There are a couple of arguments that I have heard people use to stop the discussion about investing cold. We examined the assertion that investing is simply gambling last week. Gambling is a good way to lose your money. So, it is important to invest rather than gamble. However, all investing still carries some risk. At the other end of the spectrum, some decide that they don’t want to take any risks with their money.
While stuffing your mattress with money instead of investing it may sound safe. Is it really? You will note on the speculation spectrum below that at the extreme of saving without investing that risk rises again. Why is that?
Why Bother Taking Any Risks Investing?
All of investing carries the risk that you will lose money.
Investing, at its core, is lending your money to a company or government. That can be giving money to buy a stake in the company (equity) or a loan with interest payments (fixed-income such as bonds). The riskier that investment is, the more potential reward there needs to be to entice you to invest. That greater expected return to compensate for risk is the risk premium.
You could lose money from investing in a company whose profits and prospects sour. Or lending to a government that becomes insolvent. That is called investment risk.
Diversifying reduces investment risk through spreading your money out across multiple companies and investment types. This can be conveniently done with ETF investing or more labor intensively by building a portfolio with a large number of diverse holdings. Diversification reduces risk, but does not eliminate it.
There could be events that affect the broad markets as a whole. That is called market risk. Diversification amongst multiple countries and markets smooth out that risk. Yet, we can’t get rid of market risk completely. Fortunately, even severe blows to different regions don’t usually last forever.
Market risk is lessened when we invest over long time frames. There may be short-term problems, but we are betting than humankind will make overall economic progress over the long haul.
Not investing also carries risk.
Without investing, you may not grow your money enough to meet your financial needs or goals. While that mattress stuffed with dollars from the early eighties was soft, comfortable, and reassuring. It is not nearly as comfortable now. Canada changed to loonies in 1987 which are way too hard and lumpy. Now, we also have toonies and a 2018 toonie is about the same as a 1987 loonie in buying power. Inflation has squished the loft of your financial pillow-top as illustrated below.
The value of your money is constantly eroding due to inflation.
If you don’t invest, or you have a return of less than inflation, then your buying power will shrink over time. That is inflation risk or purchasing power risk. As you can see above, it was more rampant in the 1970s. However, inflation still marches slowly onwards. Inflation, as measured by the consumer price index, has run ~2%/yr for the last twenty years.
It is so gradual that most people don’t notice it. Except for those who have been around long enough to reflect on their bygone earning years and how much further their dollar stretched back then.
Balance the investment risk against inflation risk for your goals.
This means a portfolio with enough aggressive investments to grow your money enough to meet your goals. But also safe enough to not lose it.
In broad terms, that means designing a portfolio with as much equity allocation as you can tolerate. Yet, tempered by enough fixed income (like bonds) to keep the volatility within your risk tolerance for investing. Also, some bonds more effectively dampen volatility than others.
The goal of that approach is to maximize the probable returns by taking more investment risk while avoiding sabotaging performance with bad behaviors (behavioral risk). Behavioral risk rises when your portfolio exceeds your risk tolerance.
The above strategy is to maximize investment returns. However, we really need to circle back to the goal of investing in the first place. That is where we should start when considering how much risk we need to take.
What are your goals and how much money do you need?
We can have all sorts of short-term financial goals. However, good investing has a long time horizon and is for long-term goals. We should save (risk-free money storage at a bank or GIC) for short-term goals and invest for long-term ones.
Two of the most common long-term objectives are saving for a child’s post-secondary education and funding our retirement. I discuss saving for Mini-Me’s evil medical school tuition using an RESP elsewhere. Let’s focus today on retirement.
Why save for retirement?
We have our working years to convert our human capital (earning power) into financial capital that we can draw on to pay for our needs when we no longer work. If we fail to do that, then we are dependent on social safety nets to rescue us. That means Old Age Security (OAS) and Guaranteed Income Supplements (GIS).
OAS and GIS
Before you get too excited about the opportunity to get back some of the tax money that you’ve paid over the years, consider that this really is for those in dire need. Besides the fact that it doesn’t need to be you if you make responsible choices, it also sucks. The maximum OAS/GIS for 2018 was $10769/yr for a single and $17224/yr for a couple. Even if you just share Fancy Feast with your kitty for your calories, that would cost about $3650/yr/person. Yes, I actually calculated that based on the price of a case of cat food at Walmart. The normal personal finance blogs can be found elsewhere on the internet 🙂
Canada Pension Plan (CPP)
Those who have paid themselves with salary will also have CPP. How much CPP you actually get depends on how many years you collected a salary after age 18 and how much you paid based on your income. Very few people collect the full amount. You can also get 42% more if you delay taking it to age 70 rather than 65. Assuming that you take CPP at age 65 and get the max (unlikely), it is about $13600/yr. Getting the maximum is probably optimistic.
Put together, max OAS/GIS/CPP is about $24K/yr for a single and $44K/yr for a previously dual-max-CPP-paying couple.
That is livable. Most medical students are probably looking at that as luxuriant. However, consider the following:
- Is that what you want for your retirement lifestyle? Compare that to your current spending (hopefully minus the mortgage and work-associated costs).
- That biking around town for groceries and all of those money-saving things that younger people do may not be the same when you are old.
- Who knows what OAS, GIC, and CPP will look like in the distant future? We are going to experience the grey-tsunami soon which may re-shape the already terrible governmental balance sheet. Political risk.
Some of you may say, “Yep. No problem. I am good with all of the above.” Great. You don’t need to save or invest for retirement. Otherwise, you do.
You will need to build up some financial capital to fund the retirement lifestyle that you want. Investing helps.
Building financial capital is relatively simple. You need to earn more money than you spend. In the above schematic, that means making your blue arrows bigger than your green ones.
For the work-spend exchange, that means spending less than you make.
Investing money enters the equation through earning income using your money instead of your labor. To make your blue arrow bigger than the green one in the money-investment exchange, you need to take more risk. You take those risks to get paid the risk premium and hope that you get paid it without loss from the investment or behavioral risk.
High-Income Professionals Get An Excellent Exchange Rate On Their Human Capital Through Working
This means, that it is possible for a high-income earner to quickly build a large amount of financial capital. This can be done without investing if they have a much lower spending rate. For that to be successful for retirement, then the financial capital built also needs to be large enough to still be sufficient after erosion from inflation. Critical to that balance is the time frame.
Compressed Earning Years
Most high-income professionals, like physicians, start earning the big-doctor-dollars later in life due to extensive training. For some, it is even a second career. Generally, the longer the training, the higher the income.
Similarly, specialties that burn up more mental or physical effort and/or comfort at higher rates tend to pay more too. These factors may truncate a career or at least reduce the amount or type of work one is able to do as they age.
It is subjective and not a perfect relationship. Hence all of the pay-relativity debates going on. However, the factors that result in more dollars per unit of time also decrease the units of time available for earning over a career.
More Tax Drag
With progressive taxation, more take-home pay is not a linear relationship with hours worked. More of the money earned is siphoned off as income tax when it is earned rapidly.
High-income earners have an earning advantage, but it is attenuated by career compression and progressive taxation. This makes the spending side of the equation critical. You convert disproportionately more human capital to financial capital when you shrink the spending side of the equation compared to working more.
Balancing The Equation
The most common reason cited behind the argument that people “must” take the risk and invest is inflation risk. However, that is really only one piece of the puzzle. When we consider that the reason for investing is to help us achieve a financial goal, we need to account for other factors. That generally means how well we can convert our human capital into financial capital.
For retirement planning as our goal, we are exchanging our current time, effort, skill, comfort, and security (human capital) for a pool of financial capital to provide those things to us in the future. The involves balancing more than just inflation risk.
We need to plan to balance our current needs with our future ones. That is part of spending wisely. Additionally, while doing that, it is a balance between working, spending, saving, and investing. We can’t control the inflation risk. The tax drag can be optimized with good tax planning, but not eliminated.
So, yes, it is possible to plan for retirement by removing risk from the scales and not investing. A safe low-paying investment like a GIC can probably match inflation (pre-tax). However, investment return and risk are proportionally related. If you lower investment risk/returns, then you will need to make up for that by shuffling some of the other weights on the scale.
That usually means earning more and spending less. Spending less is disproportionately more effective due to progressive income tax. It could also mean lengthening your career to increase the years of building your financial capital while reducing the number of years that you draw on it before croaking. You may also accept a lowered retirement income. These are all personal decisions.
Can you afford to not invest?
Investing is taking on risk with the reasonable expectation of getting a good return. The less money you need, the less risk you need to take growing it. Most people, even high-income professionals, will need to take on some investment risk to achieve their financial goals.
Can you get away without taking any risk?
Most people cannot because inflation will eat away at their savings. Using GICs could mitigate that since they usually at least match inflation (pre-tax). Further, most people still desire a retirement lifestyle greater than that provided for by the basic government programmes. They can afford to not take risks and they will live. Just not the way that they want to.
For high-income professionals, the answer is “maybe”. It is possible to earn and save enough without investing. However, that requires sacrifice in other areas. Working more or working longer (as long as life doesn’t intervene). Spending less now or in the future. We are fortunate that we do have more choices. Our large incomes allow us to save way more than the average person if we spend less – even if we spend as much as the average Canadian family.
Are you one of the doctors who doesn’t need to invest? If not, how much risk do you need to take? Find out next week.