Why Invest? As William Wallace put it, succinctly: FREEEEDAAHHMMMM. But we’re talking about “FINANCIAL FREEDOM”. That’s a worthy goal too, and we needn’t lose an arm and a leg for it At a minimum, we should strive for Financial Flexibility. But that’s just semantics. The point is that many of us want to get off the work-spend-borrow-work-spend-borrow treadmill. Financial Freedom means having enough money to pay our bills for a long-ish time-period so we can do whatever we want with our days. That could mean the freedom to quit a dreary job and traveling for a year, or to start a business, or to go back to school, or to change careers by starting at the bottom of the ladder in another field.
Paths to Financial Freedom
All those momentous life decisions are a heck of a lot easier if we invest our savings. At this point, I can hear the mumbles: investing is risky. Yes, but it can be managed. The real risk is not being able to get off that treadmill. Broadly speaking, the possibilities, along the risk spectrum, are these:
- Save a little every month and accumulate them in a savings account that pays almost 0% interest; nowadays anyway.
- Take out a loan when we need to fund a business or tuition or something bigger.
- Save a little and invest those savings.
Option 1 is the safest choice, but it will take most of us a long, long time to financial freedom. Most of us don’t have Paris Hilton’s good fortune or Gandhi’s level of patience.
Option 2 is a riskiest choice. Spending money we don’t have should be the last resort in most financial decisions. Yes, debt is not exactly a bad word, especially here in the US. But in my view, debt means staying on that proverbial treadmill a lot longer. Food for thought: The Latin origin of the word Mortgage translates to “Death Contract”. Yes, that’s probably taking it too far, and I’m not suggesting that we shouldn’t borrow money to buy that dream house. But the more Financial Freedom (money in the bank) we have, the easier it will be to get off that treadmill, faster. We can’t let our possessions possess us.
Option 3 is riskier than option 1. But it’s by far the most interesting one. The best thing about is that outcomes are positively skewed. Sorry, that sounds like Wall Street gibberish. The point is that the chances of a good outcome (I’ll explain in a minute), especially by investing “intelligently”, are a lot higher than chances of a bad outcome. Before we get into the “why” of this, let’s discuss the “what”.
What is a Good Investment Outcome?
Simple answer: Beat Inflation, handily; That’s it; not “beat some irrelevant ethereal benchmark” or “keep up with the Joneses” or “become a baller”. Just beat YOUR ESTIMATE of INFLATION by a big margin. Conversely, a bad outcome is, obviously, not beating inflation. The worst outcome of all is: permanent loss of capital. That is the only definition of risk relevant to us. RISK is a favorite topic at The Buylyst. Now you may ask, what does “handily” mean? We’ll get to that. But first, what exactly are we beating?
What is Your Estimate of Inflation?
You may be surprised to read that this is a subjective decision. The Federal Reserve in the US or the Central Bank in your country has an estimate of inflation but that’s a general, aggregate number for the whole country. That may not apply to you, personally. You wouldn’t superimpose your country’s GDP growth number on your personal financial prospects, would you? Maybe over a very long term; but even that is likely to be inaccurate. Let’s just say, you have a better idea than the Central Bank of the rate of inflation you face. Given your basket of consumption, which is no doubt unique to you, you can “feel” a certain rate of inflation.
Said another way, it’s how much poorer you would feel every year if your income doesn’t increase. For example, I feel about 5% poorer every year.
By How Much Should We Beat Inflation?
One million percent.
Kidding. I wish I had the blueprint for that. The point is that more is better. What I know is this: We must balance this “spread” over inflation with how much RISK we want to take. Yes, the R word again. There are many other definitions of risk out there. Wall Street loves “volatility” or “standard deviation” and “Value-at-Risk”. They sound cool, but ultimately, they’re not really useful. The Buylyst view on Risk is more intuitive. The objective is to beat inflation by as much as possible without losing money. The idea sounds simple. The execution is not. But it’s fun. And it’s known as “Intelligent Investing”. More popularly, it’s known as the “Warren Buffett style of Investing”. The seminal book on investing, “Intelligent Investing”, was written by Buffett’s guru, Benjamin Graham, and it set up Buffett to become an investing legend.
Let’s put some specific numbers around this: our goal is beat inflation by a factor of 2, roughly. Considering my estimate of inflation is 4-5% at most, I’d like to earn about 8-10% on our investments, post-tax, annually. Annually, like clockwork, would be nice. But that’s not possible, unless I become a fraudulent hedge fund manager. I have no plans of doing that. Over the long term (say 3-5 years), a post-tax 8-10% return per year on average would suit me just fine. That’s a good outcome for me. And, I imagine, that’s a good outcome for most people.
Does it Matter How Much Money We Have to Start?
Of course, it matters how much money we already have. But any amount in better than no amount. Start with $10,000. Or $5,000 or even a $1,000! Save more. Invest more. It’s a good personal exercise to figure out how much of our spending is wasteful. Consistently unsatisfying lattes, for example, is a very common cash-drain. Also, too many terribly fitting clothes bought online, which we will never return or wear again. The point is that it’s not that hard to find $100 or so of wasteful spending in a month. Boom - that’s $1,200 in Year 1. Find it. Save it. Invest it.
Remember what Einstein (allegedly) observed: “Compounding is the 8th wonder of the world!” Sow the seeds today, keep inflation at bay, and find freedom tomorrow. Compounding investment returns is awesome. But remember it works both ways. Inflation compounds too! Let’s say we assume that the general rate of inflation is 2% a year over the next 10 years. If we left about $1,000 under the mattress for those 10 years, inflation would eat up about 22% of our money. Poof. Gone. That’s how much ground we would have to cover, at least, just to maintain the purchasing power of that money. Now let’s say we invest intelligently, and the $1,000 pot earns about 8% a year over the next 10 years. Your money doubles. You’ll have about $2,159. But money loses value by 2% a year. That means you’ll have about $1,771 measured in today’s purchasing power. That means that you’ll have about 70% more money in 10 years. And about 10% of that just be the magic of compounding, because you left your money invested, and not under the mattress. “Wunderbar!”, Albert would say.
Of course, 8% returns every year is a big assumption. In fact, it’s almost impossible to get that year-after-year, unless you belong to the Bernie Madoff school of investing. I’m talking about an average return of 8%. Some years might be high-return-years, while other year might be negative-return-years. The pendulum of the markets swings perpetually between optimism and pessimism. The return on your investments, in the short term, will be hostage to the emotional pangs of the market. In the long run, the truth should shake out. If you’ve invested intelligently, you should realize the value in your investments, regardless of temporary swings in price. Whether you invest intelligently or not, chances are that you’ll be sitting on more money in the long run, if you’re not cavalier about it.
Why are Returns Positive over the Long Run?
I’m not an expert in currencies and commodities, so I won’t comment on them (I think they’re random walks most of the time). I understand how companies operate and I understand stocks and bonds issued by those companies. Bonds tend to safer investments because their yield is predictable, and their term is pre-set. These are contractual. You’re supposed to get a coupon – X% a year – and your principal back at the end of the term. Even if you’ve invested in riskier “junk bonds”, chances are that you’ll be fine in the longer run as long as another 2008 isn’t lurking around the corner. With stocks, however, things get interesting. Why should returns be positive? There’s a quantitative answer and a qualitative answer to that question. Most people focus on quantitative answers, among which the most common one especially irritates me. People throw around numbers like 8%, 6%, 10% if it’s international stocks, 12% if it’s small-cap and so on. Their reasoning goes something like this: “Well, historically, stocks have returned X% annually, on average, over the last 40 years, so that’s what you should expect over the long term going forward…”. This is lazy thinking. It’s the kind of overdependence on past data that has plagued economics and finance over the last few decades. There is a qualitative answer to this that makes more sense to me.
Why are Equity Returns Positive Over the Long Run?
Investing in stocks means investing in businesses. And investing in businesses means partly owning these businesses. That ownership entitles us to a piece of the company’s earnings and a slice of its overall value. The piece of earnings could be in the form of dividends or these earnings can be retained by the company. This last point is key: If you don’t need current income from your investments, you want to generally invest in the second kind of business – ones that retain part of their earnings to invest and re-invest them into profitable opportunities. This is your capital at work – in a new factory or a new store or a new product etc. Managements normally make these investments if their expected return on new projects surpasses a minimum return threshold, which is normally guided by the company’s cost of capital and the level of returns they believe shareholders would want. If a dollar invested, yields a dollar and a half, the company can keep the extra money as cash on its balance sheet or it can return cash to shareholders, or it can keep re-investing. I like companies that can do the latter. If that happens, return on this investment should increase earnings in the future. That increases the value of a business, because the value of a business today is the present value (inflation-adjusted) sum of those cash flows in the future. And, ultimately, its stock price should reflect that appreciation in value. Charlie Munger summarized it best:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.”
So, How Should I Invest?
Million-dollar questions; I hope. The enemy of money – inflation – must be beaten. Inflation should be kept under control over the medium to long-term, if the Fed still has credibility. 3-4% might be a good assumption. Beating this number, handily, involves investing. And there is a range of options, which makes investing confusing and intimidating. Broadly, our options are these, presented in order of my preference:
- Invest directly in a few businesses (via stocks or bonds) after patient, careful analysis that is not divorced from common sense. This is also known as “Intelligent Investing”, as coined by Buffett’s guru, Benjamin Graham.
- Invest “Passively” in Index Funds or on your own or through Robo-Advisors. We like the low fees. And the snazzy apps. But that’s about it.
- Invest in (usually mismanaged) mutual funds through your 401(K) or IRA or some other well-intentioned but mismanaged vehicle. Mismanagement is thus compounded.
- If you’re “sophisticated” (aka rich): Invest in hedge funds who think they are superhuman investors worthy of eating up 15-20% of your money. We too were enamored when we were younger; not so much anymore.
- Do nothing. We’ll repeat ourselves: inflations must be beaten. FREEEEDAAHHMMMM!
I have strong reasons for the order of preference. Check out "What are my investment choices?". The Buylyst method – Intelligent Investing – is not for everyone. Warren Buffett, the most famous Intelligent Investor, will have us know that for most people, who want nothing to do with investing, Option 2 is the way to go. No arguments there. But if you’re intellectually curious, if you interested in observing the world and reading and thinking about it, and what people (businesses) are doing to solve the world’s problems, then Intelligent Investing is for you. The “markets”, then, are simply a conduit for your worldviews. This is how Warren Buffett thinks. And it is how Charlie Munger thinks. If you want the follow their path, The Buylyst is here to make things simpler, much simpler. But it’s important to realize that if you truly appreciate the Warren Buffett way of investing – Intelligent Investing – you’ll be in the minority; you’ll have to be comfortable zagging when others are zigging. In investing, that’s a good thing.
Many Happy Returns.