A continuation of #14. If you think about playing cards or tossing a coin, you can learn a lot about fundamental investment principles, and how to think about different kinds of investments.
The lessons of our casino games in Post #14 apply to investing for retirement, as I’ll show in this post.
Here’s a way to think about investing.
Investing has things called asset classes, meaning investment of a particular type. Three of the best-known asset classes are stocks (often called equities), bonds (often called fixed income) and cash (often called Treasury bills).
A little technical detail, just for reference. It’s not necessary to remember this. It’s just general background education. In fact, skip this and go to the next section, if you like.
- Treasury bills are securities issued by governments, typically promising to pay an amount no more than a year from the date of issue. They are issued at a discount relative to the repayment amount, so you get more back than you pay for the security. Typically, government securities are considered the closest to being safe, because the taxing power of governments enables them to get the money they’ve promised to pay. Banks and other institutions buy these securities, and they are very easily traded.
- Bonds are securities typically issued by companies (or Treasury bonds, issued by governments), promising to pay an amount when the bond “matures” some time in the future, and in the meantime to pay interest on the maturity amount at periodic intervals, like quarterly. Company bonds are typically considered less secure than government-issued debt, and they are less easily traded because each bond is typically issued for a much smaller amount than government debt.
- Equities are investments in companies, entitling their owners to the company’s remaining profits, once the company’s bond-holders have been paid (and taxes paid to the government). If a company does poorly, there may be little or no return on the investment, and if it does really poorly, it may go bankrupt and the investment is worth nothing. On the other hand, if the company does well, there’s no theoretical upper limit to the profits to be distributed. A single company’s stock can have very uncertain returns, but when you add up all the companies in a country, the aggregate is usually a good reflection of the prosperity of the country. So mutual funds (also called unit trusts, and sometimes available in a variant called exchange-traded funds) typically invest in many companies, not just one, and if you buy their units, you have a convenient way to diversify your exposure to the country’s prosperity. Stock exchanges (where stocks are traded) conveniently compile an index of all available stocks, so you can invest in the whole lot conveniently. Similarly there’s also a global stock index that reflects the aggregate of the indices available in all the large (and sometimes smaller) countries in the world, so it’s possible to get exposure to the world’s aggregate prosperity.
Those tend to be the biggest and most easily traded asset classes. There are others. For example, real estate (also called property), or the stock of small companies in a small country. But those aren’t easily traded (they’re called “illiquid” assets, liquidity referring to the notion that they’re easily sold), so they tend to be found only in the portfolios of institutions that provide financial services. (An exception is your own home, of course, which may be the biggest investment you own.) Anyway, let’s ignore the illiquid ones and consider the three asset classes I mentioned at the start.
Here’s a big question: how should you think about these asset classes?
My answer may surprise you. Think of them as being casino games, with different payoff patterns. But there are a couple of significant differences between our previous casino games (in Post #14) and these asset class investment games.
- Unlike our casino games, these investment games don’t just have two “either/or” outcomes. They have a continuous range of intermediate outcomes.
- And unlike our casino games, these investment games don’t come with precise odds and payoffs known in advance. History is all we know. That’s an obvious starting point, but there’s no guarantee that the future will be like the past.
Nevertheless, as we’ll see, all four lessons that we learned in our virtual casino apply to these asset classes. Let me be explicit about how those four lessons apply.
- In publicly traded markets, where it doesn’t cost much to make a trade and for which lots of research about different analysts’ views about the future are available, there’s no easy money. These markets are called “efficient.” That doesn’t mean that people are always right about the future – that’s impossible, because there’s no crystal ball. Efficiency refers only to the ease of trading in the market and the wide distribution of information. In efficient markets, most of the time it’s pretty difficult to beat others. That’s not true of inefficient markets, in which research is sparse and therefore good research really does create superior money-making opportunities, or in which the cost of trading is so high that most people stay out of it.
- As the potential loss increases, you want a disproportionately big increase in the potential gain before you’re willing to play the game. Consider those three asset classes. We’ll find (in a future Post) that the potential losses from investing in equities are higher than in the other two asset classes. So it makes no sense for investors to buy equities, unless the potential gains when equities do well are also higher than in the other two asset classes, in fact disproportionately higher.
- Even good strategies can have bad outcomes. Over the long term, equities have done well more often than they’ve done badly (as we’ll see in a future Post), so from that perspective investing in equities is a good strategy. But it can also have bad outcomes, meaning that equities frequently (though historically, less often than half the time) involve losing money. How much of a bad outcome you can tolerate as you seek those more frequent and large good outcomes is a crucial question, often called your “risk tolerance.” Again, we’ll get into this in future Posts.
- With a good strategy (like investing in equities), the more often you play, the more likely you are to eventually win. (Or at least, that’s what has happened, historically.) What does that mean, to play the game often? Think of it this way: the younger you are, the more often you can play, because it’s the passage of time that constitutes a play. As we’ll see, over time the likelihood increases that you’ll come out ahead when you invest in equities. But that is only a likelihood, not a certainty. In fact, there’s still a (relatively small) chance that you’ll lose persistently – and that can mean ruin. Again, dealing with this chance, and how to avoid it before it hurts you too much, is a fundamental question we’ll examine.
Already you can guess that investments have two fundamental characteristics, both of which are desirable, but which are invariably in conflict with each other. One characteristic is safety: don’t lose, be predictable. The other characteristic is growth: keep going up, make my investment worth more and more. And since there’s no easy money and even good strategies can have bad outcomes, there is no investment – absolutely no investment, no matter how appealing its prospects and no matter what anyone may tell you – that will assuredly give you both growth and safety.
Basically, that previous paragraph is all you need to know about investing. The rest is about studying history and applying the principles of safety and growth to your own situation.
Investment professionals will tell you that I have grossly oversimplified this stage of the tour, and that investments are much more complex and much more nuanced than in my simple overview. And they’re right. But it needs to be complicated only for those experts who are immersed in investment markets all day long. For the average investor, the average retiree, all you need to remember is that investments involve varying degrees of safety and growth, and your “asset allocation” (the mixture of investments that you hold, divided across different asset classes) reflects your risk tolerance, that is, your tolerance for giving up some safety in search of growth.
Investment outcomes aren’t as predictable as tossing a coin or drawing a card, where the odds are known and the number of possible outcomes is limited. But there are still similarities. And the odds help us to decide whether an investment is oriented more towards safety or towards growth.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.