This is the fourth installment in Pennywise's "Investing for Retirement" extravaganza, earlier installments of which may be read here, here, and here.
What differentiates saving and investing from speculation? That is a deceptively simple question, but one worth pondering, for comprehending the subtle differences between those terms—and the approaches to handling money that they represent—can help serve as a compass pointing the way toward a more sound financial future.
Saving. You can save money under the mattress, in a glass jar, or at the bank, but you are not really a saver unless your total income is greater than your household expenses. If you toss quarters in a piggy bank but rack up thousands of dollars in credit-card debt at the same time, then you're a spender. Savers retain more of their income than they spend.
We should all aspire to be savers. Saving pays off debt. Saving makes possible our future financial goals—including a satisfactory retirement. But saving is insufficient, taken on its own.
Take a responsible saver who has paid off all her debt and places her savings in certificates of deposit. She is doing better than putting money under her mattress; CDs pay interest—more interest than a savings account, in fact. But even CDs are unlikely to earn enough interest to beat inflation.
Historically, inflation is around 2 percent to 4 percent a year, and one-year CDs right now do not match that, let alone surpass it. If the CD earns 1 percent and inflation is 2 percent, the value of your money will erode, not multiply. Besides, having all of your savings in the U.S. dollar, even if the account is FDIC-insured, is risky. If the dollar devalues precipitously or inflation spikes, the purchasing power—or real value—of your savings will wither.
Speculation. Speculators are the opposite of savers. Instead of being cautious to a fault, they are excessive risk-takers. The speculator purchases something—say, gold—on the hope that it will keep going up, not because its current price is reasonable or because it represents a sound long-term investment.
Consider the buyers of third or fourth homes in 2005 and 2006. Many buyers did not examine whether the properties were actually worth the price being paid. Those buyers had no intention of living in the houses or renting them out, but imagined selling the properties at a profit as real estate kept booming. Instead, home prices fell.
A great deal of what goes on under the name of investing is speculation. Much of ordinary investor behavior—moving into various opportunities because they seem "hot"—is speculative.
Savers make the opposite error. They hesitate to put any money at risk because of the wreckage produced by speculative excesses. They remember 1929 forever and resolve never to invest in stocks, only in federally guaranteed bank accounts. That is extrapolation from limited data. The crash of 1929 meant that 1928 was a lousy time to invest, but 1932 was a superb time to buy stocks—if, brother, you could spare a dime.
Unbeknownst to themselves, savers are speculators. They are betting big on the American dollar. If they were to become investors by adding "riskier" asset classes to the mix, they would actually diminish their overall risk. Prudence should stop you from behaving irrationally, not from investing at all.
Investment. Ideally, at least, investing represents the sweet median. It combines return of principal (getting one's money back, the dominant concern of savers) with return on principal (the ostensible aim of speculators, whose greediness often produces loss instead).
To invest intelligently in our time is challenging. The market busts of the past decade have made us acutely aware of the perils of risk. How is one to invest rationally, given that the world economy itself has taken on a speculative, unstable character?
The traditional method of astute investors was to buy assets so cheap that you were unlikely to lose and almost sure to gain. Figuring out what was undervalued was never an easy science, but it could be done. A company's earnings helped one determine whether its stock price was cheap. So did its book value, or what it would be worth if sold off in pieces. But in the Enron era, can any earnings statement be taken at face value? How many of us are accountants competent to parse every line in a financial report?
Pennywise has written now, then, and again about how the world economy is profoundly imbalanced, precarious, scam-ridden, and unequal. Nostrums about efficient markets are pleasant fictions—and just that.
So what to do? Consider these three methods:
First, think long-term, not short-term. Don't buy anything because someone says it is going gangbusters or heading for the stratosphere. Ignore talk about where the market is heading in the next year or two. Nobody knows. Know this instead: Measured across decades, every single standard asset class rises.
Second, diversify. Buy the whole market. Invest in funds; stay away from securities of single companies. Hold a variety of asset classes: bonds, stocks (domestic and international), and cash. (There are other asset classes—we will examine them in coming months—but these are the essence.)
Third, invest primarily in index funds. Index funds match market returns rather than try to beat them. Index funds free you from speculation by proxy, the money manager's quixotic attempt—while charging you expensive fees—to beat the overall market consistently for years via serial short-term betting.
Above all, be a prudent investor. Save, but do not keep all your money in cash. Do not be a speculator, chasing after the best-performer du jour.
Those are your best defenses in an uncertain world.
Comments
1. lucapacioli - January 27, 2011 at 12:24 pm
An Accounting professor would remind the buyer of CDs that the interest earned is taxable, further reducing the real rate of return.
An Economics professor would point out that speculators are necessary for markets to function since they provide liquidity. "Speculation" comes from the Latin word, "speculare," to look ahead. Prof. Pennywise probably didn't buy Google on the IPO (apologies if you did). Those who did buy the IPO looked ahead to see that a universal search engine was the next step in the development of the internet; they provided capital for this risky speculation. Perhaps someone from the humanities or psychology can tell us the point where a speculation in retrospect actually was a shrewd investment.
A Finance professor would say that "chasing after the best-performer du jour" is excellent advice for a risk-averse investor. It also isn't speculation; this is called "momentum investing."
2. professorpennywise - January 27, 2011 at 03:01 pm
Actually, my guess is that the Accounting professsor would probably know that the interest on CDs is only taxable if you earn the interest in a taxable account; you can of course hold CDs in IRAs. (This is a column series on investing for retirement.)
As for "momentum investing," boy, I agree, it really sounds terrific! Until, that is, the momentum reverses course. No one -- not even an Economics or Finance professor with a Ph.D. -- can tell when that kind of thing will occur. A lot of people have a vested interest in making sure fools keep playing that fool's game, of course. They get downright irritable when someone calls it a fool's game or speculation. They suggest gentler terms, like..."momentum investing."
Of course, some Economics and Finance professors share Pennywise's basic line of thinking on this one. Pennywise was schooled at their feet. The truth is it's not credential or field but perspective that is really the issue here. Readers should view the film "Inside Job" before they feel inclined to see academic credentials in this arena as the basis for authoritative counsel.
For ordinary investors, which pretty much means anyone with a net worth under ten million, a strategy of diversified index fund holdings is far saner than trying to catch waves.
3. drj50 - January 28, 2011 at 09:55 am
re. "momentum investing"
By the time many (most?) folks spot the wave, the momentum has outrun the fundamentals and is only feeding on itself. That can't last forever. When it stops, many find that the momentum was peaking right about the time that they bought -- which means that the wave goes back out, taking much of their "investment" with it. "Past performance is no guarantee of future results" applies to momentum, too. Especially to momentum.
4. krmc5693 - January 30, 2011 at 01:58 pm
Fourth, cgeck your investments on up days only. Sure, at that time get a fix about how your funds are performing vs. their benchmarks, where your worth is headed, but it feels better to be greeted by green fonts than red.
5. tcli5026 - January 30, 2011 at 02:40 pm
I've been thinking long term. I have a mutual fund (started in 1996) that was once worth $50,000 (circa 2004) then went all the way down to $10,000 (around 2008). Now it's back to around $19,000. I am pretty sure my lowly CD has had a better return over the past 15 years.
I'm not really trying to contradict "Professor Pennywise" (I'm sure he's still right), but the old saw that long-term investing is always much better than "savings" isn't quite the maxim as it used to be.
6. professorpennywise - January 30, 2011 at 03:39 pm
You don't state the name of the fund, but I wonder if it was actively managed rather than an index fund. I wonder that because the S&P500 index has more than doubled from the beginning of 1996 until today, with a peak year of 2007 rather than 2004. Your disastrous loss of 62% off the peak value does not correspond to the S&P500, which is down now only 19% from its 2007 peak. So if your memory is accurate (behavioral finance people talk about how sometimes we imagine losses to have been greater than they really were--we take loss poorly), you were in an unusually bad fund that sounds like a poster boy for why indexing is superior. If you'd invested in $25,000 in a plain vanilla S&P500 index fund in 1996, it would now be more than $50,000, despite the two intervening crashes--an amount much greater than if one had left the money in CDs.
That said, some of one's money should definitely be in cash (such as CDs). Cash keeps us sane, for the reasons you are pointing to.
7. tcli5026 - January 31, 2011 at 12:12 pm
Actually, I have about half a dozen funds. The one I'm referring to is T. Rowe Price Science & Technology. It did spectacularly well for a number of years, then went into a tailspin. My other mutual funds didn't have quite the wild ride, but still have had relatively low returns averaged over the 15+ years I've held them. Since the mid-2000s, I've kept all my additional money in money market accounts and CDs. I was able to lock in some CD rates at 4% and 5% (in that brief period when interest rates were high), so at least a portion of my savings is earning above the inflation rate. Right now, I have about 80% of my money in savings/CDs and only 20% in mutual funds. (I also have a defined benefits retirement plan with California, which is based on the 2.5% @ 55 principle.)
Frankly, I know I should be investing more, but the volatility of the stock market has scared me off. The only consistent investing I do now is for my daughter's 529 (I use Fidelity).
8. professorpennywise - January 31, 2011 at 01:23 pm
I see. You may know this, but to explain, in case not, the T. Rowe Price Science & Technology is both actively managed and a sector fund. By actively managed I mean it doesn't follow a general index but relies on the stock picking prowess of the fund managers. Because of this active management it charges a fairly steep expense ratio (1%, more than ten times what an index fund like those offered by Vanguard, for example, charge, at .07% in some cases); they need to do this to pay for the research that goes into the stock picking and to pay for the commissions they incur when buying and selling their choices, etc. So this is by comparison a fund that costs you, reducing your returns. Plus you are tracking only one part of the market - tech - which peaked in 1999-2000, rather than the whole of the market. You essentially are betting that tech will outperform the rest of the market. You are also betting that a manager can pick stocks consistently that will do better than the market.
In coming columns I'll keep plumping for another strategy, which is just buying the whole market in cheap index funds. You can decide if it makes sense for you or not.
While 20% equities v 80% cash is a very low ratio at least you aren't all cash so you have some minimal diversification. It is all about what enables us to sleep at night. You might try putting new contributions into equities gradually and slowly to get more of a toe back in the market without making big moves that cause you unease.
9. rhysmckinnon - February 05, 2011 at 08:01 pm
I'm continuously upset that discussions of the risks of inflation never bother with the empirical evidence that inflation isn't really worth worrying about. Not only do incomes tend to rise *with* inflation (so, therefore, your investments/savings should rise proportionally with inflation) but the costs of the sorts of things central to daily living tend to decrease over time. I highly encourage readers to view Elizabeth Warren's talk "The Coming Collapse of the Middle Class." Inflation is not something worth worrying about. The risk premium offered by stocks is not high enough to justify the actual risk.