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Saving Before Investing

2011 July 12
by Jarrod

I wrote this around 2003 as a message to new investors.  If you want to begin with the basics, you have to discuss saving before investing.  Trite but still true.  More later on this important topic.

Our distant ancestors might have invested by draining a field or building a shelter or raising children who would care for them in their old age. They sacrificed time and energy now for later benefits.  Later on, if they were able and fortunate, they might have invested in tools and customers for a trade.  Today, specialization makes it practical to translate much or all of our foregone consumption into money capital that we entrust to other people. They in turn use it to train employees, purchase equipment, design products and find customers. When we invest in anything but our own business, we merely select whose projects to back.

The basics are still there – our savings, and someone using the resources thus transferred from current consumption to create real wealth. We no longer have the same personal involvement. But as an offsetting advantage, there is much more opportunity for risk reduction through diversification in today’s world.

Why should we save? We may save to create a buffer against unemployment or ill-health. We may save for a car or a down-payment on a house.  If we have children, it is desirable to save ahead for college tuition. We may save for the capital to start a business.  Most importantly, because we can expect to live longer than our parents and their parents, we need to save for retirement.  Money should not outweigh the other ingredients of a life well lived.  But it is a significant component in an interdependent world where many desirable goods and services are obtained chiefly with interchangeable IOU’s.  We save to make sure that we have enough when we need it.

What if you are already wealthy? Then there are a new set of challenges.  But one similarity is the desire to preserve capital — and, in the face of inflation and taxes, you will be taxed on “income” and “gains” that are mere illusions when put in terms of real goods and services that can be purchased.  Today’s inflation rate, as in the 1930’s, is low, but not insignificant when compounded.  Over your lifetime, there are very likely to be periods of higher inflation rates. [This may be even truer now than it was when written, as deveeloped economy governments run huge deficits and the only way out may be to deflate the currency so as to reduce indebtedness.]

For most people, the biggest need for saving is for retirement.  The first thing most financial planners will tell the average investor is that they are not saving enough for retirement.  It is painful to recognize and deal with.  Unfortunately, the best solution is to start saving from a young age when we do not spend much time thinking about retirement. It gets harder by the time we reach middle age.  However, even if you start saving at a relatively young age, if you are in an income level where Social Security is only a modest increment to your retirement income, you need to save something on the order of 20% of  your income.

This high rate of saving is exactly what many people in emerging market in Asia are doing today, but it is at least three times the rate of personal saving in the US and likely considerably more than you are saving now.

If we do not inherit considerable financial resources, if we don’t start a
successful business,
we’ll have to save from normal income, and probably more
than we are saving now. We’ll benefit from starting to save earlier, rather than waiting until our children, if any, are out of college. We’re going to need a higher rate of return than that available in risk-free bonds or bank savings accounts. Paradoxically, despite the need for better returns, we also have to avoid serious erosions of capital through risk and taxes along the way to our goal.  Easier said than done, but reality.

If we have already accumulated capital that we depend on for spending,
the analogy to saving is properly balancing spending with real income.

Investing depends on saving. Saving is deferred gratification.  But it can be satisfying in its own way.  Think of your financial resources as a reservoir.  To fill it, we have to coordinate what flows in (saving and investment returns) and what flows out (consumption spending).  There is also a feedback mechanism involved, because the rate of investment return inflow is proportional to what is already in the reservoir.  Staying with water-based analogies, saving is the primer that allows the well-pump to draw much larger quantities.