To build wealth over the long term almost everyone needs to invest. But investing means putting money at risk, although the goal is maximum returns with the minimum of risks. But we take these risks because inflation could destroy our standard of living.
Why do we need them to beat inflation? Inflation devalues your net worth unless you find a way for your money to grow faster than the inflation rate.
Example: Inflation in the United States over the last century has averaged about three percent a year although recently, after a long period of low inflation, it started to average five percent and many fear it could be higher than that. They fear we could be returning to the disastrous double-digit inflation years of the 1970s and 1980s. By contrast, the long term returns of stocks have averaged about nine and a half percent a year. So, even after deducting for various costs such as taxes and avaricious mutual fund companies and big brokerages, consistent stock market investing, done with intelligence and discipline, tends to keep you ahead of inflation over the long term.
Let’s look at some examples of how to incorporate investments into your MoneySense plan. But remember investing is not saving. The latter has traditionally provided low rates of sometimes positive returns. And sometimes negative rates of return when one figures in the ultimate tax: inflation.
Why do I say sometimes?
In these past few years, savings interest rates were often almost zero. I say sometimes, by the way, because, when interest rates are low, your net returns, figuring in inflation, are negative. Say you get one percent on your savings account, but inflation this year is five percent. The value of your money this year declined by four percent.
That is why we are also discussing investing. The goal of the latter is to beat inflation and taxes by a substantial amount. When you do that, you are improving your standard of living. Simple example: The long-term return of the stock market is nine and half percent.
That doesn’t mean you get nine and half percent every year. It means if you consistently put money into good stocks or stock mutual funds, you tend to get an annual nine and a half percent long term-return. And we’re usually speaking of 10 to 20 years or more.
The historic long-term rate of inflation has been about three percent a year in the United States. Take out another two percent for taxes and the costs of brokerage—say about two percent—and you end up ahead with a “real rate of return—one correcting for inflation—of about four percent (Nine percent minus three percent and minus two percent).
However, investing has no guarantees. You don’t get nine percent or so every year. You can make lots of money on investments one year. Then, in the next year, you can lose huge amounts as we saw in the first part of 2020. But over the next four months, through the middle of 2020, the stock market wiped out its losses and actually was slightly ahead for the year by the end of July. And by the end of the year, it was up by double digits. It was another good year for those investors who hung on through the bad times. By the way, here is why it is ridiculous to try to time the market.
Another example of the, at times, up and down world of investments is 2008 and 2009. In 2008, the stock market as a whole was down some 35 percent. I know many people who sold everything at the end of the year who told me they would never invest in the stock market again. But what happened the next year?
It happened that 2009 was a great year for the stock market—it was up about 25 percent. And by the way, for those investors who said they were done with stocks forever, they missed an incredible runup over the next decade. The S&P was up every year save one. And even in the down year it was only off by some three percent.
So remember: It’s difficult to predict short term developments in the stock market. Therefore, it’s best not to try.
Follow a steady investing course over a long period; sometimes taking your lumps—but buying shares of otherwise good investments at discounted prices in bad years—and then getting rewarded later when markets recover. I will discuss this strategy later. It’s called dollar cost averaging.
Steady as She Goes
Why follow a steady as she goes strategy instead of jumping in and out of the market, trying to pick a spot you believe will be a market high or low, a dicey strategy known as market timing?
It’s because the same forces that greatly increase the value of an investment, say a stock, bond or a real estate investment, can also just as quickly do the reverse. It’s called volatility. That’s what many stock market investors found out in early 2020, in 2008, 2001, 1973-74 and 1929.
So, some readers are saying, why take the risk? Why not save some money every week, put it into a savings account and know that the balance will never decline?
Indeed, in a few circumstances, one can save one’s way to financial independence. Unfortunately, they are very limited to a very few people. And even the high earners have a disadvantage. They usually only earn high salaries for a relatively short period. Many of them realize too late that these extraordinary salaries end sooner rather than later.
However, in the meantime, they could do very well if they are sensible.
Let’s say you‘re a big-time athlete or entertainer making $20 million a year, then all one has to do is save 10 percent a year of your pre-tax income for five years and, even if you have near zero percent in a money market account, then you’ll still have $10 million to live on for the rest of your life. But is it reasonable for most people to save one’s way to independence?
In most cases it is not. The overwhelming majority of us are unlikely to ever make anyway near $20 million a year or even a million.
So it’s clear few of us can save our way to financial independence. Therefore, this book is for those with incomes in the middle. We must take some reasonable risks to achieve financial independence. Why must we take some risks and invest?
What Will Your Money Be Worth in 20 or 30 Years?
In most cases the value of today’s money will be worth a lot less in a few years. The reasons are inflation and buying power. We invest because inflation will inevitably reduce our buying power over the long term.
“Even a moderate rate of inflation such as 3 percent will cut the value of a dollar almost in half in twenty years,” says Liz Weston in “The 10 Commandments of Money.”
That’s because the system of central banks and big welfare states is constantly expanding and almost never cutting back. Prices always seem to go up and the only issue in debate is by how much. And that has a heavy price. It has meant persistent high taxes and inflation as governments run deficits, printing more and more money to pay for their often-reckless spending. This destructive process devalues a currency and buying power unless one’s assets value beat inflation.
Indeed, as I write this, the government, the Biden presidency combined with a narrowly Democratic Congress, is expected to take on trillions of dollars of new debt to try to re-start a stalled economy.
What is the potential danger of this big spending policy? The government doesn’t have this money.
So it will issue new money and sell more bonds. All of this reduces the value of our currency. It is a delusion, tricking people into thinking they are richer. One has more dollars and feels rich. But somehow the money doesn’t buy as many things as they did before the currency was devalued. Its buying power has declined and, in extreme cases in monetary history, people stopped accepting the devalued money. It’s happened here before.
All this new money creation means one has to increase one’s assets to keep up with inflation and ensure one’s living standard doesn’t decline. Governments print more money to pay the bigger and bigger bills. People live longer and expect more services from government. That devalues every dollar, pound or euro one holds. You almost constantly have to increase your estimate of the amount of dollars you will need to be comfortable.
The inflation rate means the slow, or in some cases, quick debasement of a currency. Whatever the debasement rate, some inflation—sometimes a little, sometimes a lot—is a constant of the modern welfare state. It’s worse in the United States because we also have huge warfare state to support since America has acted as a kind of world policeman since the mid 1940s and has been expanding its welfare state at a feverish pace. Both Republican and Democratic governments have done so. So these spending issues apply regardless of which party is in power and how much their election promises will cost a nation.
For example, in the United States, over the last century or so, the inflation rate has averaged about three percent a year. However, back in the 1970s, there were years when the inflation rate was 10 percent or more. That was disastrous for many sectors, especially those running small businesses.
I remember freelancing in the early 1980s for a weekly New Jersey publication called “The Sussex Spectator.” I wasn’t paid for the last four stories I wrote because the owner said he had to close the paper. He blamed it on high interest rates. Lots of other small businesses suffered the same as inflation wrecked the economy. Many smaller firms either couldn’t afford or couldn’t get credit.
This was also a disaster for people living on fixed incomes. Imagine you had retired and thought you have just enough for a comfortable retirement. Now all your numbers were no good. That’s because high inflation rates ripped into your buying power. Interest sensitive sectors of the economy, such as autos and housing, were also hurt the most as were elderly people whose prime earning years were gone.
Most purchases in the auto and housing sector are financed on borrowed money. Ten percent inflation caused the central bank, desperately trying to stop inflation, to raise interest rates to 20 percent. That shut out millions of would-be buyers of various things because the price of purchasing those big-ticket items through credit was prohibitive.
There Goes Your Buying Power
Let’s say you put your money in a savings account today. You earn less than one percent. Even as you accumulate more and more dollars, or pounds or euros, something bad is happening. It is something most politicians rarely mention: The buying power of your currency, the ability of a set amount of money to command the goods and services you generally buy, almost always declines over time. That is unless your amount of invested money increases at a brisk pace; that is if it increases at a pace faster than the inflation rate and faster than our ruling class is taking money out of your pockets.
Therefore, one must earn a lot of a currency to make up for the power of inflation and that savings account won’t do it. How do you accomplish this? You must find some system that can beat the inflation rate over the long term, otherwise you risk seeing your standard of living decline. Avoiding that means successful investing.
Indeed, most of us want to beat inflation today. We want to beat it for the rest of our lives, accumulating enough dollars or pounds or euros to ensure that, whether inflation is high or low, we’ll be able to accumulate the kind of stash that will let one be financially independent.
If successful, one reaches a point in which one can rely on investment income and never have to make another cent again. What happens is you can live on the dividends and other income your investments generate, but never touch the principal. That is the goal, but how does one achieve it? Let’s consider how.
What’s Your Lifestyle?
For instance, let’s say today one wants to kick back—stop working—and thinks $120,000 a year income will create a comfortable lifestyle. And let’s say one is not going to access a state retirement program such as Social Security for years, but needs income now.
Then let’s say you have $2 million in investments and, through reasonable investments in the stock market, you are earning on average of six percent a year. Then you have achieved your goal. At six percent, without touching the $2 million principal and only using the amount of money your investments yield (capital gains, dividends, etc.), your investments provide $120,000 a year in income (I’m not counting Social Security income because, given its problems, who knows how much it will provide to the average taxpayer, especially someone who has a decent level of assets. For more on this subject, please see my later chapters on Social Security, including an interview with a key program official).
By the way, for some the risk of getting six percent in the market or in some other investment just isn’t worth the worry. But one should understand the risks of investing, but also understand the risks of not investing, especially the person who isn’t making or probably will never make $1 million or so a year and can never hope to save his or her way to financial independence.
So MoneySense is primarily for the person with middle class income—say $50,000 to $125,000 a year—or even the person with less than a middle-class income but who wants to do better. I also want the well-heeled to consider these strategies. Lots of them can lose their independence.
It is also for a person who has next to nothing or very little in assets and wants to accumulate what, for him or her, is a huge stash that will take care of the person for the rest of his or her life. Of course, much of this depends on what kind of life you want to live, where you want to live and how big a house you require.
Are you the person above?
He or she thinks $120,000 a year is a great income. Maybe you need more. Maybe you need less in annual income. But let’s say the principal amount you want will be somewhere between $500,000 and $3 million. How does one get to somewhere between those numbers when starting out with nothing? Investing is a hard reality for these people. It is a reality that they must face.
Dear Mr. and Mrs. Middle Class or Would-Be Middle-Class Person, living in almost any advanced welfare state in the world: Given the proclivity of governments to take more and more of your income, given the potential over the next few years of governments to cut social programs many people depend on, it is highly unlikely, well-nigh impossible, that you can save your way to financial independence. You will need to take some risks. You must do some investing, especially in stocks. Long-term stock investing, carried out through a disciplined plan, is one of the few ways to beat inflation and other costs, tomorrow and in the immediate future.
So you, the average person who yearns for financial freedom, must put some capital at risk—he or she must invest on a regular basis over long periods. And, in the next chapter, we will work with the idea that you are ready to invest. In the next chapter, let’s begin with some common- sense investment principles that can guide the MoneySense person.
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