Should You Save, Invest or Just Spend it All Now?

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 (of $1000 per year for 30 years) 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 make 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