Economic recoveries and bull markets move slowly; recessions and downturns move fast. So, be prepared...
Do you think that once a recession looms on the horizon, you'll be able to make preparatory moves to sustain your financial investments and your portfolio? If so, you're probably wrong. You're taking on too much risk and not effectively managing the risk within your portfolio and your financial life if you naively think that pre-recession prep isn't necessary.
Recessions come too quickly for most people - it'll probably be the same for you
Too often, people fail to take prudent steps to prep for recessions, market corrections, or economic downturns - they think they'll see the signs close to it and will be able to make the needed financial adjustments. This is incredibly hard to do, however, and most people fail at it.
The main reason it's hard to do is that, unlike economic recoveries and expansions, recessions come quickly and don't tend to give warning signs until after things are already bad (so, they're not really warning signs in this case).
There's too much prep work to do pre-recession
There is too much to be done to prep for a recession, and there might not be enough time to do it if you wait for some sort of warning sign to begin. These things may include the following:
The above items are essential if you want to both protect your financial and non-financial worlds during a recession. It's also important if you're going to thrive post-recession because of recessions, market corrections, and economic downturns bring asset prices down. The smartest investors are those who are eagerly awaiting a recession with a list of quality firms and other assets to buy up at low prices.
It's hard to find great firms at any time
Generally, quality firms are those who have healthy balance sheets, strong and growing earnings, proper management, and are engaged in businesses that are not readily open to competitive entrants. This is an entire field of study, however, and there isn't enough room in a single article to even begin to delve into this topic.
1. Wealth allows you to obtain more comfort: Wealth and money allow you to have more things, better things, and get them faster. We all know that money doesn't buy happiness, but money can definitely buy you a lot of physical comfort(s).
2. Wealth allows you to make those you love comfortable: More important than making yourself comfortable, wealth allows you to improve the physical circumstances of those you love, whether that means helping your kids with a down payment, providing a good home for your family, taking care of your ailing parents, or giving a much-needed gift to a friend. Making the lives of those you love better is one of life's greatest joys.
3. Wealth allows you to affect the world: You can affect the world without having much wealth – some of the most influential people throughout history didn't have much in the way of resources, wealth, income, or power. But, having wealth does help make an impact on the world. If you've got a ton of money, you can help strangers by leaving large tips, or you can help college students by funding scholarships. With wealth, the options are almost endless.
4. Wealth allows you to demonstrate your value-creating abilities: If you're able to create value for other people, businesses, or organizations, you'll end up having money come your way most of the time. If you don't have any money, it's hard to argue that you've created a lot of value (of course, you could be a big spender). Real wealth, obtained in morally correct ways, is a big sign that you've done some things right.
5. Wealth opens up more opportunities for you: You surely don't need wealth to succeed, but having it helps a ton. If you have the money, a lot of doors open for you - they might be professional doors, they might be social doors, or they might be health-related doors. Wealthy people are able to utilize far more of this world's resources in getting the thigns they want:
Devastating portfolio declines and what it takes to recover from them – the math isn’t in your favor
Everyone thinks about gaining money when they invest, but too often we neglect how important it is to not lose money. Not losing money is so important, in fact, that one of the greatest financial investors in history (and very likely the greatest one alive today) espouses the following as his Rule No 1:
Don’t lose money.
What’s Rule No 2?
Remember Rule No 1.
Rule No 2 is obviously meant to be a little humorous, but Buffet is a serious man when it comes to investing and his rules are meant to illustrate a fundamental truth about investing – that truth is that it’s very hard to recover from a loss and that it gets harder and harder the deeper the loss.
This is all best illustrated with examples. Sometimes, a good set of examples can do more for contributing to understanding than pages and pages of text. So, let’s go over three examples, each with increasing levels of severity of initial losses.
In each example, we’ll break things down into 3 time periods – Time 0, Time 1, and Time 2:
A 25% Loss – Somewhat severe, but recoverable
With a 25%loss, your $1000 declines to $750 – this represents a one-quarter decline in your portfolio and would obviously be an unwelcome occurrence. Now, let’s take a look at what sort of returns you’ll need to recover by Time 2; let’s see what sort of returns in the subsequent time period you’ll need to make you whole again.
As you can see from the table, a 33.33% gain is required in order for you to recover and get back to the initial $1000. A 10% return, 20% return, or even a strong 30%return in one time period simply won’t do it.
That means if each time period is 1 year, even a 30% return in the year subsequent to your 25% loss won’t be enough. 30% is a solid return. The fact that it’s not enough should be the first hint that getting back to whole is a lot harder than dropping, from a mathematical/percentage perspective. It’s only going to get worse.
A 50% Loss – Very severe, but you can recover if you stay prudent over the long term
With a 50% loss, it’s a lot harder to recover. Now, it takes a 100% gain (doubling your post-loss portfolio value) to get back to whole again. If you halve your portfolio, you’ll need to double it to bring it back to its original value.
So, if a time period is one year, you’ll need to double your post-loss portfolio value to get back to your Time 0 initial value. That’s very hard. You’d be far better off having avoided such a decline because it’ll be an uphill climb getting back to baseline again. This is what Warren Buffet’s Rule No 1 points to.
A drop of 50% in your portfolio value is very severe and detrimental to your long term investing goals. It will take a 100% increase -- doubling your portfolio -- to recover from a 50% loss. This is tough, but it's doable - it might not happen in a single time period but over time a prudent and disciplined investor stands a chance at recovery.
A 75% Loss – A devastating blow to a portfolio that will take some time to recover from
With a 75%, things get really bad. Now, in order to get back to whole, you’ll need a 300% gain. A 300% gain is the same as quadrupling your money (4x return). As any investor knows, a 300% return is very hard to get – it usually takes years to achieve such returns in a well-diversified portfolio.
Let’s think about this some more. As we keep increasing out Time 1 losses by 25% increments, the return needed to get back to whole by Time 2 goes up by way more than 25%. This is based on the underlying mathematics of portfolio returns, but we don’t need to get deep into that here. The above examples should clearly show how each time the loss gets more severe, the needed gain to get back to baseline gets more and more astounding.
If you lose 75% of your portfolio’s value in a single year due to a very severe recession or, far worse, due to investing blunders, you’re going to have to make some incredible returns (300%) to recover. What makes you think you’ll beable to do that? It’ll likely take a number of years and some serious investing discipline to be able to recover in this way.
A 75% portfolio decline is devastating to any portfolio. It will take a 300% return (quadrupling your money; a 4x return) to get back to whole again. This is very hard to do in a single time period. It might take years of prudent and disciplined long term investing to recover. This demonstrates why large portfolio declines are so detrimental and should be avoided.
A bit more mathematical, for the mathematically inclined
For those that are more mathematically inclined, let’s dig a bit deeper into the portfolio maths.
Let’s assume an initial portfolio value of a – this is your Time 0 value
For any portfolio change (decline or increase) d, where is greater than -1 but less than 1, the portfolio value in the immediately subsequent period (Time 1) will be a x (1 + d)
To get back to the initial portfolio value by Time 2, we’ll need to do something to the Time 1 value to get it back to a (which we stated above was our initial value)
We can simply divide the Time 1 value by (1 + d) to get back to a – that’s [a x (1 + d)]/(1 + d)
Dividing by (1 + d) is the same as multiplying by 1/(1 + d) – that’s the amount, no matter what our initial a is and what the change d ends up being, that we have to multiply the Time 1 portfolio value by
Now, notice that if d is less than 0, 1/(1 + d) will be larger than 1. So, if d is -0.25 (corresponding to a 25% decline in our first example above), then 1/(1 + d) is 1/(1 – 0.25) which is 1/0.75. What’s 1/0.75? It’s 1.3333. That means you’ll need 1.3333 times the Time 1 value – this exactly represents an aprox 33% increase.
Let’s do a 75% decline as in the third example above – now 1/(1 + d) is 1/0.25. That’s equal to 4, which represents a 300% increase over the Time 1 value.
We can see that as d approaches -1 (moving towards a total loss), 1/(1 + d) gets bigger, but by a disproportionate amount.
Can we derive a simple way to see how our 1/(1 + d) factor changes with changes in d? Yes – it’s easy using Calculus:
d/dx[1/(1 + d)] = d/dx[(1 + d)^-1] = [-(1 + d)^-2] x d/dx(1 + d) = [-(1 + d)^-2] x (0 + 1)
so, the derivative is -1/(1 + d)^2
Calculus can be applied to lots of situations to better understand how things change. F
We can see that by squaring the (1 + d) term, we’re increasing the effects of both positive and negative portfolio changes. If d < 0, then squaring (1 + d), which will be less than 1, will only make the factor smaller. By making that factor smaller, the entire factor gets bigger because dividing 1 by smaller and smaller numbers makes the result bigger and bigger.
This should be very discouraging – the numbers tell us that negative effects are magnified when we think about the returns needed to recover.
In Antiquity, Family and Community Provided a Safety Net in Retirement
Throughout most of human history, the idea of retirement as we know it today didn't exist. People simply worked their entire lives either hunting and gather or farming (after the Agricultural Revolution) -- if they were lucky enough to survive into adulthood -- and when they were too old to work, they relied on their families to take care of them. An old person might rely on younger siblings, children, and nieces and nephews within the family or community to take care of them. While doing this they probably still had to do some work - the idea of not working at all is a deeply modern notion and even very old people in ancient times still likely cared for children, did chores around the house, and performed other familial duties (eg. arranging marriages, representing the family to other communities, and advising younger family members).
Although life was incredibly harsh with humans having to face both natural disasters and man-made dangers in the form of banditry, war, pillaging, or abandonment, most human societies operated in a way where the elders and those who were unable to work were taken care of by family. As time moved forward and as humans settle down this was more and more true - while a hunter-gatherer tribe might leave an old person to die, a farming community would likely be able to provide for the elderly because life was calmer and a bit more stable in terms of movement and physical danger.
Obviously, no one in their right mind living in the first-world should want to go back to a hunting and gathering lifestyle and especially a farming lifestyle (as farming was likely worse than hunting and gathering for overall human well-being). However, we can't deny that the family bonds that existed in the past that effectively created an organic safety net for the elderly no longer exists today.
Safety Nets Such as Welfare Provide Retirement Security in a Changed World
As the world moved forward modernized, nations around the world began creating public, centralized welfare systems to take care of those who were too old to work and had to enter a stage of retirement or diminished income-earning capability. In the United States, during Roosevelt's New Deal during the Great Depression, the Social Security system was created - this was a system where old people who were no longer working could receive income from the government (meaning from those who were earning income). In effect, this wealth-transfer mechanism sought to replace the old traditional familial and community retirement safety nets that had long since been eroded over the centuries following the Industrial Revolution.
It is difficult to argue that a safety net for old people who can no longer produce income through their labor and who don't have a large enough retirement nest egg to live on is a prudent idea - it is deeply natural to humanity to take care of one another. The difference is that instead of taking care of each other locally, we started taking care of each other on a grand national scale. This creates its own problems and perverse incentives, but it fundamentally is in line with our human nature. If done in a prudent and conservative way (something that is far from guaranteed), such a retirement safety net can at once benefit the economy through stabilizing things and benefit society through creating a better and healthier moral landscape by taking care of retirees.
Retirement Saftey Nets in Jeopardy - Self-reliance is Key
However, today the Social Security system -- a system that hasn't even been around for a century -- seems to be in jeopardy (it is projected that in 2037 Social Security trust fund reserves will be exhausted and where 100% of payments will no longer be able to be made). A system designed at a time where there were few retirees living into their 60s and 70s compared to the working population is under stress in the world where Baby Boomers are aging rapidly with access to world-class health care that will allow them to live into their 80s and 90s reliably and in good numbers. Many believe this system will not be able to sustain itself. This will be further exacerbated if unemployment increases over the coming decades due tot he rise of artificial intelligence. Young people today should not rely on Social Security to be around when they are old and gray - that is now a foolish proposition.
For young people today, the idea of retirement is different than for almost all past generations. For the first time in history, neither (1) the familial/community structure that effectively provided retirement benefits for the old nor (2) the retirement benefits provided by welfare systems like Social Security is likely to be around when today's young men and women reach retirement age.
So, we're now in a world where the old family and community structure have long since been almost totally wiped out and where the retirement safety net that came in to replace that old structure is itself in peril. We are facing a troubling and dark world when it comes to retirement - we have neither one nor the other, we only have ourselves at this point. Although a fix might occur and things might turn out well, in the end, any prudent person who is under the age of 40 should discount Social Security and only rely on himself/herself to provide in old age and retirement. This requires changes - it requires a discipline that might not have existed in the last century for most of the population in term of saving. Young people must be diligent and disciplined savers and investors if they are going to be able to amass a nest egg large enough to support them through what could be decades of retirement.
This means that saving 5% or 6% in your 401k to get your employer match, putting $5000 a year into an Investment Retirement Account (IRA), or simply having a nice cash cushion in the bank is not even close to enough. Saving rates must far exceed 10% and should approach 25% if young people today are going to be able to comfortably retire. Additionally, effort and energy must be put in to invest the savings in a smart way - saving cash will not be sufficient as growth is going to be needed over time in order to build up a nest egg.
Although a tax return means you've given Uncle Sam an interest-free loan over the course of the year -- something that probably isn't the best thing to do if you're a mature adult who knows how to handle money -- it can be a financial boost for many individuals and family in the early part of the year. In a sense, you've been forced to save over the year (you can think of it as forced savings account) and now you are to decide what to do with that savings.
Don't make the mistake of thinking that your tax refund is some sort of windfall or a gift from the government or some sort of unexpected gift that you didn't earn - your tax refund is literally your own hard-earned money that you've been forced to pay the government over the course of the year. Keeping this in mind, you should treat your tax refund like you should treat all of your money: with care, planning, and prudence. Below are a few key things you can do with your tax refund to improve your financial situation and add a bit of financial peace to your life.
1. Start or Increase Your Emergency Fund
This is No 1 on our list of things to do with your tax return because for most people a strong emergency fund is the single best first step then can take to securing a better financial life.
Those that have some sort of guaranteed income might not need a rainy day fund as much as everyone else because there is far less volatility in their monthly income - for the rest of the world an emergency fund stands in between you (and your family) and financial disaster, stress, and worry should something unpleasant happen (and in this life, something unpleasant usually does happen every once in a while).
Getting your emergency fund to a solid level (typically 3 to 6 months of living expenses) is usually even more important than paying back even high-interest debt. A person with a large amount of credit card debt and nothing in the bank at all clearly is exposed to a lot of suffering if he/she loses their source of income or if an unexpected event or emergency comes up. Of course paying down the debt is very important, but without an emergency fund, there is too much exposure to even the slightest financial emergency.
Without any money, a job loss, a flat tire, a leaky roof, prolonged sickness or any other of the many things that can go wrong, will lead to a lot of pain in your life. Having even $1000 in the bank will help shield you and having a full 3 to 6 months of living expenses in the bank will give you a very pleasant calm in knowing that you've got enough stashed away to make it through most financial emergencies.
If you don't have an emergency fund, a tax refund can be used to start one at your local bank - better yet putting that money into an online savings account where it's a bit harder to reach might be a better option.
2. Pay Down High-Interest Debt
If you already have a proper emergency fund in place, the next best thing to do with your tax refund is to pay down high-interest debt. Such high-interest debt can be credit cards, personal loans, consumer lines of credit, and car loans, etc. These all qualify as bad debt in most cases - things like student loans, mortgages, and business loans (although clearly undesirable) are better because they generally carry a lower interest rate (because they are backed by either tangible assets or are not-bankruptable) and are generally taken out for thins that increase in value over time. Paying down high-interest debt will save you money on interest, will strengthen your overall financial position, and will bring some peace into your financial life.
There are two options when paying down credit card debt:
Generally, either of the above will work and actually pay down debt aggressively is more important than which of the above methods you choose. However, you can decide how to approach paying down your debts based on your own understanding of your personality - if you're the kind of person that might need a momentum boost by seeing a credit card fully paid off, then maybe focusing on the smallest balance is better for you even though it's not the best approach from a purely mathematical standpoint.
3. Take Advantage of a Bank Bonus Offer
If you've already got your debt situation under control (meaning you don't have credit card debt or other high-interest debt as described above), then you might consider using your tax refund to get even more money via a bank offer where you get a bonus for opening up a savings account.
Online banks such as Capital One 360 and even brick-and-mortar banks such as Chase often offer bonuses for opening up a new savings account. The general gist of it is that if you deposit a certain amount of new money (eg. $10,000), you get a bonus.
One offer online was for a $200 bonus for a $10,000 deposit - this equates to an almost immediate guaranteed return of 2%. To get 2% in the markets you would have to expose your money to a bit of risk. To get 2% in a guaranteed way (like you're getting with this bonus) you would likely have to lock away your money (circa 2017) for a period of at least a couple of years. Clearly, an almost immediate 2% gain is quite lucrative a low-interest rate environment and taking advantage of such an offer could give you extra boos on top of your tax refund.
4. Open an IRA
If you don't have an Investment Retirement Account (IRA) or if you're not currently contributing the maximum amount allowed, opening an IRA could be a useful way to store your tax refund and it can help lower your tax burden next year (as long as your income during the year in which you're putting the money into the IRA at least is as much as your putting in). You might want to speak to your tax professional about the best way to approach it and if this is really a good idea for you, but for most people, an IRA can help lower taxable income and, thereby, lower the overall tax burden for next year.
5. Start a College Fund for Your Children
If your financial house is in good shape, it might be time to start thinking about college for your kids (or their financial future in general). Whether college is a few years away or whether you have a newborn, saving for college is always a prudent idea and it will greatly benefit both you and your children.
A good idea is to save the money in a place where it can be used for non-college expenses. The world is rapidly changing and if your child is very young, it is not easy to predict what the academic or occupational landscape will be like in 15 years - college might be drastically different and so might college expense. Therefore, it is prudent to save in a place where your hands won't be tied in terms of how to use the money and where you won't have severe penalties if you or your child chooses to use the money for non-academic expenses (eg. starting a business, paying for a wedding, buy a house, or whatever other hopefully useful endeavor he or she chooses to embark on).
1. You're too little risk in your portfolio, so you're going to have a very hard time beating the market
Proper finance goes far beyond the cliche risk vs. reward thinking, but there is some truth in that oversimplistic expression of financial theory - you must expose yourself to at least some risk in order to obtain returns. A portfolio that is without any risk will only earn the risk-free rate. Portfolios that aren't exposed to less risk than other, all else equal, will generally earn less than more risky portfolio.
Obviously, prudence would dictate that the proper amount of risk be taken, proper risk mitigation tactics should be used, and preferably deep value investments will be made in order to create extremely low-risk higher return investments. However, shying away from any risk or taking too little risk will usually lead to subpar returns.
Investors should examine things such as the following in order to better understand their risk tolerance:
This means that a single 30 years old earning $100,000 a year with a healthy emergency fund is likely not exposing himself or herself to enough risk if they have the vast majority of their money in CDs. They would do themselves a big service by prudently moving some money into the stock market so that far higher returns over the long run can be gained. Such a move could move the return of the portfolio from 2% to 8% - a difference that will likely mean millions of extra dollars over the course of a full investing life.
2. You are churning your portfolio too much - excessive trades lead to poor investing outcomes
Too many investors buy and sell and buy and sell and buy and sell. They spend ridiculous amounts of mental energy, precious time, and precious money on trading fees attempting to:
Churning your portfolio will cause damage for the following reasons:
You're not a hedge fund or a trader. You don't have a supercomputer sitting near Wall St. You don't have PhDs working for you. Play the game where you have an advantage, not the game where you are deeply handicapped. Buying calmly and sitting is usually better than heavy coughing for most investors.
3. You're trying to pick stocks, BUT you're a terrible stock picker
Top investors such as Warren Buffet and Monish Pabrai can pick stocks - they have a true talent for it and they spend their lives doing it. What makes you think you can compete with them? Would you enter an Olympic swimming competition just because you enjoy taking laps at the local YMCA? No - that would be ridiculous. So, why do you think that you are capable of picking stocks when the cards are deeply stacked against you?
Of course, some small time investors are great at picking stocks. They are talented and lucky. If this is you, you don't really need this advice. But if you keep putting in time and energy tiring to pick the next five bagger or ten bagger only to see your portfolio trail indexes such as the Dow Jones or the S&P 500, you must ask yourself why you are wasting so much time. Why not just sit back, buy the index, and relax?
Take a hard look at your portfolio if you're in this camp and be honest with yourself. You can leave a bit of play money to mess around with, but the majority of your money might be better off in excellent mutual funds and ETFs that track both US and global indexes. These mutual funds and ETFs can be matched to your risk tolerance and time horizon and they offer market returns at almost no effort to the investor.
Rates of return play a tremendous role in investing performance - without adequate returns, it's difficult to build real wealth
A fundamental principle of investing is that rates of return are key - but most people don't really understand their profound importance. Of course, most savers and investors know that the rate of interest they get on their savings or the rate of return they get on their investments matters a lot, but they are too easily willing to give up valuable return to things such as the below.
The common thieves of investing returns
The common thieves of peoples' investing returns have proven to typically be the following:
It's important to note that not all of the above fees are bad - you're paying these for a reason. For example, you want the mutual fund to hire a good money manager - this person will need to be compensated well. You clearly understand that administrative fees are going to exist for mutual funds and ETFs. Trading fees obviously are required so that the brokerage is paid for the service they provide you - this is a small price to pay for being able to enter and exit positions with ease.
However, you still don't want to overpay. You will not want your mutual fund or ETF to spend excessively on hiring poor-performing managers, spring money on lots of useless advertising, or running thing so inefficiently that the administrative fees are too high relative to similar funds. You'll obviously want to shop around to find a reputable and high-quality broker, but not one that charges excessive fees relative to what's available on the market. You'll also want to be disciplined and not constantly enter or exit positions so you don't accumulate excessive trading fees that will eat away at your capital. Common sense will dictate that even if the fees are reasonable in principle, they could be unreasonable in practice (meaning in amount).
To illustrate this point well, let's use an example. Examples are often an excellent way to illustrate importance finance principles in ways that are easy to understand - a theory is good but seeing numbers and graphs often allows people to really visualize the concepts being presented and gives the motivation to use the new knowledge they gained.
Investing $10k at different rates of a return - a simple example
Let's start with $10,000 in our example and let's invest that money at different rates of return - the return rates will be from 0% to 8% in intervals of 2%. First, we'll break down the possible rates and understand where you might obtain them:
Now, let's see how $10,000 will grow at each of the above rates of return by taking a look at the graph below. From looking at the graph we can see that the 0% return stays constant throughout with all of the non-zero returns separating from it more and more over time. We can also see that each 2% increase does not bring a proportional increase in the final amount - the increase itself increases over time.
The 8% portfolio brings the initial $10,000 to almost $500,000 but the 6% doesn't even reach $200,000. We can say how important even a small increase in return can make over the long term. That 2% difference is sadly something too many investors ignore. It makes sense given the human mind's propensities that a person wouldn't be able to totally and intuitively grasp the importance of even a 0.25% difference in return, but through education, we can see that the small differences end up with very big differences in results.
How can a 2% difference result in a greater than 50% difference in the final portfolio value? This doesn't seem to make too much sense at first glances - the 2% difference is only 1/4 of 8%, so shouldn't it result in a 25% difference? The maths of finance don't work this way - this is an incorrect way of thinking through it. The way it works is that the 2% you forgot on the first year doesn't stop there - that 2% you would have gained is no longer able to be around in the second year to earn additional return. For example, by forgoing 2% on the $10,000 investment, you forgo $200 in your first year, BUT it doesn't end there - in the second year that $200 would have been working for you t earn a return. The same is true in the third year, the fourth year, and so on. In effect, the person who invests at 8% is able to not only bring along that extra amount every year but to also keep that amount invested and earning. In effect, changes in investment returns compound over time. This is the underlying principal as to why small differences in return can have tremendous impacts in final portfolio value.
We aren't going deep into the maths here, but you can reference a 2013 article titled "The Arithmetic of Investment Expenses" by William F. Sharpe. The article is accessible to most readers and the title should give you a hint at the complexity of the maths - it's not very complex to calculate nad understand the impact of fees on final returns.
Next, we'll present another graph - this time with the same $10,000 initial investment but now we'll look at a broader spectrum of return rates (0% to 18%).
As we did above, let's take a look at how each of the additional returns can be achieved:
As you can see from the graph, the initial investment returns we plotted on the first graph are made to look minuscule here. Although most investors shouldn't expect to obtain returns over 14% over the long term, this graph clearly represents how important every percentage point is to the final portfolio value.
Benjamin and Gerald - How final rates of return end up mattering a lot in the long run
Finally, to really bring this home, let's go over one more example - this time let's look at two men. One is Benjamin and one is Gerald. Both Benjamin and Gerald invest $10,000 on the birth of their first child - this could be a college fund or a sort of "start of life" fund so that their progeny is financially stable. Clearly, both Benjamin and Gerald are intelligent, prudent, and caring individuals and parents - most people don't do such things. Another thing that's clear is that their children are quite lucky - they have dad's who care enough to put away some money for them at their birth. Both Benjamin and Gerald have $10,000 ready for this investment - they are quite similar in this and many respects. But, let's now see how they're different?
The strange thing is that Benjamin and Gerald are far more similar than different - in the thing that matter (caring, prudence, planning ahead, etc.), they are clearly quite similar. Their differences, as we'll see shortly, will be quite small and trivial if it wasn't for the outcome those differences would lead to.
Benjamin takes his $10,000 and invests it in a fund over the course of one year in a series of 24 purchases, once every month. He shops around for a good brokerage - the makes sure they're reputable and reliable but keeps an eye on trade pricing too. Benjamin chooses a long-term growth fund but looks at expense ratios, loads, and the quality of management in order to make sure that he's choosing the best fund for his strategy.
Gerald takes his $10,000 and invests it in 60 purchases because he is attempting to time the market. Gerald doesn't shop around for a brokerage and chooses the first one he finds. Gerald doesn't shop around for a fund, but instead takes a recommendation from his friend or family member - this fund has the same strategy as Benjamin's fund but isn't managed as well, has a load, and has a higher expense ratio.
Both Benjamin and Gerald leave the money in their account after the first year and never touch it again - they pass it down to their children who also are wise enough to leave it alone and let it grow.
Take a look at the tables above to see the actual numbers Benjamin and Gerald are dealing with. In effect, Benjamin and Gerald end up with different starting amounts and different return rates (9.75% vs. 7.25%) due to their different choices. These small differences made in the first year have tremendous impacts on the final portfolio values after 50 years. While Benjamin's portfolio is valued at over $1 million in 50 years, Gerald's is valued at only a bit above $300,000 - this is approximately a 70% difference. This 70% was a result of about a $600 difference in initial investment and a 2.5% difference in return. Most people would probably ignore these differences, but they are clearly extremely important.
If you're interested in further reading, below is a paper titled "The Arithmetic of Investment Expenses" by William F. Sharpe - a paper published by the same William Sharpe who created the famous Sharpe Ratio on how fees and expenses can impact the terminal value of a portfolio.
Investing vs. Speculating: Understand the difference so that you aren't taking needless and fruitless risks with your financial portfolio
What is investing? An attempt at a definitive definition.
Here's our definition for what investing is:
Investing, in the financial sense of the word, is the deployment of capital (usually money) into the purchase of shares, purchase of assets, development of commercial ventures, or other financial schemes in order to obtain a return on that deployed capital with a reasonable expectation (grounded in some sort of reasonable analysis) that the risk-adjusted or expected return is positive.
That's a long and somewhat fluffy definition, but any definition that would cover the broad range of activities that could properly be classified as investing will be somewhat fluffy. Let's break down the main elements of that definition and discuss them briefly.
...the deployment of capital...
This means you use some sort of capital (usually money) to invest. Without using or committing capital, you're not really investing. You can invest your time and energy into things, but that wouldn't qualify as financial investing. You must deploy capital in some way for your activity to properly be called investing in the financial sense of the word.
...or other financial schemes...
Investing requires the deployment of capital in a specific way. It requires that the capital be used to either purchase shares of a firm (the firm can be publicly traded or privately held), purchase assets (purchasing gold, Bitcoin, fine rugs, or fine art might qualify as asset purchases), develop commercial ventures (start a business or develop a new office building), or to pursue some other type of financial scheme. It's not easy to make an exhaustive list of the other possible financial schemes because there are many possibilities. For example, a properly documented and agreed upon private loan to an acquaintance can qualify as an investment. The purchase of various derivatives products might qualify as an investment as well. Even the purchase of rare grapes for the purpose of creating a unique wine could qualify as an investment. It's impossible to describe every possibility here, of course, but this should give you a general understanding of what I mean by a financial scheme.
...in order to obtain a return...
Investing requires that the deployment of the funds is done to obtain some financial return. If no return is expected or desired, then the deployment of capital is more like a donation or a purchase depending on the circumstances. Financial investing requires that it is done for the purposes of growing your capital base by receiving a return on the invested funds.
Investing requires that we are reasonable in our expectations of the financial return from our endeavor. If we are unreasonable or foolish, it's not investing in my opinion. A reasonable person using reasonable analysis techniques (they don't have to be complicated, just sound and reasonable) should be able to agree that a positive return is possible. This means that if unfounded, biased, or inappropriate techniques of analysis are used in order to determine what the potential return is (either expected return), it is not investing in the proper sense of the word. For example, using deeply incorrect assumptions that you know don't make sense to calculate your expected return wouldn't hold up to this standard. You wouldn't be investing here, but would instead be fooling yourself and possibly speculating. Additionally, not dong any analysis whatsoever before deploying capital would preclude the activity from being called investing. The analysis doesn't have to be complicated (although deeper analysis is likely better), but some sort of thought must be given to what is occurring if we are to call the activity investing.
...that the risk-adjusted or expected return is positive.
This point speaks to how we calculate the return. We state that the return has to be positive, but we need to know how to calculate the return. In calculating the possible return, a more sophisticated investor should adjust for risk, calculating what is called the risk-adjusted return or the expected return (these two names can generally be used interchangeably in a non-academic or unsophisticated setting). There are complicated mathematical formulae for calculating risk-adjusted numbers, but what is meant here is something more basic: the return you expect to get should from your investment should be the adjusted for risk, with less probable outcomes discounted more intensely. In other words, the return can be thought of as a weighted average of the possible returns, each return weighted by its probability of occurrence. Going further, this means that investing requires that the expected return is positive. That expected return might never occur, but at the outset (when we deploy the capital) the expected return should be positive. No rational individual would deploy capital into a financial scheme that has a negative expected return.
Speculation isn't investing; neither is work or saving!
Investing, in the financial sense of the word, can be distinguished from other uses of capital or energy. Investing is not:
Keep the definition of investing in mind to avoid foolish speculative bets or to confuse saving with investing
In conclusion, we see that investing is a specific type of deployment of capital and is distinguished from work, saving, and speculation. Keeping the definition of investing in mind could help us differentiate between investing and speculation by applying the definition in a disciplined way before we deploy our capital. Investing is a fundamental part of individual wealth-building and it allows for a society to grow and prosper, but it should be done wisely and carefully so as to make sure that foolish bets are not being taken.
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledger technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).