What to invest in and how to invest are often discussed at length. So, why not go a step further and examine why investing is considered a good use of money in the first place?
The truth is, we are not programmed to invest. Like many other things in life (“Come inside or you will catch a cold”, “you have to train if you want to become an athlete”, “you have to study if you want a job one day”) investing means sacrificing immediate enjoyment in exchange for potential benefits in the future. There are two go-to reasons that most investment professionals present for your consideration. There is a third reason worth considering (ah, the suspense!) but let’s first review what common wisdom dictates.
Reason 1: A smarter way to achieve goals
Google “why invest?” and you’ll probably come across one of these two statements:
“Invest to grow your wealth over time and reach future objectives”
“Compound interest makes your money work for you”.
These are the two mantras of any respectable financial institution, and they pretty much say it all. To accomplish some objectives, you probably need more money than you currently possess. By investing the money in your savings account that you don’t need urgently, you could achieve these goals. Does it work? It depends where you invest your money, but on average yes (we’ll also see later as well that averages are not always something we should trust).
Building on Compounding Returns
One advantage of investing is that if you get it right – your money benefits from the snowballing effect of compounding, the primary mechanism behind investing.
Financial advisors often run this sort of simulation to illustrate compounding: invest 100,000 CHF today and let it grow at an annual rate of 5% (a magical number in the financial industry) and in 15 years you will end up with almost double the initial amount. 207,893 CHF to be precise (chart 2). We just need to find the magical investment to generate that 5% for the next 15 years, but that’s a different story.
But can’t you reach goals without investing?
With savings, a second and third pillar (provisions to ensure pensions in Switzerland), it might seem like we’ve got enough to meet our future needs. But what about bigger dreams and goals? And we aren’t talking about unrealistic aspirations here.
“What if I live to a hundred? Do I have enough to finance 35 years of retirement?”
“What if my daughter wants to go to EPFL or ETH? Can I afford their accommodation in Lausanne or Zurich?”
“Nice watch! Wouldn’t it be a nice present for my fortieth birthday?”
While these goals may seem within reach, they are often accompanied by a few worries:
“My savings won’t be enough for this.”
“I can’t afford this right now, maybe in 5 years.”
“If I buy this now, will I be able to save enough for the future?”
Of course, borrowing, when possible, is a viable option to get what we want now without having to wait, but it comes at a cost. Borrowing is the exact opposite of investing: someone gives away some money temporarily so that you can put it to use, and when you return it later with some interest, they gain.
So, if we don’t consider investing, what options do we have with some money set aside (but not enough) and a bit of time ahead of us?
Earning a Better Salary – Is it enough?
If we go by federal statistics, a better salary over time seems statistically feasible for most. As a rule of thumb, as we grow older, we tend to amass experience and responsibilities (and more than a few white hairs), and our salaries (usually) reflect that.
But the figure below shows that this adjustment is not linear: our salaries tend to grow faster in our younger years, but after a certain age it seems harder to earn more. In any case, aiming for a higher salary is worth pursuing, but it might not be enough.
Winning the Lottery – what are the odds?
Certainly, a historically appealing option! With a tiny upfront investment, anyone could win big. But over the past 20 years, the Swiss lotto has produced on average 24 new millionaires per year for thousands of tickets sold at each draw. So, the odds are not in our favor. On the upside, most of the revenue generated by lotteries in Switzerland is used to finance public utility projects.
Investing and saving – a middle path
That being said, investing is in a way complementary to saving. Investments usually grow over time, with the full power of compounding kicking in the longer we wait. Savings based on salary grow exponentially when we are younger, then plateau and eventually decrease.
Reason 2: The Inflation Argument
The second weapon in an investment professional’s arsenal involves a couple of big words. The first is “inflation”, another mysterious concept that even investment professionals don’t fully understand (a bit of humility doesn’t hurt). Not because they are not financially literate – the investment community has a rather high standard when it comes to diplomas and qualifications – but because of the complexity of the topic.
If we open a book on economics, we might find the following: “Inflation is a sustained, generalized increase in the prices of goods and services in an economy”. The definition seems fairly simple. And scary. Goods and services in an economy are what we buy and consume every day: food, clothes, energy, train tickets, hotel stays, movie tickets, etc. Can you imagine the negative effect on your daily life if all their prices went up for a prolonged period? To make it worse, imagine if your salary doesn’t increase proportionally.
The Swiss Scenario
Since 1984, prices in Switzerland have risen on average by close to 1.2% from one year to the next. What causes prices to increase and how it affects us is far from being clear. Many theories have been proposed by academics and each government measures inflation differently. In Switzerland, this task is assumed by the Swiss Federal Statistical Office. Every month, they record the prices of about 1,175 goods in more than 5,000 stores across different cantons and aggregate them into a basket that represents what an average household consumes.
And it doesn’t end with inflation
Even if your salary increases to match the rate of inflation, the cash that you deposit each month in your savings account has no “protection mechanism” against inflation. It is also vulnerable to two other threats: taxes and fees.
In Switzerland, taxes are levied on personal wealth by cities and cantons. Taxes on personal wealth vary from one canton to another, but they usually apply if your wealth is above a certain threshold and generally amounts to less than 1.0%. And of course, most banking services also come at a cost.
Let’s take an example to illustrate their impact. Suppose that on the 31st of December 1999, before you entered the new century, you had 100,000 CHF in your savings account. Let’s assume that your household’s spending budget looks like the basket calculated by the Swiss Federal Statistical Office. Let’s also assume that you are not tax-exempt and that your capital would have been taxed at a rate of 0.5%. Finally, we will suppose that your bank charges you 1 CHF per month for keeping your saving in their book. Twenty years later, inflation, taxes, and fees would have eroded your purchasing power by more than 10,000 CHF.
Reason 3: You’re already investing.
You might still have reservations about investing. But that doesn’t mean your money isn’t being invested. Take pension payments as an example for the Swiss scenario. Every month, a part of your salary goes into your second pillar, an occupational pension fund. Have you ever wondered what happens next? The monthly pension contributions from millions of employees or self-employed people are being reinjected in the economy. Where does the money go? It depends on the choice made by the people in charge of managing the pension fund.
Let’s take the example of Publica, the largest pension fund in Switzerland that manages CHF 42.5 billion for more than 66,000 active members and 42,000 pension recipients (if you are working for the federal administration, the ETH, or other administrative units, this is the institution in charge of your pension). Their annual report shows us how they intend to invest the money of insured people. For example, in 2020, they plan to invest between 7% and 16% of pensions in international equities. So, whether you like it or not, it seems like someone is already investing on your behalf.
Table 2: Publica pension fund 2020 strategic asset allocation
Taking active control of your money can ensure that its destiny is aligned with your values.
Does this apply to savings?
One might argue that pensions and savings are not the same, but the savings in our bank account don’t sit quietly either. The money deposited each month in your bank account is registered in the bank’s book. The bank must find a way to make this money work, otherwise, how could it pay its employees and pay interest on your money? We won’t go into the details of a bank’s balance sheet, but the money is used to finance the bank’s activities. If we ignore the regulatory capital the bank puts aside (the sort of iron reserves required for operations), the money from savings accounts is used to make loans to other clients or businesses. In return, the bank collects interests. A portion of these interests can be returned to you (now you know where the little gain you see at the end of your annual statement comes from!) but sometimes you get nothing too.
Like any other business, the bank takes some (measured) risks. If for example, the money the bank borrows from your savings account is lent to someone unable to pay it back, the bank records a loss (banks have a very poetic name for it: “A non-performing loan”). Now, if too many losses occur, they may not be able to guarantee your savings. If the bank is mismanaged, that’s a risk for your money too.
The Swiss financial system is one of the most robust in the world, and a depositor protection scheme guarantees the first 100,000 CHF you put on a deposit account. But the risk is not fully eliminated and from time-to-time banks make the news (some of you may remember how some cantonal banks had to be rescued in the early 2000s).
Taking more control of your money
While this may sound shocking, the point is to draw your attention to the fact that your money is being used to finance the economy and pay the bank. Without necessarily considering the worst, it raises some ethical questions. Maybe your money is indirectly used to finance something or someone you would have probably not chosen to finance. Of course, there are also many instances where your money is put to good use. But instead of leaving it to chance, taking active control of your money can ensure that its destiny is aligned with your values.
And how can you take active control?
Well, the answer should be obvious at this stage.
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