Session 1. Investing And Your Life

Welcome! A friend of mine used to say that I couldn’t be taught anything that I wasn’t almost ready to learn anyway. I think that was a nice way of saying that I could only learn in very small steps. Maybe that is the best way to get ideas across as well.  I know your time is valuable, so let's begin.

We are going to assume very little. This is especially necessary because most of what we all believe about investing is wrong. The problem is that the stock market is so unlike the world that we have grown up in that none of the normal rules apply. So I ask for a suspension of disbelief, and a little patience, as we build the foundation together.

Our distant ancestors might have invested by draining a field or building a shelter or raising children who would care for them in their old age. They sacrificed time and energy now for later benefits.  Later on, if they were able and fortunate, they might have invested in tools and customers for a trade.  Today, specialization makes it practical to translate much or all of our foregone consumption into money capital that we entrust to other people. They in turn use it to train employees, purchase equipment, design products and find customers. When we invest in anything but our own business, we merely select whose projects to back.

The basics are still there – our savings, and someone using the resources thus transferred from current consumption to create real wealth. We no longer have the same personal involvement. But as an offsetting advantage, there is much more opportunity for risk reduction through diversification in today’s world.

Why should we save? We may save to create a buffer against unemployment or ill-health. We may save for a car or a down-payment on a house.  If we have children, it is desirable to save ahead for college tuition. We may save for the capital to start a business.  Most importantly, because we can expect to live longer than our parents and their parents, we need to save for retirement.  Money should not outweigh the other ingredients of a life well lived.  But it is a significant component in an interdependent world where many desirable goods and services are obtained chiefly with interchangeable IOU's.  We save to make sure that we have enough when we need it.

What if you are already wealthy?  Then there are a new set of challenges.  But one similarity is the desire to preserve capital -- and, in the face of any currency inflation, that cannot be done without saving.  If you pay taxes, the problem is worse, because you will be taxed on "income" and "gains" that are mere illusions when put in terms of real goods and services that can be purchased.  Today's inflation rate, as in the 1930's, is low, but not insignificant when compounded.  Over your lifetime, there are likely to be periods of higher inflation rates.

Source:  US Dept. of Agriculture

For most people, the biggest need for saving is for retirement.  The first thing most financial planners will tell the average investor is that they are not saving enough for retirement.  It is painful to recognize and deal with.  Unfortunately, the best solution is to start saving from a young age when we do not spend much time thinking about retirement. It gets harder by the time we reach middle age. You might want to bring up a spreadsheet and work out the following calculation for yourself.  Otherwise, you will have to take my word for it.  Suppose that your portfolio earns 5% more than inflation, that you need to provide a retirement income of only half your previous income, and that you do not want to eat into your capital after you retire.  You are 45 years old, your future salary will go up only with inflation, and you intend to retire at age 65. Assume your tax rate remains constant.  How much of your salary will you need to save each year if you begin your retirement savings now?

Assuming that you can get a 5% real return (net of inflation), you will need wealth of 10 times your pre-retirement income. How much do you need to save in each of twenty years to accumulate 10 years of income? Multiply the first year's saving times the product of twenty 1.05's.   Add to the result, the product of 1.05 compounded similarly over 19 years.  Then add the same for 18 years and so on.  You will discover that a stream of constant savings invested at 5% will be worth 33 times the annual contribution at the end of twenty years. To get one year's income saved in twenty years, you will need to save only 1/33 of your annual income each year.  But to get 10 years worth of income saved, you must save 10/33 of your annual income, or about 30% each year. Unrealistic, you say?  That is right, for most people, and it is the reason that they cannot accumulate sufficient retirement capital to live off its income.  (This topic will be reviewed again in Session 9, when we return to an appropriate spending rate for a balance with real income, assuming capital is already accumulated.)

This high rate of saving is exactly what many people in East Asia are doing today, but it is many times the rate of personal saving in the US and likely considerably more than you are saving now. You may feel that you can earn much better than 5% above inflation if your portfolio includes a high proportion of high-return stocks.  But consider that even a 100% stock portfolio has averaged only about 6 to 7% above inflation in the U.S. over the last 75 years.

If we do not inherit considerable financial resources, if we don't start a successful business we’ll have to save from normal income, and probably more than we are saving now. We'll benefit from starting to save earlier, rather than waiting until our children, if any, are out of college. We’re going to need a higher rate of return than that available in risk-free bonds or bank savings accounts. Paradoxically, despite the need for better returns, we also have to avoid serious erosions of capital through risk and taxes along the way to our goal.  Easier said than done, but reality.

If we have already accumulated capital that we depend on for spending, the analogy to saving is properly balancing spending with real income.

The first key concept is that investing depends on saving.  Saving is deferred gratification.  But it can be satisfying in its own way.  Think of your financial resources as a reservoir.  To fill it, we have to coordinate what flows in (investment returns) and what flows out (consumption spending).  There is also a feedback mechanism involved, because the rate of inflow is proportional to what is already in the reservoir.  Staying with water-based analogies, saving is the primer that allows the well-pump to draw much larger quantities.

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