The Limiting Reagents of Investing

One of the advantages of being a chemist (besides the incredible attractiveness that is associated with guys who study science) is the interesting perspective it provides you on things completely unrelated to science.  I suppose that happens with every profession, of course; whether you are a butcher, a baker, or a candlestick maker, you tend to apply your personal knowledge and experiences to the world around you, including your finances.  What your profession teaches you about the world, you’ll tend to apply to your money as well.

A Chemist, doing Chemist-type things

Which brings us back to the thought at hand: chemistry.  One of the main considerations in chemistry is the concept of limiting reagents. Not to get too deep into the finer points of chemistry, a limiting reagent is the species that reacts which limits how much of the product(s) can be generated.  Determining the limiting reagent enables you to figure out how much of the product(s) that can be made (and when you’re in lab, determining how much of the product(s) you’ve been able to make).

That short little paragraph might not be enough to explain the concept (which is usually the subject of a solid lecture or two in a general chemistry class), so let’s consider a more familiar example: a fire.  To have a fire, you need three things: an ignition source (such as a spark or a match), something combustible to burn (wood, oil, a candle, whatever), and oxygen.  In most situations, the oxygen is effectively unlimited (even a huge fire can’t consume more than a tiny, tiny portion of the oxygen that makes up 24% of the atmosphere) while the combustible material is limited.  The amount of fire you can generate is limited by how much material you have to burn.

The Limiting Reagents When Investing

All of this got me thinking about investing, and what limits the amount of money you can earn throughout your investment career.  It occurred to me that what limits your investment returns varies throughout your lifetime.

  • When you are young: Your investment returns are primarily limited by how much money you invest.  The difference between investing $4000 per year and $5000 a year when you have only $10,000 set aside will make a big difference in how much money you’ll have in the future.
  • When you are older: As you age, though, the amount of money you invest starts to become less important; the impact on your net worth between investing $4000 and $5000 is much less pronounced when you have a net worth of $500,000.  Instead, the amount of profit you generate is much more dependent on how much of a return your investments generate; the difference between a 8% return ($40,000 on our $500,000 example) and a  6% return ($30,000) can make a big difference in your final net worth.  (Particularly when the miracle of compound interest starts to kick in.

When exactly does the change over occur, from greater dependence on amount of money invested to greater dependence on investment return?  Well, there’s no exact dividing line; as your investments keep growing, the amount your future net worth grows will start to rely more and more on investment returns.  Assuming most of your investments are in stocks and that said stocks return about 10% each year, investment returns will generate more income when your total amount invested is ten times your yearly investment amount.  So, if you’re putting aside $5000 a year, your investment return will exceed that amount when you have $50,000 in your account (or around that amount).

The Lessons to Be Drawn

While thinking about all this, a few lessons occurred to me.  First, when you’re younger, the most important thing to how your net worth grows is how much you invest, not the return you earn.  It’s better to get started with your investment as soon as possible, rather than obsessing about finding just the perfect investment.  When you are starting out, worrying too much about your investment choices will just delay your net worth’s growth.

Next, as you grow older, the importance of a solid returning investment grows and grows.  While it is tempting to hide your money in safe investments and not take on any risk, keeping your money growing requires taking on a certain amount of risk.  Keep a portion of your money in safe investments (to protect yourself from declines in value) but remember that you need to keep growing your money as well.

The last, and most important lesson that I’ve drawn from this line of thinking, is that there are lessons that can be learned about managing your financing all around you.  Applying what you learn throughout your life to your money and personal financial management can yield lots of interesting insights.

What sort of lessons has your job taught you?

3 Responses to The Limiting Reagents of Investing

  1. FS: My twitter handle is @amateurfinance; thanks for noting that I didn’t have anything up, as I’ve now added a ‘Follow Me On Twitter’ widget to rectify the situation. I saw all the comments from my Yakezie post, and just responded to everyone. Thanks for putting it up!

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