The Basics of Investing
Given stories of gigantic “ponzi schemes,” bank failures, and obscene Wall Street bonuses, the thought of handing over your hard-earned money to the financial industry is not very appealing. And, as a result, most people I meet wonder what to do with their shriveled, shrinking, nest egg. Of course, the answers to that all-important question are as numerous as there are nest eggs out there. Nevertheless, it may make sense to “hit the reset button,” and reflect on the very basics of investing.
Why do we save?
A generation ago, people use to save towards the purchase of a good—a TV, car, washing machine, home, etc. But this changed with the advent of the credit card, the auto loan, and second mortgages. Instant gratification was invented and we could pay for the goods AS we enjoyed them, not BEFORE. The birth of consumer loans also meant that there were now only two reasons to save: 1) for a rainy day and 2) for when we grow old and can no longer work but still need to consume.
In other words, the most common reason we save today is to pay for something much later (i.e.: retirement). Thus, the important thing is to have the money we save now grow in such a way that it will match up with the cost of those things we will want to pay for later. There are two things to consider: 1) how much our investment is going to grow and 2) how much the price of the things we will want to pay for in the future will be.
The price something will be in the future depends largely on how much inflation there will be. If our savings do not earn the same percent return as the inflation rate, then we are actually growing poorer even as we save. So the first question as savers we should ask ourselves is what the likely future inflation rate will be.
Inflation: What causes it?
Basically inflation is determined by how much money is available in the economy. And this amount of money is largely determined by how much people get paid for work and how easy it is to borrow money. Since wages have not gone up much in recent years, and the current job market is terrible, and given how hard it is to borrow money because of the financial crisis, there is not much chance that inflation will increase in the next year or two at least. In fact, the bigger worry right now is DEFLATION.
What’s the problem with deflation? The big problem with deflation can be easily understood by looking at a home financed with a mortgage. If you borrowed money for a house and the house drops in value because the cost of everything is dropping, you still owe the same amount of money but the house is worth less. When we enter into deflation, all people want to do is save money to repay debt. Economists call this the “paradox of thrift” in that savings is a “good thing,” but if everyone saves at the same time, then it can have negative effects for the overall economy.
So, what is the best way to save for the future in a deflationary environment? That’s pretty easy: Just leave your money in the bank and watch its purchasing power grow as the prices of everything else fall. A very forward thinking Japanese person in 1990 who was planning to purchase a house in 2009, only needed to leave his or her money in the bank as house prices just hit a twenty-four year low in Japan!
In order to fight off deflation, the US government is scrambling to bail out financial companies in the hope that they will lend more, and is also coming out with “stimulus packages” of government spending to pump into the economy so that more people get wages. In turn, all this government activism is raising the fear that inflation could rise dramatically in the future. Why? Because governments around the world are promising to pay for lots of things; and the way governments pay for things is either by borrowing the money by selling bonds or, if not enough people want to buy this government debt, by printing actual money to buy their own debt. But for the moment at least governments are losing the battle against deflation as people are paying down their debt faster than the government can print money and inject it into the economy.
Let us now look at some main types of investments to see how they fit into the inflation/deflation picture.
Stocks are simply a way to own a piece of a business that will be earning profits that should, on average, grow at or above the rate of inflation. When you buy a stock you are essentially passing your extra money forward to someone else who needs it and who will hopefully be good stewards of it by using it to invest in the equipment and people and other assets required to grow their business.
A bond is just a loan to either a government or company. The main concern with bonds is whether the borrower will be able to pay you back and what interest rate you will receive. Now, there is a big debate about US Federal government bonds (a.k.a.“treasuries”). These bonds have no risk of you not getting your money back since the government can always raise taxes or even just print money to pay you back. However, it is by no means certain whether government bonds will be a safe investment or a horrible one—it all depends on whether there is inflation or deflation. The current interest rate you receive on bonds is very low, but you will be happy with even a small return on your money if there is deflation and the cost of living drops. It seems that buying government bonds now is really a game of chicken, and best left to professional speculators, which is ironic since government bonds are supposed to be among the safest of investments.
Commodities are goods that we, as a society use in our daily lives (oil, gold, food, etc.), a.k.a. “stuff.” The idea is that the prices of this “stuff” will rise in line with inflation and if you think the world might be running out of “stuff,” then maybe the prices will rise even faster than inflation. When talking about commodities, it’s important to keep in mind that demand for most of them will fluctuate in line with the economy. So when the economy is strong, there is generally more demand for “stuff” like oil and copper. The one commodity that is different from the others is gold. Gold has been used for ages as the ultimate store of value, since aside from its good looks it is extremely hard to dig out of the ground and thus there is never going to be any meaningful increase in supply of it. There is also not much practical use for it either so its predominant purpose is as a money substitute. While in theory gold should hold its value against inflation, the reality is that historically gold has just barely kept up with inflation and has performed much worse than stocks and bonds over the long term. If you are determined to invest in something that will hold up amidst inflation, consider a vegetable garden or solar panels. The money spent on creating a source of food and electricity for yourself will pay off handsomely if inflation drives food and energy prices higher.
Recently, it seems like hedge funds are vying with terrorists for public scorn, but let’s have a quick look at what they actually do. Most hedge funds use those basic assets discussed above, but do things with them so that the return is different than the assets themselves. The result is that the returns that hedge funds deliver will be different than what you would receive if you owned the stocks, bonds, or commodities themselves. Investors give hedge funds lots of money to manage because investors value the diversification provided by hedge funds. There is actually a useful social purpose for hedge funds in that they help keep money flowing around the financial markets so that companies with good ideas can raise money to expand their businesses even when financial markets are weak.
So that’s a brief and totally non-comprehensive overview of some of the issues worth considering amidst all the chaos and emotion of investing these days. There are no easy answers, although a mix of stocks, hedge funds, and vegetable gardens seems sensible to me.
—Rod Rehnborg manages an investment fund for institutional clients at Marshall Wace GaveKal. His specialty is “market neutral” investment strategies in Japanese stocks that deliver returns with low correlation to the stock market. He is based in Hong Kong.