coin lying on the floor somewhere in a dark room. There is no time limit, and you are given two choices — either find the coin in dark room A, where you can roam around freely, or dark room B, where the room is really just a narrow hallway and only one person can fit through.
Adding to the twist is that the second room, the narrow hallway, has a four-foot ceiling, meaning you need to either crawl or at least be on your knees the whole way. Furthermore, you are told that the coin is just at the end of the corridor, where the only challenge then is your endurance in making it to the end. The hallway could be 15 miles long, and you'd have to crawl the whole way, but it's still a sure thing if you are patient.
So, which would you pick, and why?
Room A is a solid choice, given that it could take years to crawl through room B. After all, in room A, you can roam around freely trying to find that coin, and if you are lucky, you can pick up the million dollar prize in no time.
But think about the reality for a second. Once you are in room A, everything is pitch black. You have no idea how big the room is. In fact, you might need to run for a long time before you hit the walls. You will be excited and energetic at first, but as time goes on and you are still in the dark, will you still have the confidence that you will eventually find that coin? As anxiety sets in, will you give up or keep looking?
On the other hand, in room B, you are pretty much guaranteed to eventually get the reward. You are most definitely not going to find it quickly, but you know that if you keep crawling, the coin will be there, and the million will be yours. Now, which will you pick?
The Real Path to Prosperity
When it comes to your investment decisions, do you use the same logic to make the your choice? Many people read about the long-term growth potential of the stock market, and they ignore volatility because they believe that time is on their side, but is that you? Do you pick room A, where you have a chance to strike it big instantly by picking that awesome hot stock with no guarantees that you will ever find it, or room B, where you buy a diversified basket of low-cost index funds, lowering the volatility and pretty much guaranteeing yourself a smaller but steadier appreciation over time?
Tons of people still have a huge equity exposure because they ration that as long as they stay the course, everything will be okay. But what about the 50%+ drop of the S&P 500 in 2008? If you are in room A, what happens when fatigue sets in and you start doubting your chances? Should you keep looking and stay invested?
Volatility makes a huge difference in your investment returns. Risk tolerance is not only a test of your youth, but also a test of your mental toughness. For many people, the narrow hallway is a better approach.
The good news is that unlike the contest, you can drastically shorten the hallway of room B by being financially responsible. You can raise the ceiling to more than 10 feet by saving more or shorten the hallway by spending less.
For the responsible, the million is theirs for the taking if they choose the safe (and somewhat boring) approach.