Save or invest?

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As we start 2012, it’s easy to find lots of economic doom & gloom in the financial news these days.

Whether it’s Japan, Europe, or our own stock markets, the financial “experts” are predicting meltdown and chaos everywhere. Whenever a problem crops up in one corner of the world, it’s assumed that it’s going to ripple through the entire global economy until it takes down our stock markets. If there’s not enough scary international news then the media obsesses over U.S. real estate values or crime on Wall Street or domestic economic forecasts. This has to be a terrible time to invest, right?

Personally, I’m not buying all the doom & gloom. The media has done a great job of pointing out global economic concerns that we’d do well to avoid. However, some of the pundits gloss over the very real differences in the cultures, politics, and legal systems that make another country’s problems different from ours. Admittedly we have plenty of our own economic problems (most of them self-imposed) but positive economic news is usually ignored– or criticized for not being good enough. You can’t sell a magazine (or website advertising) with a headline announcing “The economy will eventually get better!”

I read a lot of financial history. (It’s comforting because I usually know how the story ends, and in the meantime I learn new aspects of how the problems came up and how they were handled.) In every period of recorded history, there’s always been someone who’s announced “OMG, this time it’s really different!!” (The expletives and the exclamation points might change, but the sentiment is always the same.) The interesting thing is that they’re right– every time is different, even if we mess it up in the same old ways. But we’ve predicted the end of the world for over five millennia, and yet somehow we’ve always managed to stumble clear of the impending disasters. Again, though, nobody would read a history book titled “Everything Will Be OK!”

One way that things are different this time (“Really”!) is our awareness. Internet global connectivity has made it far easier to report the local news all over the planet. Within a generation, the pace of the news cycle has evolved from “days” to “minutes”. We’ve boosted our information access by several orders of magnitude, and when you can read 10,000 times as many newspapers in one hour then it’s a lot easier to find the problems to obsess over– they’re trending on YouTube & Twitter!

I’m impressed at how the advertising industry exploits doom & gloom. “Fear marketing” is a very powerful tool to convince the average American investor that they can’t possibly handle their own money in an uncertain economic future. And if fear isn’t working, we can always turn to trust– how can you count on your own analysis & emotions during these turbulent times? Investor psychology will make you question your own behavior, even if the crooks aren’t trying to scam you out of your money– surely you need someone who can watch your back. At every turn a new investor is being warned to surrender their assets to a financial professional who’s much more qualified to tell them how to make it to retirement. For a suitable fee.

I can certainly understand why we’d be tempted to live for today. And even if we managed not to spend everything we earn, I can understand why we might want to bury the leftovers in a coffee can in the back yard– rather than “invest” it in a rigged market where we can’t even trust our own judgment.

But as skeptical & cynical as I am, I can think of a couple of situations where it could be wise to save your money in a bank account, CD, or government bonds instead of investing it in stocks or other risky assets.

One situation is when you’re just starting out. Believe it or not, most of us are far better at earning money (“getting a job”) than we are at investing it. Even if we read a book or take a class, we’re still going to have to learn how to tolerate the inevitable market volatility and all the financial news being thrown at us. Life is incredibly busy when we’re just starting out, and for some of us the finer points of investing or asset allocation just aren’t very compelling. It might take a decade before we’ve become accustomed to the global media screeching at us, let alone learned to do our own research– or at least to ignore the doom & gloom to focus on our own financial basics.

Another situation is “liquidity”: when you want to have cash on hand for a specific purpose in just a few years.

Starting out

Canadian financial analyst Jim Otar has compiled his articles into a book that debunks much of the conventional wisdom of investing and retirement. We can apply history to plan our own retirement, but if we succeed then we aren’t really able to tell whether our analysis worked– or whether we were just lucky. On the other hand a failure could immediately make it clear whether something wasn’t working or if our investments had been savaged by bad timing. “Unveiling the Retirement Myth”  shows that it’s best to avoid “bad luck” by (believe it or not) planning for the worst. He helps his clients design their investments with asset allocation and diversification, and then to have a “Plan B” if the worst happens when they’re about to retire. He also shows them how their plans would have fared during the worst parts of the 20th century. He can’t predict the future, but he can certainly show what the past was like.

The book is a fascinating survey of all the problems that can crop up during retirement planning. We all make assumptions about the “average”, but average returns and average volatility don’t apply to individual investors. A small difference in the sequence of investment returns will make a huge impact on an investment portfolio, and the timing of bull & bear markets is unpredictable. The best solution is to design for the worst case and then to have a plan if the future turns out different this time. (So far so good.) Investors also have to either educate themselves enough to be aware of their own financial behavior, or they have to be willing to hire someone to warn them when their investor’s behavior is leading them into bad situations.

I’ll write up a book review for another post, but my recommendation is “Buy it.” Yeah, the book costs $5.99 to download to your computer and e-reader. It’s over 500 pages long, and some of the pages have (*gasp*) math formulas and graphs on them. Luckily the book is written so that you can skip the scary math parts if you want to, and it’s well worth the price of a fancy caffeinated beverage. You might be able to find it in a library, but if you’re not near one of these libraries then pay for the download.

Otar suggests that if you’re a typical investor starting from zero, then you should save until you have twice your estimated annual retirement withdrawal-– two years of retirement expenses beyond your pension. (If you can’t predict what your spending will be, let alone whether you’ll have a pension, then use a bare-bones budget from your first year on your own after school. It’ll be close enough for this task.) When you’re starting out, preserving “seed capital” is more critical than aggressive investing. What you lose in compounding time you’ll make up in developing a tolerance to “behavioral risk”.

Wait a minute. Aren’t we supposed to take a long-term view, start our investments compounding as soon as we can, and be aggressive while we’re young? Sure– but only if we can handle the stress. A young investor may be hyperaggressive during a bull market or might cash out at the depths of a bear market, and the trauma of losing so much may keep them out of the market for years. But if they save up seed capital, the years it takes them to do so gives them plenty of time to educate themselves on asset allocation and to learn to ignore the daily CNBC hysteria volatility.

Here’s the math: big risks early on can have big consequences, but investing early doesn’t make much more of a difference than saving early. Otar points out that someone starting with nothing, saving 15% of their income every year, and investing it at 6% will need 70 months before the account value exceeds their annual earnings. An aggressive portfolio earning 10% would achieve the same value in 64 months. Just six months’ difference– over 90% of it due to saving and less than 10% of it due to investing.

So if you’re just starting out and you think you’re vulnerable to being scared by market volatility, then maybe it’s better to save before you invest.

Second situation: liquidity. 

Warren Buffett is one of the world’s greatest investors, especially in his ability to tell a story. In 1939, Buffett’s great-uncle Ernest wrote a letter advising a son to keep $1000 cash in a safe-deposit box for emergencies or opportunities. (You can see the image of the letter on page 23.) In today’s dollars, the inflation calculator at the Bureau of Labor & Standards pegs that amount at over $16,000.

Buffett’s advice is still sound today: have an emergency fund, and if you’re saving for a specific opportunity then keep your savings as safe as cash.

So who today has $16K sitting in their safe deposit boxes? Heck, I don’t even have a safe deposit box. However, I have plenty in the 21st-century equivalents: CDs and I bonds. Sure, I may handle a spending crisis with a credit card or a check from our home equity line of credit. But in a few weeks when it comes time to pay the interest on those accounts, I can simply pay them off with a CD or a government bond that’s as readily accessible as cash in a safe-deposit box.

The same logic applies to saving for a short-term goal like a new vehicle or owning a home: keep it liquid. It’s painful to save thousands of dollars at today’s record-low CD rates, but the point of saving the money is to have liquid assets when you’re ready to buy. I bonds don’t pay much either, but at least they attempt to keep up with inflation. You’re making sure that the money will be there when you need it, and when you’re paying cash you’ll get a significant discount from the price of borrowing on credit to “buy”. The savings of the discount will more than make up for “missing out” on a “hypothetical” 10% annual return of a risky stock-market investment.

So how do you handle the “saving or investing” decision when you’re just starting out with a military paycheck? Do whichever makes you confident and able to sleep at night. When you’re too worried to feel comfortable with the stock market, then follow Otar’s advice. If you think you have what it takes to ignore stand strong in the face of volatility and adversity, then pick an asset allocation and stick with it. Servicemembers should try to save all you can for your short-term goals (like a small emergency fund or a replacement vehicle) and then max out the Thrift Savings Plan & Roth IRA(s) while you’re earning a reliable income. If you’re planning to leave active duty within a year then stop investing and start saving for that short-term goal. But once you’ve met the short-term goals, and once you’re comfortable with the stock market, then invest as much as you can in your chosen asset allocation.

Related articles:
“Chasing yield”
JD Roth at “Get Rich Slowly” on investing behavior vs education:  Why Financial Literacy Fails (and What to Do About It)

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WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

  1. Another excellent post, Doug. You deserve high praise for all the research you do for the readers of your blog.

  2. Interesting. I “accidentally” followed this path. I’ve posted a few times on how a graph of early investing and compound interest got me saving for retirement at age 21, and that I knew I’d thank myself someday even if I wasn’t thinking far ahead at the time. But I wasn’t forward-thinking and went with the default investment of my 401(k) plan, Vanguard’s Treasury MM fund. Later I switched to riskier funds based on coworker chatter, but it wasn’t until age 30 or 31 that I really learned what I was doing with respect to asset allocation, risk tolerance, savings goals and inflation.

    • I think most of us follow the “save” pattern by default when we start our adult lives. My daughter and I have been talking about her college graduation in 2014. She’s beginning to realize that she’ll need to save for a car, apartment rental deposits, maybe some new uniforms, and (oh yeah) Craigslist furniture. Most of her money focus is on two-year CDs. She’s still maxing our her Roth IRA, but she’s sticking with cheap index funds and learning to ignore volatility.

    Comment? Question? What's on your mind?