You probably already know how important it is to invest. But this overview guide explains why investing is so important for you in ways you may not have considered. This will help you understand inflation and risk in way you can put to use and improve your life. It will also help you differentiate between the variety of buckets of money you need to have and how best to invest each one. Finally, by having clearly defined investment buckets, it makes it easier to invest each bucket appropriately.
What is investing?
When you put money into the bank, buy bonds, stocks, mutual funds, ETFs, real estate a business, gold, art, antiques etc. with the goal of getting your money back plus earning a profit or interest, that’s investing.
Why do people invest? Everyone has their own reasons. But mostly people invest because they want their money to grow in order to help them achieve their financial goals both long and short term. When people are successful growing their money, they enjoy the benefit of having their money work for them instead of them having to work for their money. Let’s look at this a little closer.
Let’s say you invest $10,000 every year for 20 years. If the money earned nothing, it would grow to only $200,000 ($10,000 x 20 years). But if the money earns 5%, the account value actually grows to almost $350,000. Impressive, right? You have almost twice as much and you didn’t have to lift a finger. That’s the power of compound interest and time and I’ll explain that in detail shortly.
The point is, you now have $350,000 because you invested $10,000 every year for 20 years and earned 5% on the money. Had you invested the money without earning a return, you’d have $200,000 after 20 years as I said. And if you spent that $10,000 every year instead of investing it, you’d have nothing. Simple stuff – but if you put that idea to work, it will change your life.
Inflation – Another Reason People Invest
We invest in order to have a better future. But the reality is, we also have to invest just to maintain the purchasing power of our money. In other words, your money has to grow at least as fast as prices go up every year or you will fall behind.
Think about it; $5000 today buys a lot more than it will 20 years from now. That’s because of inflation. In fact, at nominal inflation rates (2.9%) your $5000 will only buy $2822 worth of goods and services 20 years from now. So just to stay even you have to grow your money over time. If you don’t you will be forced to tighten your belt more and more as the years go by.
Let’s look at this a different way.
Assume it generally costs you $5000 a month to live now. That includes housing, food, gas, utilities – everything. A year comes and goes and you realize you still have the same lifestyle but now it costs you about $5200 a month – a $200 a month increase. Food, cable, utilities, gas has all gone up a little in price. That $200 increase is inflation. Your cost of living went up without your standard of living changing.
In any one year, you may not feel it, but over many years this can be a huge problem. Let’s go back to our example above.
Let’s say inflation averages 4%. So, if you spend $5000 a month to live now, it will cost you $5200 a month to live exactly the same way next year. And if your income doesn’t go up, that means you’ll have to get by with less. Cutting back by $200 a month may not be that difficult, but what happens in 5 years?
What costs you $5,000 today will cost you over $6000 a month in 5 years with a mere 4% inflation. If you don’t grow your income you’ll have to cut back about 20% of your lifestyle. Ugly.
In 10 years, it will cost you $7500 a month to live and in 20 years it will be just shy of $11,000. That’s why it’s important to grow your money and your income to at least keep up with inflation. In this example, if your income stays constant, in 20 years, your income will still be $5,000 per month but you’ll have less than half of what you need to maintain your current life style. That is unacceptable and it’s the central reason why I’ve written these series of guides. To help you overcome these problems.
How is inflation measured?
In the United States, inflation is represented by changes in the Consumer Price Index (CPI). The Bureau of Labor Statistics (BLS) is the government agency responsible for collecting this data. What they do is measure the changes in prices that urban consumers pay for a market basket of consumer goods and services over a period of time.
7000 consumers take part in surveys put out by the BLS and they come from all walks of life; rich, poor, employed, unemployed and they live all around the country. The survey tracks money spent on housing, food, entertainment, travel, health care, clothing etc.
CPI vs Your Personal Inflation Number
Depending on where you and how you live, your personal inflation might be different from the government’s number. For example, if you already own your home, housing price increases don’t matter to you. But if you need expensive medicine that keeps costing more and more, that is a big part of your personal inflation rate. So your inflation rate might be higher or lower than the CPI.
And guess what? Your personal inflation rate is much more important than the government’s data because that’s the world you have to survive in. The bottom line is, inflation is a part of your life no matter what.
What Causes Inflation?
There are two main causes of inflation; demand and supply. When consumers start buying more and more goods and services, prices go up unless there is an increase in supply. Here’s why that happens. Let’s say you own a cell phone company and everyone is going berserk for your newest product. You can’t make enough of them to satisfy all your customers. Your factories are already working at full capacity and there is just no way to get more phones on the shelves.
You say to yourself – “Hey, I can raise prices and still sell all my phones. Let’s do it!” and that’s what happens. When people are willing to spend more and more in order to get “stuff”, inflation is the result.
Across the broad economy when consumers have more money in their pockets (due to pay increases at work, tax rebates or other causes) they tend to spend more. And when hundreds of millions of people start spending more, even if it’s just a little more, it sends a signal to businesses that they can charge more and still sell their wares. That’s because demand outstrips supply.
Another cause of inflation is costs. Let’s look at oil to illustrate how this works. Let’s say the cost of oil doubles in price from $50 a barrel to $100 a barrel. That means it’s going to cost you more to drive to work and to go on vacation because of that increase. But it doesn’t stop there. It’s also going to cost the airlines more to fly you from Los Angeles to New York because their fuel costs are rising. It’s also going to cost your food store more money to ship in the groceries you want to buy.
Transportation costs are an important part of almost every business in the United States so when oil prices go up it usually means the cost of doing business goes up along with it. In most cases, businesses pass those costs along to consumers and that translates into inflation.
Is inflation good?
Inflation is both good and bad. If inflation is extreme, prices rise very quickly to the point where consumers can’t afford to buy what they want or need. When they stop buying because things are too expensive, businesses lay off workers since they don’t need to produce as much. This often leads to a slowdown in the economy, higher unemployment, lower stock and real estate prices and a possible recession.
But think about moderate inflation because it can be a good thing. In that situation, prices rise moderately. People are generally optimistic because they are making more money and it is relatively easy to find work. And when prices are generally rising consumers have an incentive to buy now (before prices go up any further) so demand keeps climbing. That in turn helps business make more profits and expand, hire more people and provide pay increases.
Inflation is also a great help to people who have mortgages or other debts. That’s because they pay back loans with dollars that are easier to come by and worth less than the dollars they borrowed.
Historical Inflation Rates
If you are planning out your finances, it’s important to have an accurate perception about inflation. Here is a graph that depicts inflation rates as measured by changes in the Consumer Price Index (CPI) since 1956.
You can see that the rate jumps all over the place. There were periods of very high inflation (in the late 60’s, mid 70’s and late 70’s) and other periods when inflation was rather tame. But let’s try to get a different perspective by looking at the data decade by decade:
Here we can see that inflation has been sloping down since the 70’s and the average long-term rate is 3.22% per year. (To be conservative, that is the benchmark that you might want to use when comparing investments going forward. ) This doesn’t mean inflation will continue slowing down. We’ve seen periods when inflation heats up just as well and that could very well happen.
Inflation and Other Risks
Inflation is one risk that all investors face. If you ignore the risk of inflation, you may not achieve your financial goals. In fact, you could go broke in retirement if you don’t pay attention to this as I explained above. But inflation isn’t the only risk we have to deal with.
There is also the risk of permanently losing your money as a result of making bad investments. So loss of buying power (inflation) and loss of capital (investment risk) are two major challenges investors have to deal with.
People use different investments to combat these distinct problems. As you’ll see as we go through the guides in this section together, some investments might be good at dealing with one of these risks. But none are good at solving both of these problems – at least over the short-term. Ultimately, that means good investors have to learn to compromise.
Before we talk about that compromise, let’s look further at investment risk.
Risk To Your Capital
Investment risk is the chance you take of getting back less money than you put into an investment. If you could avoid taking this risk, you probably would. But in order to build your wealth and beat back inflation over the long term, you’ll probably need to take some short-term risk along the way. The question is, how much is enough investment risk? How much is too much?
To begin answering these questions, we have to consider the conflict between your financial and emotional needs.
On the one hand, you want to grow your money as quickly as possible because that could help you achieve your goals faster. But the greater potential for gain, the greater the potential for loss as well. That’s a pain everyone wants to avoid.
So, you have a financial need (to grow your capital) which conflicts with your emotional need (not to worry about your money or financial future). Now it’s time to take a closer look at the compromise I spoke about earlier.
How to Reconcile Your Financial and Emotional Needs
In order to navigate your financial life despite these conflicting needs, I suggest you use a chart like the one I created below:
I made this chart for a person who has financial needs which include retirement income in the long-term and stability in the short-term. She also has long-term emotional needs for retirement security and short-term emotional needs for sleep-at-night.
Let’s look closer at this person’s situation. Her short term financial and emotional needs are in synch; she needs security and low-volatility. So for this person, the solution is easy. A low-risk, low return, liquid investment should do the trick.
But her long-term needs conflict. She says she needs retirement income security. But that may require her to make investments that have short-term volatility.
Many times people who have a strong need for short-term security allow that need to influence long-term investment decisions. If that happens, she might move her long-term investments (that offer the potential for long-term growth) into shorter term investment that solve her emotional need for security. If she does that, she may end up failing to achieve those long-term goals. I’ll provide a potential solution to this shortly. For now, it’s important to recognize the potential conflict and costs.
I suggest that you create your own chart now. Separate out your long-term and short-term financial and emotional needs. Do your financial and emotional needs synch or conflict?
How to Resolve the Conflict Between Financial and Emotional Needs
It’s important to acknowledge that you have both financial and emotional needs. But at the same time, it’s important to prioritize between them using your logic.
Rationally, you probably need both stability and growth. You need security and stability for money you know you need over the short term. And you need to grow other money in order to achieve your long-term goals and overcome inflation.
If that is true, why not determine how much money you need for each goal and invest accordingly? To me, that makes most sense and is quite frankly the only way to answer the question. Moreover, by having money invested correctly and matched to the corresponding financial goal, it helps you stick with your long-term strategy.
This is easy to say and hard to do. Now, let’s consider some tools to help you implement this solution.
The Power of Short Term Money
The first order of business is to set aside enough cash in liquid, safe bank accounts for short-term needs and unexpected problems. This will make it easier for you to stick to long-term investing – at least from an emotional standpoint. Why? Because you know that no matter what happens in the market, you have a nice nest egg you can get to at a moment’s notice if need be. That allows you to relax a bit and focus less on short-term performance of long-term investments.
How much money should set aside for short term and emergency needs?
Some people say you always need the equivalent of 6 months’ income in your emergency fund. This could be true. But in most cases, it’s wrong. You have to dig just a bit deeper if you want to get an accurate number. This is important because there is actual danger in having too much liquid as well as having too little. Here’s how to make sure you get this right.
Understand that your emergency money set aside actually should be used for more than just emergencies. I like to think of it in 3 parts:
1. Known expenses.
To start off, do you have a specific expense that is coming up over the next 12, 24, or 36 months? This is typically for well-defined and pre-determined needs like doing major work on the house, college costs, a new car etc. They also include recurring predictable expenses such insurance and taxes.
2. Unknown Expenses
Now let’s deal with those costs you don’t know about – true emergencies. This is a little trickier but not all that tough. Break out your check book and go through the last several years making note of all the “emergencies” that came up. I’m talking about the big costs that seemed to come out of left field. What was the greatest single expense you had to deal with unexpectedly over the last several years?
Guess what? That’s probably the highest amount you’ll need in the future too. I know this is just an approximation, but my experience tells me it is pretty reliable.
I’ll give you an example. Back in 2009 our pipes went on strike and flooded our home. We had to take out our entire bottom floor and redo our kitchen. The total bill was $50,000. The odds of us needing to replace our bottom floor again are pretty low but I use $50,000 as the amount I need for an emergency fund. I know this isn’t scientific, but it works pretty well.
If you have other circumstances coming up, adjust your number.
3. Loss of Income
Next, consider how long would it probably take you to find a new job if you lost your current gig. Then put aside an amount that would cover your family over that period.
When you add these numbers up you’ll have a good idea of how much you need to set aside for emergencies.
Here’s an example of what it might look like:
Upcoming roof repair $7500
Potential job loss – 6 months’ income $45,000
Largest one-time emergency over last 10 years $20,000
This is the amount this particular person might want to set aside in their emergency account. Some people might respond and say they don’t have that kind of money. That’s OK. Start with what you have and build up to it.
Others might say that since they have other liquid investments, they can just liquidate those investments should the need arise.
I understand that approach but I’m not a fan. The reason is, if things get bad, you may need to liquidate that investment at the worst possible time and have to cash in when values are low. That’s why I prefer that you set up an actual emergency account with the appropriate amount. You may not receive much interest on that money but the access and safety of that money are worth more to you than the return you give up.
Your Other Buckets
Once you build your emergency and short-term reserves, it’s time to set aside money to fund your mid-term and long-term goals.
With mid-term needs, simply identify how much you’ll need by examining expected expenditures over the next 5 years for items such as a car replacement, travel, roof repair etc. That should be very easy to calculate. This is money you want to grow but money you need to grow safely.
How to Invest For Mid-Term Goals
You want to be careful here. If you invest too conservatively, you fail to leverage the asset of time and that’s just a waste. On the other hand, if you take too much risk, you jeopardize achieving your goals. Let’s get a handle on this by looking at historical returns for different investments over that 5 year period.
JPMorgan did a study and looked at all the 5-year rolling periods from 1950 to 2013 and how a 50/50 balanced portfolio performed. The found that the maximum average annual gain was 21% per year and the worst average annual gain over any 5-year period studied was 1% per year. Most people fell somewhere in the middle.
You can see that, at least in this study, the 5-year investors never had a losing experience as long as they stuck with their 50/50 portfolio.
Just to give you a reference point, when they looked at an all equity portfolio, the numbers fluctuated from +28% to -2% per year.
This is by no means a guarantee. You could do far better or far worse. This study just shows you what happened during these periods. The past is no guarantee of future results.
Now, I’m not recommending you use a balanced portfolio to fund your mid-term goals. I would need a lot more information about you before I could make any suitability suggestions.
What I’m saying is that you might consider using some element of growth in your portfolio to fund these goals. And I’m also saying you probably should not use an all-equity approach for mid-term goals. Here’s why.
In the example above, the worst experience for a 5-year investor was a loss of 2% per year for all equity portfolios. That may not seem like a lot of risk to take in order to potentially compound your money at very high rates but think again. If you lose 2% per year for 5 years that’s an overall 10% loss. If you put $100,000 in the market that you need in five years but end up with only $90,000, you fail. You may not achieve an important financial goal and it may have a significantly negative impact on your life. You have to consider the downside of investing and the shorter-term your goals are, the more risky the market becomes.
And by the way, who’s guaranteeing that you will only lose 2% per year? Nobody. Your experience could be much worse. That’s true even if you use a balanced model.
How to Move Forward in An Uncertain World
It’s true that the past is no guarantee of the future but in order to make a rational decision, you have to use some parameters. The bottom line is, the longer you invest, the more opportunity you have to smooth out returns – to allow the good years to offset any bad years. And in the “How to Invest Using Mutual Funds” guide I’ll provide some ideas on how you may be able to protect yourself against nasty bear markets.
Next let’s examine what to do about long-term goals.
Why It Makes Sense To Invest Long Term Money Using At Least Some Growth Equity
Let’s say you have a financial goal you want to achieve twenty years or more from now. The only question that matters from a financial standpoint is, what is the best way to grow your money over long periods of time? The answer is, equity and real estate.
What is most important is to achieve your goals. It would be nice if the 20-year ride is as smooth as possible – and we’ll cover ideas on how you might try to do that. But what’s most important to you is to achieve your goal 20 years from now. That should be more important than eliminating all short-term volatility.
If you invest some of your money in equity or real estate to achieve those long-term goals, the value of your investments will fluctuate. So what? It doesn’t matter unless you make emotional decisions about your investments as a result.
Short term thinking can destroy your long-term goals.
Short-term thinking can lead to investment decisions that bring low returns. That could jeopardize your ability to reach your goals. And by the same token, short-term thoughts can lead to too much risk. Some people like to gain ground fast so they speculate on what’s going to happen to gold, tech stocks, pork bellies etc. That often ends up costing investors more than ultra conservative investments.
We’ll cover this in greater detail in the guides that explain how different investments work.