Why Ordinary People Must Invest

Source: Barron's Chinese

The concept of retirement did not emerge until the late 19th century. Prior to that, most people worked until they passed away. There were no golden years, no new lifestyles or hobbies, and no leisurely walks on the beach.

In 1889, Otto von Bismarck, Chancellor of the German Empire, established the world's first government-funded retirement program, transforming this situation. At that time, individuals aged 70 and above became eligible to receive payments from the government.

When asked why he created such a retirement program, Bismarck replied, "Those who lose their ability to work due to age or disability have every reason to expect care from the state." Although Germany's retirement age was initially set at 70, it was later reduced to 65 in 1916.

Bismarck’s revolutionary idea eventually inspired government-funded retirement programs in many countries worldwide, including the United States. Why did this concept sweep across the globe? Because people began living longer.

In 1851, only 25% of the population in England and Wales lived to the age of 70; by 1891, this figure had risen to 40%; today, over 90% of people reach the age of 70. During the same period, life expectancy in the United States and other developed nations experienced similar growth.

The significant global increase in average life expectancy acted as a catalyst for the contemporary concept of retirement. With the advent of retirement systems, the need for investment and wealth preservation also grew.

Before this, people had no concept of investing because there was no need to invest for the future. However, advancements in health and medicine over the past 150 years have changed all of that.

Now we have a reason to invest, and we understand why people in the past did not. But this is not the sole reason for investing—it is merely one of the primary ones. Three reasons why growing wealth is more important now than ever before:

1. Save money for your future self.

2. Hedge against inflation.

3. Replace human capital with financial capital.

We will discuss these reasons in turn and consider why they are important for personal finance.

1. Save money for your future self.

As we discussed earlier, individuals should save for their future selves, primarily their elderly selves. This is because there may come a day when you are unwilling or unable to work, and investments can provide you with a pool of funds to use in old age.

Of course, it is difficult for people to imagine their older selves, which often feels unfamiliar. Will the future self be the same as the current self, or will there be significant differences? What experiences might shape or alter a person? Can you accept your aging with equanimity?

Despite the potential differences between the future self and the present self, research indicates that considering the future self is one of the best ways to improve investment behavior.

For example, an experiment asked a group of people to view their "aged-progressed images" (digitally processed photographs showing them at an older age) to examine whether this would influence how they allocated retirement funds. Indeed, it had an impact! Individuals who saw images of themselves as elderly allocated (on average) 2% more of their retirement savings than those who did not see such images. This suggests that visualizing oneself in old age may help encourage long-term investment behavior.

In studying which motivations most significantly affect saving behavior, other researchers have drawn similar conclusions. They found that, beyond saving for emergencies, individuals who cite retirement as a motivation for saving tend to accumulate more savings compared to those without such a specific motive.

This implies that other financial goals, such as saving for children, vacations, or a house, are unrelated to improved saving behavior. However, saving for retirement can enhance saving habits. Researchers found that even when controlling for standard socioeconomic indicators like income, the experiment yielded the same conclusion.

As I emphasized in Chapter Two, income is one of the largest determinants of the savings rate. However, studies show that even with the same income, those who cite retirement as a savings motivation are more likely to save regularly. Therefore, if you want to save and invest more, be a little selfish (think more about your future self). But your future self is not the only reason to invest.

The reason you should invest is also because there are other adverse financial factors.

2. Hedge Against Inflation

Henry Youngman once said, 'Americans are getting stronger. Twenty years ago, it took two people to carry groceries worth ten dollars. Today, a five-year-old can do it.'

Unfortunately, Youngman was not referring to the growing physical strength of young Americans but to the depreciation of the dollar. Youngman’s joke pokes fun at inflation, or the inevitable reality that prices generally rise over time.

You can think of inflation as an invisible tax paid by holders of a specific currency. Year after year, they pay this tax without even realizing it. Their grocery bills slowly climb, maintenance costs for property and vehicles increase, and education expenses for their children rise annually. Meanwhile, have their wages increased? Perhaps they have, or perhaps not.

Regardless, the harm caused by inflation will continue to grow. While the impact of inflation is usually small in the short term, over longer periods, the effect can be quite significant.

As shown in Figure 9.1, at an annual inflation rate of 2%, the purchasing power of money will halve in 35 years. At an annual inflation rate of 5%, the purchasing power of money will halve every 14 years.

This means that at a moderate level of inflation, the prices of everyday goods should double approximately every 20 to 30 years. If the inflation rate is higher, prices will increase much faster.

An extreme example of inflation (hyperinflation) occurred in the Weimar Republic after the end of World War I. During specific periods, inflation rates could be extremely high, with prices of goods even changing within a single day.

As Adam Fergusson described in his book 'When Money Dies':

There is a story… where diners found that the bill had increased by the time they finished their meal compared to when they ordered. A cup of coffee priced at 5,000 marks would cost 6,000 marks by the time it was consumed.

Although such situations are rare, they illustrate the destructive impact of inflation in extreme cases. However, there is an effective countermeasure—investment—that can mitigate the effects of inflation. Holding assets that maintain or increase purchasing power can offset the impact of inflation.

For instance, from January 1926 to the end of 2020, $1 would need to grow to $25 just to keep pace with inflation. During this period, could investments in U.S. Treasury bonds or U.S. stocks match this growth? Yes, and quite easily.

If you invested $1 in long-term U.S. Treasury bonds in 1926, by the end of 2020, that $1 would have grown to $200 (a return approximately 13 times higher than the inflation rate). If you invested $1 in U.S. stocks in 1926, during the same period, that $1 would have grown to $10,937 (a return approximately 729 times higher than the inflation rate)!

This demonstrates that investment can offset the effects of inflation to preserve and grow wealth.

For retirees, the impact of inflation is even more pronounced, as they face rising prices but lack corresponding wage growth. Since retirees do not work, their only weapon against inflation is asset appreciation. Keep this in mind, especially as retirement approaches.

Overall, while there are always valid reasons for holding cash (e.g., emergencies, short-term savings), over the long term, holding cash is almost always disadvantageous because inflation erodes its value annually. Therefore, if you want to minimize these losses, now is the time to invest idle cash. If the incentive to hedge against inflation is not compelling enough, the appeal of replacing human capital with financial capital may persuade you to invest.

3. Replacing Human Capital with Financial Capital

The last major reason for investing is to replace human capital with financial capital.

In Chapter Two, we defined human capital as the value of your skills, knowledge, and time. While your skills and knowledge continue to grow, your time does not.

Therefore, investing is the only way to fight back against the passage of time and convert diminishing human capital into productive financial capital, which will provide returns for a long time in the future.

What is your human capital worth today?

Before discussing this issue, we must first determine the current value of your human capital. We can calculate it by estimating the present value of your future income.

Present value is the value today of future cash flows. For example, if a bank promises to pay 1% annual interest on your deposit, then giving them $100 today would yield $101 after one year. Applying this logic in reverse, the present value of $101 one year from now is $100.

In this example, the $101 in the future is discounted to the present at a rate of 1%, which is commonly referred to as the discount rate. When assessing lost income, most personal injury lawyers use a discount rate of 1% to 3%. Therefore, if we know how much you will earn in the future and have a discount rate, we can calculate how much that income is worth today.

For instance, if you will earn $50,000 annually over the next 40 years, your total income over 40 years will be $2 million. However, assuming a discount rate of 3%, the present value of these future earnings is approximately $1.2 million.

This means your human capital is worth about $1.2 million. Assuming these estimates are accurate, you should be willing to exchange hard work for $1.2 million. Why? Because you could use that $1.2 million to replicate your future income.

In other words, if you invest $1.2 million today at an annual return of 3%, you could withdraw $50,000 each year for the next 40 years, after which the funds would be depleted.

As you can see, the annual cash flow of $50,000 is exactly the same as your income over the next 40 years! This is why human capital and financial capital are interchangeable.

This is important because your human capital is diminishing. Each year you work reduces the present value of your human capital, as you have one less year of future income.

Therefore, the only way to ensure you have some income in the future (beyond government-provided income) is to accumulate financial capital.

Accumulating financial capital to replace human capital

You can imagine that the present value of your human capital decreases each year, while your financial capital increases to offset the decline in human capital. As shown in Figure 9.2, we assume that you earn $50,000 per year for 40 consecutive years, save 15% of your income, and achieve an annual return of 6%.

This is what happens when you save and invest. Each year, a portion of your earned income should be converted into financial capital. When you start viewing money this way, you realize it can be used both to consume goods and to generate more wealth for you.

Essentially, by investing, you are rebuilding yourself as a financial asset, which can provide you with income once you are unemployed. Thus, even after you stop working a nine-to-five job, your money continues to work for you.

Among all the reasons people should invest, this may be the most compelling yet also the most overlooked.

This concept helps explain why some professional athletes, despite earning millions of dollars a year, end up bankrupt. They fail to convert their human capital into financial capital quickly enough to sustain their lifestyle after leaving their sports careers.

If most of your lifetime earnings are accumulated over 4 to 6 years, saving and investing becomes even more critical for you than for others.

Regardless of how you earn money, the realization that your earning capacity will eventually diminish serves as one of the strongest motivations for investing.

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Editor/Rice