Why Invest? And Is Investing Suitable For Everyone?

A pile of dollars, which could have earned from hard work and accumulated through diligent saving or a windfall, or through inheritance, will remain the same pile of dollars, if nothing is done with it. It does seem to be rather a shame, with inflation eroding the value of those dollars, and especially since by simple actions such as putting it in a bank, interest can be earned on that money, as time passes. Einstein has called compounding the most powerful force in the universe. Yes, Einstein of e=mc². He didn’t think nuclear power, the same energy that gives the sun its glory and shine was the most powerful force. He thought compounding was THE most powerful force.

For the most part, the principal value of your savings in a bank can be considered risk-free, in the sense that even if the bank goes belly-up, your savings are guaranteed by government fiat, usually up to a certain amount. In Singapore it is S$20,000 (with a plan to revise it to $50,000) currently after the government withdrew its unlimited guarantee, which was put in place during the 2008 financial crisis. In the US, it is up to US$250,000 by the FDIC (Federal Deposit Insurance Corporation).

Another form of investment, in fact, even safer than putting the money in a bank (which has limits on its protection), is that of a sovereign or government bond. The return of your principal is underwritten by the “full faith and credit” of the issuing government. But bonds are less liquid than bank account savings, meaning, that there might be a reduction in your principal should you decide to withdraw your money before the tenure expires or you have to sell that bond in a secondary market, and you might face losses depending on the value the market attributes to that bond, depending on the interest rate environment and the issuer’s credit quality. (The 2008 financial crisis have put the full faith and credit of some governments in doubt, so the theoretical risk-free rate might not after all be completely risk free. Some of these governments include those of some countries in Europe and even more troublingly, the US, where a Chinese ratings agency has given the US government debt less than AAA rating.)

Other financial assets, such as common stock in public listed companies, certificates of deposits (available in the US), bonds (corporate and aforementioned sovereign, as well as other forms of debt such as collaterised debt obligations, municipal debt etc), derivative such as futures and options, property, commodities, mutual funds and hedge funds, are among the universe of other investable assets. Even art and wine has become investable. Some of these assets are traded on markets, providing the liquidity and serves as a meeting place to conduct such transactions between buyers and sellers, while others can be traded through over-the-counter (OTC) or customised transactions.

The most popular among the investment classes today must be stocks, which allows one to buy a stake in a publicly listed company making one part-owner of that company. This allows one to share in its profits, and also its risks, since the stock holder can lose all his capital invested should a company go bankrupt. This clearly is far riskier than having cash in a bank account or a sovereign bond. The only reason why anyone in a sane mental condition would participate in this risky venture is, yes, you guessed it, the chance of gaining a bigger reward, than the interest rates obtained on a savings account or bond.

Exactly how much reward is required to entice someone to part with his money to place into such an investment? We have established the minimum amount, and that is, he must earn more than he can earn on a completely risk-free investment, or that of the sovereign bond of a comparable tenure to the length of time he wishes to be invested in that company. Above that, the additional return, or premium he demands depends on his risk appetite and what is known as the market risk premium, or the systematic risk he has to endure if he buys the entire stock market.

And here we come precisely to tackling that question, is investing suitable for everyone. The answer is no. It is not. It requires that the prospective investor take on a certain risk, in expectation of an uncertain reward. I will end this first post with the words of famous investment manager and thinker, Peter Lynch, best known for his top ranked Fidelity Magellan equity fund: “In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.”