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knowledge bank

Dec 12 2016
Lawrence Lam

You are an inadvertent investor

Asset allocation
 Investing is not an optional activity – we are currently all investors, whether intentionally or inadvertently.

Given that investing is not an optional activity, we need to be aware of our investments and what implications these (intentional / inadvertent) decisions will have on our future.

Regardless of investment goals, investing should be, at the very least, a defence against inflation.


Investing is not an optional activity

Constant updates on financial news, information and statistics fill our newspapers, TVs and personal devices every day. These updates provide us with very detailed information regarding aspects of the economy that may not affect our everyday lives. So why is this information so important that it needs to be on the daily news? The answer, I argue, is that we are currently all investors, whether we choose to be or not. And this news is relevant to all of us whether we like it or not.

Most of us have a bank account and that bank account will contain some money. The money we have that bank account will serve a purpose in our lives. For example, we may be saving for a home, we may be purchasing goods with the money, we may be using it to pay off our debts, or we may just be saving the money as a buffer against unforeseen circumstances. Ultimately, we want this money to serve a purpose for us. We unconsciously make two choices:

1.     spend the money now; or

2.     keep the money for use later.

If we choose to spend the money now, we have less to spend in the future. In economic jargon, this is called an intertemporal choice. [If you’re more interested in this topic, the Chicago Booth School of Business has published an interesting paper here: http://faculty.chicagobooth.edu/richard.thaler/research/pdf/intertemporal%20choice.pdf]. For the majority of us, we will spend some money now, and keep some for later.

Of the proportion we keep, regardless of whether we make a conscious decision regarding where to keep the money, we will make an investment decision. Even if we choose to do nothing and keep the money in our bank account, we have already unconsciously decided to keep the money as cash. We have invested the money in a bank deposit.

As long as we have savings, we will be making investment decisions, so we are already investors. And as long as we are investors, we should be, at the very least, aware of our choices and what impact these choices will have on our future.

Implications of our choices on our future

Each type of investment has its risks and rewards. Over the short term, we may be more concerned about risks rather than returns. For example, if we anticipate an upcoming expenditure, we will be more inclined to set that money aside in a bank deposit until such time it is required so that the amount is kept safe. The implication of this decision is that a bank deposit typically has a low rate of return compared to other investment options. Over the short term, we would rather preserve our money than take excessive risk, so it is understandable that we may choose to forgo a higher rate of return in favour of preserving our money.

However, the implications change significantly if we adopt a longer-term view. I argue that it is necessary to take risk in our investments over the long term in order to preserve wealth. It is not a choice. The eroding waves of inflation make it unwise to keep all our money in a bank deposit.

Investment as defence against inflation

Over the past 10 years, the price of goods and services in Australia has risen at an annual rate of 2.4% per annum (http://www.rba.gov.au/calculator/annualDecimal.html). In other words, a $100 item in 2006, would now cost us $127 in 2016. If our income remained unchanged over the past 10 years, our ability to purchase goods would have decreased by 27%. The rising cost of goods and services forces us to keep up, otherwise our wealth is eroded over the long term.

Over the long run, term deposits average a 5% to 7% rate of return, providing us with reasonable protection from inflation. Risk is low, but returns are equally low. Some argue that term deposits are safe investments over the long term. I would agree, but I would add that shares are equally low risk of over a long-term horizon. The chart provided by Fidelity confirms that the Australian ASX 200 index has always appreciated over any 6-year period since 1986. See the chart here: http://www.fidelity.com.au/fidelityP2/?LinkServID=B91D14A6-B125-E8DC-BB83AAD60C35BC5A. For no additional downside risk over a 6-year period, shares have generated a return of 9.5% per annum.

With current bank deposits returning 2% to 3%, in my view, it is not an option, but a necessity, to look for investments beyond bank deposits. Investments with the ability to increase along with inflation are preferred instruments for preserving long-term wealth. Whether you are aware or not, we are already running in an investing marathon against the constant headwinds of inflation.