Like it or not, we are all investors
Sooner or later anybody who’s working for money and saving a portion of their earnings because it is a prudent thing to do or just happens to have some ‘excess savings’ will be faced with the inevitable question: What do you do with your money?
While this question appears simple on the surface it actually leads into a veritable rabbit hole with such complex subjects as decision making under uncertainty, psychology, structure of modern society and the price and value of time itself.
Introduction
What do you do with your money?
One of the functions of money is to allow us to structure our purchases over time by saving or borrowing. In an ideal world the purchasing power of what you saved or borrowed should stay the same without you doing much of anything. Price fluctuations for certain services and goods are inevitable overtime due to technological progress and changing preferences but why is it a good idea to have ‘general’ price inflation of 2% every year1? Apparently, given almost complete lack of financial education in the public system, the idea is for the general population simply not to notice.
That’s in theory, in practice inflation has been as a high as 10% in the US and Europe very recently. And way higher than that throughout history. We won’t even mention Turkey or Argentina. As is, it’s a “hidden” tax on savings. Even if you choose to do nothing with your money you are ultimately sponsoring some government above and beyond the taxes you already paid. The sum total of your contribution to society has been paid to you with I.O.U tokens controlled by a third party (central bank) that can create an infinite number of additional tokens with very little supervision and a vague mandate to preserve ‘price stability and full employment in the long run’.2 Not only that, special interest groups can easily highjack government agenda to maximize their returns and not worry about abstract ‘greater good’. History repeatedly teaches us that central banks and governments in general are run by people who are there for a short time (unlike the results of their actions) and are not motivated by ‘Liberté, Egalité, Fraternité’.
We won’t get into the justifications for having general price inflation above 0%3 as it’ll take us off track. Government and central bank actions during the COVID crisis may have highlighted the shortcomings of the social contract we find ourselves in, however, this is not going to be a discussion about money printing and inflation. If you look at pretty much any period in modern history you will find questionable policies with high degree of regularity4. Even in our most immediate history, the period post 2008 financial crisis is characterized by growing asset bubbles, high indebtedness and growing social inequality while on the surface it appeared fairly benign with low official inflation.
In fact, we seem to be going from one extreme to another which is consistent with the thesis put forward by Neil Howe in his excellent book The Fourth Turning. Navigating this kind of environment is not going to be easy but that’s the world we live in and it’s our job to adapt. As a result, doing nothing with your money is not a very sustainable option5.
Unfortunately, doing anything other than nothing implies risk. Things that involves risk should be approached with care and ideally with education followed by experience. Even understanding how much risk you are actually taking by doing A or B is an art in itself that’s best learned by mentorship and experience. If we take action that involves risk and ultimately affects our entire accumulated wealth we should do so intentionally not due to external pressure. Doing things under pressure and without proper training often results in errors, some of which can be significant.
Hopefully there's 2 things you will get out of this:
- You will have to do something with your money.
- Whatever you do will involve some risk so go simple and slow.
Having discussed The Why let's now move on to The What. In the spirit of keeping things simple we'll focus on investment instruments that are easily available and easily understood first.
The Basics
What are some of the options available to us to manage our savings?
Bank Deposits
The easiest thing you can do is simply keep your savings in a bank deposit account. This is the most liquid option, your funds are always available. Gone are the days of keeping cash under the mattress. Many payments these days actually require a bank account with debit or credit card. Unfortunately even now the interest rates offered by banks are quite low even in the face of high inflation not to mention the bulk of the period post 2008 financial crisis when interest rates on bank deposits were practically 0.
As a result keeping all of your savings in a bank deposit is also not very practical. Beyond some amount deposited in a bank to cover day to day expenses and maybe some emergencies the first logical place to invest in is shelter.
Real Estate
House prices always go up!
Housing has historically been a great place to put your money into. However, it is highly dependent on where and when you are buying and selling. Many people in North America, Australia and New Zealand view housing as the ultimate safety deposit box that not only preserves the purchasing power of your money but also multiplies it (thanks to the leverage implied in mortgages). The reality in the global context is a lot more complex.
You are buying bricks or wood chips on a plot of land. The structure itself will be deprecating over time. What you are relying on is growing population (ideally through immigration as natural population growth can be lower than the amount of new housing being built) in a location that is becoming more popular and government policy that generally favours growing asset prices. Immigrant destinations such as Canada, Australia or New Zealand seem to fit the bill.
By contrast, many other countries around the world don’t have the best track record of house price increases in the last few decades. Just look at price statistics from Italy, Greece or Spain.
Source: ‘The Economist’
This excellent article on ‘Residential property price statistics up to Q1 2022’ from BIS also does a good job summarizing this data.
It’s also important to keep in mind that real estate is immobile and illiquid. It can take years to sell depending on price and location. In extreme cases it can be destroyed or become impossible to sell such as in Ukraine very recently or many other places around the world throughout history.
Real Estate Investment Trusts (REIT) are one of the options available in some markets to overcome the shortcomings of real estate investing while preserving some of the attractiveness. However, that’s not a basic anymore since you can’t live in a REIT.
To sum up, real estate can be a great investment subject to a number of conditions. However, it does not liberate you from all risk or guarantees a return. From this point of view real estate is actually not that different from the other investment options we’ll review next.
Beyond Basics
Human resourcefulness has produced a lot more options than we’ll cover here including things like Actively Managed Funds (including Hedge Funds), Private Equity, Special Investment Vehicles, Derivatives and Crypto assets. Many of these more esoteric investment types require more experience and specialized knowledge to evaluate, so we won’t touch on them in this review.
Money Market Funds (GICs, CDs)
Putting money in a money market fund (also knowns as certificate of deposit or guaranteed investment certificate) is as close to a simple deposit in a bank as possible. It’s basically a guaranteed bank deposit with interest that will be returned to you at the end of the deposit period. This is considered to be a very low-risk investment because FDIC (or equivalent in your country) insures investments of this type up to $250,000. Principal difference here is that you cannot access your money without penalties until the end of the deposit period. You are running 0 risk with your principal and will get principal with declared interest at the end of the maturity period. With short term US interest rates at over 5%, this is actually a pretty appealing option right now considering its risk-free nature. Generally speaking the longer the loan period, the higher your interest is likely to be.
Treasury Bills
A Treasury bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. These instruments are considered very safe investments and in fact the Money Market Funds above will likely be fully (or almost fully) invested in Treasury Bills and will offer you the interest on T-Bills minus a management fee.
The Treasury Department sells T-bills during auctions using a competitive and non-competitive bidding process. They can be bought via your broker or directly at treasurydirect.gov. The big difference between investing in a money market fund and T-Bills directly is that T-Bills are often ‘marketable’. That means you can sell them before the maturity period and buy them after they were issued on the open market. This will obviously affect the price you get back for them but it’s a flexibility worth considering.
Longer-Term Bonds (and Bond ETFs)
When you buy a bond (short or long term) you’re essentially lending money to an entity. Generally, this is a business or a government (municipal, provincial, etc). Companies issue corporate bonds, whereas local governments issue municipal bonds and the federal U.S. government in the form the U.S. Treasury issues Treasury bonds, notes and bills. Bills discussed above cover the short end of the borrowing spectrum up to year. Notes and bonds cover the longer end of the spectrum up to 30 years and in some cases up to 100 years. In retrospect, a 100 year bond issued by Austria during the 0% federal funds rate craze turned out to be one of the best swindles of investors in recent memory, on par with the Cannabis Stock Bubble in Canada or the US Tech Stock Bubble from early 2000s.
While bonds are considered a low risk investment the risk is clearly higher than with T-Bills but theoretically lower than stocks (discussed below). Generally, the longer dated the bond is the higher is the risk. There’s a risk that the entity will default, there’s also a risk that inflation will be much higher than the interest on the bond which will make it very difficult to sell them on the open market without a loss. While they can certainly be sold it will not be for anything near par and it will be a long time before the issuer actually repays them at par.
Just have a look at performance of TLT (a 20+ year US government bond ETF) over the past 4 years. If you bought longer term US government debt anytime since the COVID crisis you’d be down significantly.
Stock (and Stock ETFs)
Stocks along with Money Market Funds are arguably the simplest type of investment. When you buy stock, you’re buying an ownership stake in a publicly-traded company. Many of the biggest companies in the world are publicly traded and you can buy shares in them. Some examples include Apple, Google, Amazon and Microsoft.
When you buy a stock, you’re hoping that the price will go up so you can then sell it for a profit in the future. The risk, of course, is that the price of the stock could go down, in which case you’d lose money. As you’d expect there are stocks that have done very well and stocks that have done very poorly.
Generally speaking buying a broad market ETF such as SPY or QQQ or RSP is the safer bet in terms of capturing US market returns without doing much research. Investing in individual stocks requires better understanding of what you are doing and what you are investing in and as always it’s best to start small and gain experience. While it's tempting to load up on some unknown microstock in the hope of making it big, the risks are often such that you are more likely to lose everything.
Mutual Funds
A mutual fund is a pool of investors’ money that is invested in a number of companies. Mutual funds can be actively managed or passively managed. An actively managed fund has a fund manager who picks securities in which to put investors’ money. Fund managers often try to beat a designated market index by choosing investments that will outperform such an index. Mutual funds can invest in a broad array of securities: equities, bonds, commodities, currencies and derivates.
Mutual funds have the same risks as stocks and bonds, depending on what they are invested in. With proliferation of ETFs, you can often build your own actively managed portfolio very cost effectively, so the only thing you are paying for in a mutual fund is the human expertise of the fund manager. Caveat emptor.
Real Estate Investment Trusts (REITs)
A real estate investment trust is a company that owns, operates or finances income-generating real estate. REITs pool the capital of many investors. This makes it possible for individual investors to earn dividends from real estate investments — without having to buy, manage, or finance any properties themselves.
Properties in a REIT portfolio may include apartment complexes, healthcare facilities, hotels and so on. In general, REITs specialize in a specific real estate sector. However, REITs may also hold different types of properties in their portfolios, such as both office and retail properties.
Many REITs are publicly traded on major securities exchanges, and investors can buy and sell them like stocks, so they carry the same risks as stocks and bonds.
Conclusion
This wraps up our brief review of the investment landscape we find ourselves in. First we explored why, ultimately, we are all investors in this day and age. Second, we reviewed some of the basic instruments that help us manage our capital. In the next article, we’ll focus a bit more on The How and go over common performance metrics that help us evaluate our investments over time.
Footnotes
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The accepted Federal Reserve mandate is 2% annual inflation and ‘full’ employment. ↩
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As John M. Keynes has famously remarked ‘In the long run we are all dead’. Keynes also very well understood the negative social effects of rampant inflation. See this passage from his The Economic Consequence of the Peace (1919). ↩
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See The Price of Tomorrow by Jeff Booth for an interesting discussion on the topic that's not just a restatement of the old mantra about how bad the Great Depression in the 1930s in the US was and how Keynesian inflationary economics saved the day. ↩
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See The Fourth Turning by Neil Howe. ↩
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Unless of course you choose to not participate in society and therefore you do not have this problem. ↩