A Lesson in Finance
Since I live in the US and I presume most of my readership is in the US, I will confine this essay to the US equity markets, but the concepts can be applied globally. The US Stock Market has historically returned about 11-12%. Investing about $30K today will yield $3MM in 40 years, but this ignores inflation, which has averaged 3% historically. Inflation erodes the purchasing power of the $3 MM. So, when analyzing investment returns, we control for this up front so that everyone is talking about the same thing: the real value of the investment. If we subtract the 3% from the historic returns of the stock market and we get a ballpark estimate of the real annual return of somewhere between 8 and 9%. Given the inflation devil, we can count on the market to return 8% real, over the long term.
The "Time Value of Money" concept means that a dollar today is worth more than it is tomorrow. So, let's analyze a $30,000 investment in the stock market over 40 years at 8%. If we invest $30,000, today, and sit on it for 40 years with an 8% real rate of return, compounded annually, we will have $651, 735.64, assuming no taxes and no transaction costs. Another way of saying it is that in 40 years, $651,735 will be equivalent to $30,000, today, given these parameters. Or, the $3MM at 12% in 40 years will have the purchasing power of $651,735 in today's dollars.
Now let's look at what we would need to do to have $3,000,000 in the future. In order for us to have $3 million, in an 8% interest rate environment, we would need to invest $138,092.80, today, assuming that you meet the market in your return over the course of the investment. The 8% is the mean and there are deviations around that mean. The standard deviation, in finance, is how we measure risk. That is to say, you won't earn 8% every year; there will be deviations around this long term average return. However, for those who invest for the long-haul, they will find that more often than not they will hit their annual 8% real return target in a diversified portfolio.
There are two kinds of risk about which we must worry, when investing: systematic and unsystematic. Systematic risk refers to the risk associated with the market; it is the risk that you face due to changes in the overall market. We cannot control this piece. Then there is the unsystematic risk component, which is something that we can control.
The best way to eliminate unsystematic risk and ensure that you meet the market is to invest in an Index Fund, which is a fund that includes all of the market. There is no unsystematic risk and one does not face the huge transaction costs that one would face were they to buy one of each stock in the market. If you want to match the market, then invest in an index fund.
On the other hand, if you think that you can beat the market by engineering a sophisticated portfolio, then you would decrease the systematic piece of your risk and increase the unsystematic piece. This would increase your risk, but you would also have a potential to beat the market and the risk can be managed through diversification. For unsystematic risk, the way we deal with it is to diversify across different sectors of the market, such as energy/utilities, airlines, telecommunications, etc.
This strategy is a hedge such that if one sector falls vis-a-vis the market, another will rise to a certain degree with respect to the market and depending on their relative risk levels and the weights in your portfolio, the movements will offset each other.
Depending on your risk appetite, we could also include some T-Bills to help you manage your portfolio risks, given a certain appetite for risk. We use T-Bills, or what we call "riskless securities", because they are backed by the US Government, which has never missed an interest payment since it has been in business. I could start talking about Betas - a measure of a stock's relative risk vis-a-vis the market, but it would only complicate this analysis and it might confuse you.
In terms of any portfolio, the key is diversification to minimize risk and maximize exposure to the market such that you optimize your portfolio, given your risk appetite. The best strategy to construct a portfolio that meets or beats the market (75% of the Mutual Funds out there don't do beat this benchmark), while minimizing the portfolio's exposure to risk. A good strategy for a young person would be to buy an Index Fund in a Roth IRA (i.e. with after tax $$), which meets the market return, but also bears the market risks. To further minimize an investor's risk, one would divert some of their nest egg away from the Index Fund and into bonds and some international holdings.
As we near retirement, we will want to gear down the aggressive capital appreciation strategy of our youth and allocate this capital into more conservative investments such as bonds. As a matter of fact, young people should have bonds in their portfolios, anyway. This serves as an effective means to insulate our portfolios against market variations, or systematic risk. Young people should probably allocate 10-20% of their nest egg toward bonds and another 10% to international holdings. If I were constructing a portfolio, I would probably have 10% in a Bond Fund, 10% in an International Fund, and 80% in an Index fund.
There all kinds of different kinds of bonds that people can buy and interest rate games that speculators can play. I could go into these, but it would make this post very long. It is too long to get into in one post and there is a difference between investing and speculation. Speculation is like gambling; one should only engage in it, if they can afford to lose the cash.
The key is to invest for the long term and be diligent about investing on a consistent basis. Ultimately, your long term return depends on how much risk you assume; the market rewards those who assume risk in their portfolios. Your job is just to minimize your exposure to it. The theory teaches us that the more risk you are willing to take, the more reward you can expect. That is not to say that there won't be bumps along the way. It just means that over the longer term, when things average out, you will be compensated for the added risk you assumed, given that you took appropriate measures to manage the risk in your portfolio.
The "Time Value of Money" concept means that a dollar today is worth more than it is tomorrow. So, let's analyze a $30,000 investment in the stock market over 40 years at 8%. If we invest $30,000, today, and sit on it for 40 years with an 8% real rate of return, compounded annually, we will have $651, 735.64, assuming no taxes and no transaction costs. Another way of saying it is that in 40 years, $651,735 will be equivalent to $30,000, today, given these parameters. Or, the $3MM at 12% in 40 years will have the purchasing power of $651,735 in today's dollars.
Now let's look at what we would need to do to have $3,000,000 in the future. In order for us to have $3 million, in an 8% interest rate environment, we would need to invest $138,092.80, today, assuming that you meet the market in your return over the course of the investment. The 8% is the mean and there are deviations around that mean. The standard deviation, in finance, is how we measure risk. That is to say, you won't earn 8% every year; there will be deviations around this long term average return. However, for those who invest for the long-haul, they will find that more often than not they will hit their annual 8% real return target in a diversified portfolio.
There are two kinds of risk about which we must worry, when investing: systematic and unsystematic. Systematic risk refers to the risk associated with the market; it is the risk that you face due to changes in the overall market. We cannot control this piece. Then there is the unsystematic risk component, which is something that we can control.
The best way to eliminate unsystematic risk and ensure that you meet the market is to invest in an Index Fund, which is a fund that includes all of the market. There is no unsystematic risk and one does not face the huge transaction costs that one would face were they to buy one of each stock in the market. If you want to match the market, then invest in an index fund.
On the other hand, if you think that you can beat the market by engineering a sophisticated portfolio, then you would decrease the systematic piece of your risk and increase the unsystematic piece. This would increase your risk, but you would also have a potential to beat the market and the risk can be managed through diversification. For unsystematic risk, the way we deal with it is to diversify across different sectors of the market, such as energy/utilities, airlines, telecommunications, etc.
This strategy is a hedge such that if one sector falls vis-a-vis the market, another will rise to a certain degree with respect to the market and depending on their relative risk levels and the weights in your portfolio, the movements will offset each other.
Depending on your risk appetite, we could also include some T-Bills to help you manage your portfolio risks, given a certain appetite for risk. We use T-Bills, or what we call "riskless securities", because they are backed by the US Government, which has never missed an interest payment since it has been in business. I could start talking about Betas - a measure of a stock's relative risk vis-a-vis the market, but it would only complicate this analysis and it might confuse you.
In terms of any portfolio, the key is diversification to minimize risk and maximize exposure to the market such that you optimize your portfolio, given your risk appetite. The best strategy to construct a portfolio that meets or beats the market (75% of the Mutual Funds out there don't do beat this benchmark), while minimizing the portfolio's exposure to risk. A good strategy for a young person would be to buy an Index Fund in a Roth IRA (i.e. with after tax $$), which meets the market return, but also bears the market risks. To further minimize an investor's risk, one would divert some of their nest egg away from the Index Fund and into bonds and some international holdings.
As we near retirement, we will want to gear down the aggressive capital appreciation strategy of our youth and allocate this capital into more conservative investments such as bonds. As a matter of fact, young people should have bonds in their portfolios, anyway. This serves as an effective means to insulate our portfolios against market variations, or systematic risk. Young people should probably allocate 10-20% of their nest egg toward bonds and another 10% to international holdings. If I were constructing a portfolio, I would probably have 10% in a Bond Fund, 10% in an International Fund, and 80% in an Index fund.
There all kinds of different kinds of bonds that people can buy and interest rate games that speculators can play. I could go into these, but it would make this post very long. It is too long to get into in one post and there is a difference between investing and speculation. Speculation is like gambling; one should only engage in it, if they can afford to lose the cash.
The key is to invest for the long term and be diligent about investing on a consistent basis. Ultimately, your long term return depends on how much risk you assume; the market rewards those who assume risk in their portfolios. Your job is just to minimize your exposure to it. The theory teaches us that the more risk you are willing to take, the more reward you can expect. That is not to say that there won't be bumps along the way. It just means that over the longer term, when things average out, you will be compensated for the added risk you assumed, given that you took appropriate measures to manage the risk in your portfolio.
posted by Sean | 8:59 PM
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