One of the biggest and most dangerous investing mistakes is a mistake, that most people will never understand.
I have seen many lives ruined because people didn’t know about it. And on top of it all, hardly anybody even talks about it in the investing world.
You are probably familiar with the term Return on Investment (ROI). ROI is probably the most important metric in the investing world. In simple terms, ROI measures how much money was made on the investment as a percentage of the purchase price.
For example, let’s say that you invested $1,000 in the shares of ABC company. After a while, the price of the stock went up and you were able to sell the shares for $1,150.
What was your ROI in that case?
To calculate ROI, the return of your investment needs to be divided by your initial investment. After that, you just multiply the result by 100 to get a percentage.
So, in this case, $150 divided by $1,000 equals 0.15. And multiplied by 100 equals 15.
Your ROI, in this case, is 15%.
Simple and easy. No secrets there. Every investing book and website will tell you that.
But what if I told you that the ROI calculation is wrong and misleading?
You might think that I’ve gone nuts.
But give me a moment to explain what I mean. At one of the seminars I attended at the start of my investing career, one of the speakers was selling a stock-trading course. His claims about the ROI we would get with his trading system were bold, but he made it look so easy, so I started to believe him. And even though he charged almost $2,500 for the ticket, I bought it.
Now, I won’t tell you the embarrassing part of this story, where I lost a lot of money and almost had a nervous breakdown as a result of attending the course. To save myself the embarrassment, I will use an average Joe as an example.
When the average Joe attends this kind of course, the first thing he finds out is that you need to have special software in order to use the strategies covered in the course. Ok, that’s $450 per month, but who cares about that? Isn’t financial freedom worth $450 per month?
Now, the second thing Joe notices is that you need to analyze a lot of stocks with the software every day. So he ends up sitting in front of the computer screen for two hours a day, watching boring charts. But as you know, Joe’s goal is financial freedom and isn’t Joe’s financial freedom worth a couple of hours per day?
After a couple of years of learning and trying, Joe is an experienced trader. And even though he lost some money in the first two years, he has finally become profitable in the third year!
He started the year with $20,000 in his account and now he has $24,000. That’s 20% ROI and he is ecstatic. He jumps around the house; he tells all his friends about his achievements. Life couldn’t be better! But think again.
Don’t you have a strange feeling that we forgot about something when doing the ROI calculation?
Of course! You guessed it. There is his initial investment in the course and there is the monthly cost of the software.
You are right. But I think there is another cost that we didn’t account for, and it is much greater than the other two.
It’s Joe’s time.
And there you have it. ROI calculation is misleading and incomplete if you don’t account for the time you spend making and managing your investments.
If you spend 10 hours per week for investing, it is a cost. And from my experience, almost nobody accounts for that when they are calculating their ROI.
So what does the real ROI calculation look like?
And that makes investing a totally different ball game!
All of a sudden, you realize that if you spend a lot of time investing, your real ROI is much lower than you thought.
But to calculate the real ROI, we need to know what the value of Joe’s time is. You can calculate the value of your time by dividing your personal income by the number of hours worked per year. When you calculate this, you get the value of one hour of your time. Try it out for yourself!
Let’s say that Joe’s annual personal income is $50,000. And let’s assume that Joe works 1,800 hours per year (U.S. average according to OEDC).
If we divide $50,000 by 1,800 hours, we get the value of one hour of Joe’s time. In this case, it’s approximately $28 per hour.
If Joe spends 2 hours per day on investing, 200 days per year, that means that he spends 400 hours per year investing.
Let’s multiply that by the value of his time ($28 per hour) and we get $11,200. That is the value of the time Joe spent investing in one year.
Now, let’s put that into the real ROI equation. First, we need to deduct the value of the time Joe spent on investing from his return:
And now we can finalize the equation by dividing that negative number by $20,000.
That means that the real return is minus 36%.
Joe thought that he made a nice 20% return on investment – but, in reality, he lost 36%.
In the time Joe spent on investing, he could have made money working part-time or setting up a new business. Even flipping hamburgers at McDonald’s would have brought in more money than what he did trading!
That is why not accounting for the cost of time is one of the most dangerous mistakes I see in the investing world.
Don’t let it fool you.
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