Should You Save, Invest or Just Spend it All Now?
The rewards of saving and investing are great, but investing is not for
everyone.
Imagine for a moment that your dollar bills are like potatoes. If you eat a
potato (spend a dollar on a consumable), it's gone. If you plant a potato
(invest a dollar) it will multiply several fold in quantity in one
growing season (unfortunately dollars take longer to multiply). But if you plant all the potatoes (invest all your money) you
might starve to death before the harvest. Another consideration is that disease could wipe out your
crop. Perhaps another possibility is to plant all your potatoes and borrow other
potatoes to eat, with a requirement to pay back more potatoes than you borrowed.
In this scenario, the return on planting potatoes is quite rapid. All else
being equal, most people would probably try to plant at least some of their
potatoes (invest their dollars) while eating only the remainder.
But perhaps not everyone would plant potatoes. Perhaps some people would have
so few potatoes (dollars) that they were all but forced to eat all of their
potatoes just to stay alive and might even feel forced to borrow more potatoes
to eat as well.
Similarly, no matter that the rewards from investing are expected to be high,
there will always be some people who simply have no money to invest or who
otherwise will choose not to invest. And there are always people who need to or
choose to borrow for consumption purposes.
Saving/Investing Can Be Very Rewarding
$1,000 "real" dollars (adjusted upward for inflation each year)
saved/invested per year for 30 years at an interest rate that averages 5% higher
than inflation will grow to $66,439 "real" dollars. This means that a
total investment of $30,000 has more than doubled in purchasing power.
If the interest rate is increased to 7% higher than inflation, the savings
instead grow to $94,461. At an interest rate of 10% higher than inflation (which
is hard to achieve), the savings grow to $164,494.
If the interest rate remains at 5% higher than inflation, but the investing
period is changed to 35 years, the savings grow to $90,320. At an investment
period of 40 years and a 5% interest rate the savings grow to $120,800.
This illustrates that saving/investing can be very rewarding and that rewards
increase rapidly with the interest rate and the number of years.
These examples are not as dramatic as some you may have seen. Some authors
will illustrate the growth that occurs with an interest rate of say 15%. But
they are usually ignoring the impact of inflation. A 15% return after inflation
would be extremely rewarding, but is not at all realistic.
Saving/investing allows purchasing power (after inflation) to double, or
triple or more over 3 or 4 decades. That's a long time, but as someone said,
those decades will pass by whether you save or not. The cost of saving is the
foregone consumption. But if some people can meet all their needs and still have
money left to save and invest then those people may consider that there is
really little or no cost or pain to saving.
Consider too, that it is not at all unusual to live for 80 years or more and
that many people have descendents that they wish to bequeath money to, so your
investment time horizon can easily stretch to 55 years or more.
The benefits of saving and investing are extremely large if you wait enough
years. But is it worth it to forego spending now and take the risk that you
will be too old to enjoy it later or possibly even dead?
There are no right answers to these questions.
Are you a Spender, a Consumer, a Saver or an Investor?
Each of us will likely occupy all four groups at various times in our
lives. But at any given point in time, each of us likely fits mostly into just one of
the groups.
1. Spenders - Tend to spend all of their monthly earnings. Willing (or feel
forced) to
purchase furniture and even vacations on credit. Likely to run balances on
credit cards. Preparing for retirement is either way in the future or
consists of buying lottery tickets.
2. Consumers - Likely to spend all of their monthly earnings but tend to
avoid consumer debt. Will borrow for a mortgage and car but usually not for furniture,
vacations and cloths. Do not run monthly credit card balances. Tend to have a
pay-as-you-go philosophy. Not saving for retirement.
3. Savers - Likely to live frugally and to regularly save a portion of their
income. They like to save for a rainy day. The rate of interest that they get on
their savings is not the motivation to save. First priority is paying off the
house. Also typically saving some amount for children's education and for
retirement.
4. Investors - These people have the same motivations as savers but they are
more concerned about the rate of return, Usually willing to take some risk in
search of a higher return. May not live as frugally as savers and may even
borrow to invest.
None of these groups is inherently better than the others. It's a matter of
personal preferences and circumstances. Most people will occupy all four
positions at various points in their lives.
How Savers take Advantage of Spenders (or is it vice-a-versa?):
Some spenders are very much motivated (or virtually forced) to live-for-today. Some of them would
borrow $100 now to enjoy some purchase even if they knew that they would have to
pay back $200 or more in one year. This is what makes loan-sharking a reality.
On the other hand some spenders would refuse to borrow the $100 now unless the
eventual re-payment was less than say $105.
Luckily for spenders, there are many savers out there who would basically
save money even if they received no interest on their money. Others have to be
enticed with say 10% interest or more before they are willing to save money.
Today the market rate of interest is about 2% to 4% for savers and from 7% to 20%
for borrowers. (Banks and financial institutions take the difference, in return
for matching savers with borrowers).
Spenders may feel that they are taking advantage of savers. Some spenders
would (if necessary) pay 25% interest rates and they are happy that the market
lets them borrow at say 7% to 20%. Some spenders think that Savers are foolish
to forego consumption now in return for a paltry 2 to 4% interest.
Meanwhile some Savers are so dedicated to saving for tomorrow that they would
save even for zero interest. Some Savers realize that after inflation and taxes
they are falling behind. But they still save because they feel that they don't
need to spend the money.
A Saver knows that by foregoing a consumption now and saving their money
there will come a time (eventually) where they could spend the interest to buy
what they want and still retain the original principal (even adjusted for
inflation). In this way Savers my feel
that they are taking advantage of Spenders.
In any event the market sets the interest rates for both Savers and Borrowers
and both parties get what they want.
How Long Term Investors Can Take Advantage of Short Term Investors:
Investors expect to earn a higher return than Savers but also understand that
they are taking more Risk and may in fact lose money on their investments.
The reward that investors expect over and above the
risk free savers rate of return is very analogous to the relationship between
Borrowers and Savers.
At a given point in time, the stock market investor might expect to get say a
5% higher return compared to the risk free saver. Some might argue that the 5%
is necessary to compensate for the extra risk and that an investor should be
indifferent between the risk free rate and the 5% higher stock market rate of
return.
In reality, each person has their own view of how much extra expected return
they require in order to take on the risk associated with the market.
A 25 year old in saving for retirement has time to ride out any market
down-turns and might choose to invest in the market even if the expected rate of
return was only 2% higher than the risk free rate.
A 70 year old who expects to need the money in five years has a short time
horizon and who is generally risk averse might not be enticed into the market
unless the expected return was say 15% higher than the risk free rate of return.
The market then sets the actual expected return premium on the market based
on the equilibrium of the supply and demand for equity investment funds. It has
been suggested that market equity risk premium reflects an average time horizon
of about 1 year.
As a result the 70 year old, is priced out of the stock market. He or she
would need a 15% expected return premium. It's not available so the 70 year old chooses
the risk free treasury bill approach.
An opportunity
for most investors is that the market risk premium is 5% (based on the average
one year time horizon) while (arguably) many long
term investors would choose the market even if the risk premium were only 2 to
3%.
Investors with long term horizons and a higher
tolerance for risk can essentially take advantage of the fact that the market
risk premium is set by a average investors with a much shorter time horizon and a lowish tolerance for risk.
In other words, from the point of view of those with a long time horizon and
a tolerance for short term fluctuations, the market risk premium is higher than
it really needs to be.
The end result is that the market allows people with a long time horizon to
build up a larger wealth by, in a sense, taking advantage of the high premiums
that the average investor demands for the assumption of the risk of short term
fluctuations. The long term investor is not indifferent between the equity
market rate and the risk free rate that has been set to achieve an equilibrium
in the total population. Instead the long term investor strongly prefers the
equity market return (even with its volatility) to the risk free return.
Investors with a long time horizon and a tolerance
for short term fluctuations should take advantage of this by investing most or
all of their assets in the market rather than in the risk free investment.
The bravest long term investors can also take advantage of savers by
borrowing some of the savers money at or close to the risk free rate and then
investing it in the market. However, while this should work in theory, this can
be dangerous and can lead to the financial equivalent of the farmer who planted
all of his potatoes and ended up starving to death, due to a drought. So, I
don't recommend this last route.
My overall conclusion is that the rewards of saving and investing makes
it attractive to those people who are earning enough money to afford the
savings.
Shawn Allen, CFA, CMA, MBA, P.Eng.
President InvestorsFriend Inc.
October 21, 2001