Savings, Inflation and Index funds - Investing path part 1
Can savings be enough? How does inflation get into it? And what about index funds?
Snir's investing desk is a newsletter focused on intelligent, value investing for the individual investor. The subjects are evergreen and deals with the essence of investing, mental models, and concepts.
There are many ways to invest our money. We can buy an index fund, give our money to a professional money manager, actively invest it ourselves, purchasing a real estate asset to rent, and more.
Different approaches require different skills and attention and yield different results. It is essential to reflect and examine our circumstances when we choose a path.
In this 3 part series, we'll go through several investing approaches to determine which one can work for you. We'll consider the risks in each approach and your personal circumstances.
In this part 1 we'll cover Saving money and the implications of inflation, as well as Index fund investing.
In part 2, we'll cover Professional hedge funds and Buying a real estate asset.
In part 3, we'll cover active investing in stocks.
When we talk about investing, visualizing the future is essential. For that reason, I built the investing calculator tool. This tool will allow you to type in your current settings and speculate about potential futures with different approaches. This tool is meant to be used alongside this article.
Setting goals and economic abilities
To start, you have to decide on 3 core numbers:
- Retirement age
- Life style cost after retirement
- Investment account yearly contribution (which affects the current lifestyle cost ability)
These numbers can drastically change the outcome:
- Early retirement means fewer years to accumulate wealth while having more years to live off retirement money.
- After retirement, a high cost of living means a quicker burndown of the capital, requiring either more money to be saved before or retiring later to have fewer years living off the retirement money.
- Saving more earlier in life can significantly affect your wealth looking 20 years into the future thanks to the compounding effect. 10,000$ with a 7% annual return for 20 years is ~38,700$. But give it 40 years, and it will be ~150,000$.
These numbers require some thought to output something realistic for you.
The yearly contribution to your investment account, for example, should reflect a sensible average throughout your working years. As a student, you might not earn as much as later in your career. Later in your career, you might want to start a family, that will limit your ability to contribute to the account. Try to consider all that.
Then, choosing a retiring age and lifestyle cost can affect the realistic options you'll have to reach these goals.
Why do I choose to be an active investor?— Snir David (long term investing) (@snird) December 4, 2020
I want to retire early and have a comfortable lifestyle.
For this to happen I need annual returns of ~15% per year for the next 14 years.
It's not crazy, but it's not something I can achieve with an index too.
Consider your needs.
Savings (and Inflation)
The easiest path of investing is not doing it at all.
Unfortunately, saving money, even on a very high percentage of your income, is doomed to fail due to inflation.
Inflation is continually destroying the value of our money. It might do it slowly, but compounded over decades, it is substantial.
To examine the effect of inflation, we first need to get an inflation number. Even though in recent years inflation was low, we are looking here at an adult lifetime. That's at least 50 years.
Looking at the last 100 years, we can expect an average of ~3% per year annual inflation.
You might get lucky and only get 2% annual inflation in your time. Like those born in the 30s, you might also get unlucky to suffer a much higher average inflation rate in their time.
3% per year it is then. When compounded, it means prices will multiply every ~24 years - two times at least within your adult lifetime.
A living cost of 50,000$ per year now will be 200,000$ per year within 48 years.
Let's take an example scenario:
- You are 25
- You earn 100,000$ a year on average throughout your career.
- You save 40%! That's 40,000$ every year.
- Your lifestyle costs 60,000$ a year on average (taking into account starting a family, unexpected expenses, etc.), and you never upgrade.
These are pretty generous terms. Within those terms, when you reach age 60 you'll:
- Save for 35 years.
- Save 1,400,000$
By now, 35 years later, your 60,000$ lifestyle is a bit more than twice pricier. It'll be 168,000$ per year. And it is growing.
On these terms, you'll have money for ~8 years. By the age of 68 you'll be broke.
And this is on really good, almost unrealistic terms of savings and living costs and without considering inflation occurring within your working years.
Inflation is crazy. We'll have to take it into consideration in all of our next examinations (and my investing calculator tool allows you to consider it automatically).
Index fund investing
Index funds are everyone's darling in recent years. And for a good reason.
Historically, investing in an index fund yields 5%-10% return annually (depending on the index, the timespan, etc.) and does so without any hassle from the investor.
You dollar-cost-average every month into an index fund and get the market results. You then adjust your living costs and savings accordingly, which is typically sensible when assuming average market returns, and you have a retirement plan without worries.
There are a few caveats, though, and each deserves a lengthy post, but I'll try to cover it here quickly.
First, past returns are not an indicator for the future. The S&P 500 did 7% a year on average, but that does not mean it'll have the same performance for the next 30-40 years.
Second, many great investors claim that the hype over index-fund investing made so many retail investors rush in, regardless of individual stocks price, which resulted in a recent index funds bubble.
If we are indeed in a bubble state, we might see a drop so deep that the index won't recover for decades. Similar things happened before in large economies. Take a look at this graph of the NIKKEI, Japan's stock market index.
Investors getting in on this index in the 90s are yet to recover. 30 years later.
But risks aside, let's assume the S&P 500 will keep its average performance for the next decades, and you'll be able to get 7% returns annually.
We can use the investing calculator tool to see the outcome.
In the case of this photo, the investor will run out of money too early. And this is before accounting for inflation.
Use the tool with your conditions.
You'll often find that index investing will require a reasonable savings rate to retire at age 60-70, depending on the savings rate and the living cost.
That's good, but don't expect an early retirement option out of it.
That's it for the first part.
In the next part, we'll cover hedge funds, real estate, and active investing.
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