Financial Investments

Hi dear RIPvestors,

I started writing a post about investments last week, a post where I wanted to cover all aspects of investments. As soon as I wrote down the first draft I realized that no, I couldn’t have done all in a single post. So I decided to cut down the first post at a very high level abstraction over the concept of investing, i.e. put your resources at work to get even more out of them. That resulted in a post I liked and that inspired me to write more on the topic.

It’s now time to draft a schedule for this investing series [Update: well, the schedule changed a little bit over time. Please take a look at the lasts post to get the most recent schedule]:

So, this post is about Financial Investing, i.e. what it means to invest on financial, immaterial, liquid assets. Yeah, even just writing these things down sounds scary to me. “Immaterial” is a scary word.

When you invest in a financial asset, the physical thing you own is a record on a database on a machine. Yes, this is scary. And it’s not just that: that record on that machine holds a psychologically-leveraged number that, for example, a small and insignificant piece of information like the Brexit can make it bounce by 10% up and down in 2 days. Not scared yet? We’re not done: that pseudo-randomly oscillating number on that database represents the value in terms of units of a currency that is bound to the credibility we all have in the economy of a nation or a union of nations. There’s no more a “gold guarantee” for your 10 Euro bill. A little bit scared? Let’s add that the database where your possession is stored is not owned and guaranteed by a government, but by a company you trust that may still be hacked, go bankrupt, act maliciously. Enough? What about your bank? Can’t it fail? Your broker? Can’t it fail? Your fund manager? Can’t it fail? It scares me as it scares you.

buylandBottom line: finance is a game and you should run away from it. People with way more experience than you suggest you run away from finance. Don’t keep money in digital form, in any bank. No, wait, don’t keep money in any form! They’re just fancily printed pieces of paper. Buy goods, they are solid. Buy land, they’re not making it anymore – Mark Twain.

Have a nice da… you still here? Move on guys, the post is over!

Still here? Ok, let’s try to not think at the fictional world we all live in for a while (we’ll come back on it later in this series) and move on. So you’re brave enough you still want to play with numbers in databases. Cool. Let’s start with the basics.

Save. Yes, the very basics is: don’t spend all of your money, save some. And don’t save what’s left after spending, spend what’s left after saving. Pay yourself first. By spending less than you earn you will walk toward Financial Integrity and you’re left with money that will be accumulating in the bank. Cash, more cash every month! This is good, isn’t it?

Cash

Cash is generally good. Having cash is powerful. You can take actions, you can make big purchases, you can face unemployment or unexpected expenses like a home repair. Having some cash at hand is mandatory and every financial expert, not only on the internet, says the same: if you have none, store some cash first. Even if you have debts – unless they have very high interest rates – accumulate cash at first. It’s called Emergency Fund.

Thanks RIP, you convinced me! I’ll spend less, avoid debts and save some money. I’ll build an infinite Emergency Fund 🙂

Cool, so you are accumulating cash! Where? Well, I don’t know… you may simply leave your money on your checking account at your bank. Or cash out your earnings every month and keep all the bills under a mattress, it’s almost the same. The bank solution is more practical (don’t need to hire soldiers to protect your mattress) and more generous, since you’re donating money to your bank instead of throwing it away. No, I don’t mean you’re giving them an opportunity to steal your money – I said I’m setting aside the “world is doomed” scenario – I mean you’re letting them use your money as they wish giving you back a close to zero (or even negative) interest rate.

“Who cares RIP! I just care about my money. I want them to be safe!

Ok, you’re generous by hearth, we all appreciate that! You don’t want to make more money, you have enough, so you’re ok with what you have and with what your money buys and will buy in the future! You’re very cool! Wait… did I say “with what your money will buy in the future“? What a stupid question, it’s obvious that your money will buy in the future what it buys now, won’t it? Uh? Prices tend to go up?

inflaOh no, i forgot to take inflation into account! Well, historically interest rates have been matching or even higher than inflation rates, haven’t they? Well, yes for a while. My father built a small fortune by simply “keeping the money in the bank” (or close-to-zero risky investments) in 1970-2000. Those days are long gone now. You won’t find a checking account whose interest rate is bigger than inflation rate. And don’t forget your interests are taxed.

So I hope I convinced you that your cash is losing purchasing power over time. The longer you keep your money in cash form, the more you lose. The more you have, the more you lose. Technically, if you keep saving money at a constant pace (say 100 Euro per month) you’ll reach a point where extra monthly savings just compensate inflation loss. In the 100 Euro per month case, assuming 0% interest rate (normal in a checking account) and 2% yearly inflation rate, the month your balance reaches 60’000 Euro your extra 100 Euro will just compensate inflation! The month after, your 100 Euro won’t even do that job! You’re not just being generous toward your friendly bank: you’re damaging yourself.

Holy crap RIP… cash sucks a lot. So? Should I keep no cash at all??

No, dear imaginary friend, you should keep some cash, but in general not too much. I told you about emergency funds, right? I think it’s healthy to have one. There are objections to it, there are people who think you should not keep any cash but invest all of your NW, there are big supporters of hoarding cash, there are debates on the topic but in the end it’s a matter of size and time.

If you know you’re going to need a lot of money soon (home or car purchases, a month long vacation or financing a master degree for example) it’s ok to keep your wealth in cash or in (almost) zero risks liquid investments.

If you’re not planning for a big expense in the near future, the internet approved size of your emergency fund is between 2 and 6 months of current expenses. You can keep it even smaller if you live/work in a country with nice unemployment support or employee friendly labor laws. For example, here in Switzerland we have mandatory unemployment insurance: in case I lost my job I’d get 70% of my salary (not actually, there’s a cap which is less than 50% of my current salary) for the following 20 months.

Anyway, don’t do like I did until February 2016. I kept most of my net worth in cash and I’ve lost opportunities during last 7 bull market years. Be smarter than me, take some risk and invest the money you’re not going to need soon somewhere else.

Amazing! Thanks RIP! I went to my bank adviser and he suggested me to lock my savings in a saving account! I’ll be rich soon!

Saving accounts

Oh no… The saving accounts trap!

Saving accounts have been good for a while, but now they suck too. A lot. I got stuck with a 0.1% gross interest rate saving account (and a lot of money saved there) at my Swiss bank. I couldn’t withdraw more than 100K CHF per year, so I had to wait 2 years to get all the money out (depleted in March 2016). Never ever put money on a saving account again if getting the money out of it is complex and the interest rate is lower than the inflation rate.

Saving accounts are special tools offered by banks that give you a slightly imperceptible higher interest rate with respect a normal checking account, but in exchange your money may be more or less locked. It’s not worth a shot nowadays. Just don’t do it.

Ok RIP… What should I do with my money? What’s left? Should I lend it to someone?

That’s a better idea! We’re getting there. If you don’t know how to make more money out of your wealth, lending to those who have ideas (or are somehow in the need of money) is a good starting point!

Bonds

Quoting Wikipedia:

bond is an instrument of indebtedness of the bond issuer to the holders.

Investing in bonds means lending money to someone who’s willing to borrow at a certain price. Essentially the bond issuer is willing to pay an annual interest on the money they’re borrowing from you. The interest is usually waay better than the one your bank offers you on your checking/saving accounts. Why? Because the bank acts as middle man between you, the lender, and those who needs money, the borrowers / bonds issuers. Investing in bonds cuts the middle man out. It comes with a certain amount of risk: the bond issuer may go bankrupt, may fail, may become unable to fully repay the loan. The more solid an issuer the safer the bond and the lower the interest is too.

There are bonds issued by companies, governments, municipalities. There are fixed rate bonds and variable rates. There are asset-backed bonds and inflation indexed bonds… There are hundreds of bonds types, we’re not going too much deep here.

Examples of government issued bonds are Certificate of Deposit (CD) / Government Bonds / Treasury Bonds.

Thank you so much RIP! I’ll keep 6 months worth of expenses in my checking account as emergency fund and then invest all the rest in bonds!

That’s a strategy. It can be very fruitful if you’re willing to become an usurer or taking some risks. Venezuelan bonds this years have been the bargain of the century. The country’s crisis demanded for a very high yield on bond emission to edge against the risk of nation default. No default – but hyperinflation that reduced the actual yield – so… big gains!

Anyway, to get greater returns you have to take risks and bet on the survival rate of desperate situations. Not my desired strategy. Not very aligned with my values. I’d rather bet on the success rate of the healthiest than on the survival rate of the sickest.

Uh… can’t I lend money to the healthiest then?

Yes, sure my friend. But you’ll discover that the stronger entities are able to make profits out of the money they borrow, so everyone wants to lend money to them. Since they are solid and will pay you back, the yield of your bond is probably low. What you want to do is join them in their business. Buy a fraction of a solid company that generates revenues you can profit of. You want to buy their stocks.

Stocks

stocks-vs-bonds

From wikipedia:

The stock (also capital stock) of a corporation constitutes the equity stock of its owners. It represents the residual assets of the company that would be due to stockholders after discharge of all senior claims such as secured and unsecured debt.

Buying stocks of a company is similar to acquire a business, without the hassles of handling it. Instead of “open a bar” you may decide to buy 10% of an existing bar and outsource all the bureaucracy and simply join the profits party (if any)! Well, unless you own a lot of stocks of a company, a significant percentage of a company’s equity. In that case you’d probably not be following this blog for advices 🙂

Anyway, in case you own enough stocks of a company you can take part of the company’s decision making process and your vote matters.

Cool RIP, you convinced me! I’m gonna invest all my money in stocks! I’m going to buy stocks of the most profitable company! I’ll sit and wait for money to come! I don’t understand why everyone doesn’t do the same!

Well… they’d do but there are few factors you’re missing my friend:

First: stocks are traded on a stock market, based purely on supply and demand rules. It means the stock price reflects what people agree to buy/sell it. It means that everybody wants to buy stocks of your “most profitable company“, and those stocks already reflect this intent in their price.

Essentially, the stock price contains all the information publicly available about the expected revenues of a company in the present and the future. You should invest in a company if you think the company is going to beat these expectations. Guess me, you’ve less information to make this call than the expert and informed professional investors.

Second: do you really want to buy stocks of a single company? What about the company going bankrupt? What about new competitors for the company? What about bad product decisions of your company? What about your company not meeting market expectations?

The truth is: investing in individual stocks is a risky job and you need to know deeply the company you’re investing in, the products they provide, the directions of the market, technology, research, governments decisions et cetera. I don’t say it’s not possible, a lot of people invest in individual stocks. If you guessed the right company you can achieve stellar performances! Problem is, back to first point here, it’s a bet. Everybody has at least the same information you have (probably waaay more than you have). Who’s going to find the next Apple? You or the investor firm who sent a spy on vacation with the CTO of a startup to get insider trading information?

RIP… you scared me… Now I really don’t know what to do with my money 🙁 I don’t want to bet on a company or two, it’s risky… Is the mattress still there? If not I’m going to buy a Ferrari and who cares about the future!

Not yet, my friend, please hold on. You’ll buy your Ferrari (if that’s what you want) later. Let’s put your money at work so that you’ll buy your car out of your investment revenues!

The golden rule of the risk adverse investor is: differentiation. Differentiation means not putting all your eggs in the same basket. There are tons of techniques to achieve this and – surprise – they don’t require you to spend too much time on it!

Let’s try to buy stocks of several companies instead of betting on a single one! How to do it?

One way is to buy random stocks every month, sell them at the end of each month and repeat. Not joking, it statistically works! Not my first choice though.

A slightly better alternative is to invest time and become a stocks expert and do your trades buying and selling stocks according to your predictions. It may be fun but as we’ve seen it’s very very hard to be smarter than the other investors. It’s hard to perform better than the “pick random stocks every month” algorithm.

Another alternative is to hire an expert to manage your investments. Problem is: no matter how expert the expert claim themself to be, it’s still very hard to beat the market. Plus, your expert costs you a lot of money to try to beat the market. Last but not least, the world is full of financial advisers and they usually don’t work on your best interest. As I said in last post, the financial adviser may be interested in selling you specific products. May be your bank contacts you to make you buy their amazing products and a nice suited up financial adviser will tell you how cool the products are, being driven by their goals first (getting a bonus for the sale), bank goals second (selling their products) and your goals as last. Not a very smart move.

Probably the simplest and best alternative for an average investor is to buy stocks of a lot of companies, ideally stocks of every company on every market!

buffettoWait RIP… how can I do that? There are too many companies around. Then I assume I shouldn’t buy a single stock of every company but something more complex like purchasing more stocks of the companies with bigger capitalization. I don’t know, I’m confused… How can I buy all of them, including for example Berkshire Hathaway whose stocks  are quoted at 224,000 USD each (August 2016)?? I can’t buy a fraction of a stock.

You’re right, it’s impractical (but not impossible, a lot of long term investors do this) to buy individual stocks and have enough portfolio diversification. That’s the job of an investment fund!

… which is the topic of next post in this series 🙂

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