Investing Basics – Why Do We Need To Invest?

As self-employed professionals, we all know that we have to save for retirement. The above question may seem a bit basic given this fact. Yet I’ve also told you that the first absolute principle of financial planning is simply spending less than you earn and the bigger the difference the better. As a professional, you already have the opportunity to save much larger sums of cash for retirement than the average person. Why do you then need to take that cash and place it into some investment that you really don’t understand what the hell it actually is? Most people will know the answer to this question is that investing can produce additional cash which will grow your retirement even more.   Those same people would also know if they put their cash into some kind of investment, there can be a chance it will lose money and you now have less savings. As rational professionals who value our intellect and competence, why do you take your hard earned savings and trust it to some kind of a financial salesperson you barely know? In addition, it will be placed into investments you are totally ignorant about along with the potential to actually lose your savings if it isn’t a successful investment. In my humble opinion, the answer that society, your parents, or your advisor told you to invest isn’t a sufficient enough reason to have blind faith in this process.

I believe understanding why we invest is essential to the foundation of personal finance and investing. Truly understanding it and along with clear financial goals are essential to actually allow the investing process to work properly on your behalf for the long run. You need to believe and have faith in your investing to the same degree you believe in evolution or the laws of gravity. Although evolution and gravity will still keep doing what it does despite your personal beliefs and actions, investing is quite the opposite. The uncertain flip-flopping investor, who panics after every market downturn, can literally take a guaranteed long term winning solution into a significant losing endeavour. So now I need to make you believe in why you need to invest for the long term…..

Inflation

The number one enemy of everyone’s financial well being is inflation. We have all heard the term but what does it really mean? You can review the Wikipedia definition, but it simply means stuff you need to live will cost you more in the future. We intuitively know this is true. We all remember riding our bikes to the candy shop or buying milk out of the school vendor for far less then these goods cost now. The issue is inflation is a slow moving enemy that doesn’t seem so significant in our day to day lives. We need to start respecting its impact over long timeframes. Let’s assume we are 30 years old. As per this link, the average Canadian 65 year old today should expect to live till they are 85 years old.  The trend is we are consistently living longer and it may be reasonable to believe a 30 year old today can live until 90 years old if trends continue. So let’s use a 60 year remaining lifespan for our hypothetical 30 year old. How much would our basic $10 meal cost us in the last 5 years of our life from age 85-90?

I found this fun calculator (link) where you can plug in any historical timeframe and understand how much the cost discrepancy would be. Over the last 100 years, Canada has an average inflation rate of 3%. Different rolling 20 or 30 year time periods have some larger swings in this number as low as 0.5% and as high as 7%, but most economists agree that developed nations will run 3-4% on average long term.

In our example, when we are 85 years old using a 3.87% inflation rate (this is the last 55 years average rate), the $10 meal at 30 years old will now cost us $80.89! A $50,000/ year lifestyle expense now would be about $400,000/year for the equivalent lifestyle at 85 years old!

From our example, we can see why even if we were prodigious savers of $100-200,000/year, letting it sit in cash to be eroded away by inflation will leave us high and dry in retirement. It reminds me of a scene from a show I liked called Narcos. Drug lord Pablo Escobar had hidden millions of dollars underground in case he ever was on the run and needed funds. Unfortunately when he dug up the money, it had become moldy and totally worthless. Inflation is the equivalent of rats or mold eating up 7 out of 8 dollars you tucked away at age 30 for your future use at 85 years old. What a piss off! Now that we respect the power of inflation, the next question is what to do about it.

Risk Tolerance

Anyone who has seen a financial advisor has likely been asked about their overall risk tolerance, which in turn helps them decide your asset allocation.  This is a fancy way of saying what types of investments most represent your risk tolerance and in what percentage of your total savings to allocate to each individual asset class. Your risk assessment analysis would be posed something like “How comfortable would you feel with a 30-40% loss suddenly in your stock market portfolio?” A planner would likely explain to you that in the long run this “aggressive” portfolio with larger swings up and down (defined as high volatility in investment jargon) will be balanced out over the long term and likely provide a better overall return. Most people would still find the words “aggressive” and “highly volatile” to seem dangerous and quite scary. Fear is an incredibly potent emotion and has been hard wired into our brain for evolutionary purposes. Hence many will decide they don’t need to shoot for the stars in their investments and prefer a more “balanced” risk profile. A particularly risk adverse individual will want no chance of a significant temporary loss of savings and are deemed a “conservative” risk profile.

Given the context of how a planner commonly presents this issue, selecting the balanced portfolio seems quite reasonable. It is a legal requirement for an advisor to go through your risk profile, but they will still get paid if you choose balanced or conservative investments (albeit they will receive slightly less commission). It isn’t worth the time of a planner to go through an hour long discussion as to why conservative or balanced risk profiles are actually short term safe or “low volatility”, but actually higher risk long term than an aggressive portfolio. This seems counter-intuitive, but it is secondary to a lower probability for more conservative portfolios to keep up with our enemy inflation. A planner may also put themselves at risk if it appears they pushed too hard to convince an individual into a more aggressive portfolio, even if it is better for that individual in the long run.

Our risk tolerance assessment should instead be posed with the question “How comfortable are you that the majority of the dollars you put in investments today will be eaten by inflation by the time you retire”. The majority of individuals will say “not comfortable at all!” They inherently know this would be risky to retire with a lower standard of living than they enjoy now. Any investment that returns lower than 4%/year over long periods of time will run the risk of losing out to inflation.  The previous “conservative” investor now feels more empowered to fight the good fight against their enemy inflation. They can understand that reducing their short term risk of loss feels safe, but it will likely guarantee the risk of not having enough to purchase inflation adjusted goods in their future retirement.

The next question would be “Is your goal in retirement to have your savings keep pace with inflation?” The previous conservative investor may be happy with this if they know that they can’t bear to lose any money, even if it is only in the short term. Most “balanced” investors will see that this doesn’t really fit their goal of investing. It is already hard to save during your working years and most of us want our investments to do more than keep up with inflation. Investments do have the potential to work like an employee, producing additional savings while you continue to fight the grind of your daily career. Suddenly, many “balanced” investors realize the need to be more aggressive with their asset allocation in their fight against inflation when investing for the long term. An essential part of the discussion around increased risk tolerance is with a LONG TERM investment horizon. I will discuss this more in our topics on each major asset classes and their short and long term investment characteristics.

In the next Investing Basics post, we will discuss compound interest and all its glory. This will be followed by a look at different asset classes that you can choose to invest in. Did the effect of inflation surprise you? Did your mindset on your investing risk profile change after reading this post? Share your thoughts below!

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