By Alan Silverstein, Fort Collins, Colorado.
Email me at firstname.lastname@example.org.
Last update: February 15, 2016
Here are some "philosophical" thoughts about the true meaning of money, taxes, saving, and investing, including beating inflation, as I sometimes see it.
Purpose: Where does this essay come from? As a long-time engineer I have some unusual problem-solving and modeling habits. Often I try relating human-created abstractions or behaviors back to underlying physical realities like time and space.
Narratives: Also being aware of models (or narratives, or rules of thumb) as simplified representations of more complex systems, I like searching for the simplest models that are valid, non-trivial, and useful. Part of being human is always looking for a "simple narrative" (or model) with great explanatory and predictive power. We love our narratives, even if they are wrong! (In a self-referential way, I love this narrative about narratives even if it is wrong. But anyway...) So here are some narratives I hope you find thought-provoking or even useful.
Illusion: Money in any form is an illusion. It's a man-made abstraction to replace simpler systems for directly bartering goods and services. However insofar as social consensus broadly supports the money illusion over wide time and space, it's a very useful creation.
As if real: What I find amazing is how often people work through "money puzzles" of all kinds as if the money itself were a real object. This is even true of writers offering financial advice. It's very rare for anyone to ask, "what does this mean in real life?" What are the tangible results (in goods and services) of this money wrangling, and why should it be that way?
Time value: One broadly held assumption is the time value of money. In terms of immediacy of gratification, and faced with the likelihood of inflation versus deflation, a dollar is worth more now than it will be in the future. Conversely it's taken for granted that money saved rather than spent now will grow, even compound, to have more buying power later. That is, returns should exceed inflation, at least for reasonable amounts of risk taking (volatility) and given enough time. We all take for granted how how "obvious" it is that you should be able to save and invest for the future in a way that gets you great returns -- at least well above inflation.
Deferral: Why should future money ever be worth more than present money? "I can have one slice of pizza today, but if I don't need it and I can put it off long enough, I can have two slices later." My take on this expectation is that deferral of gratification is usually rewarded by other people (borrowers) who cannot afford to wait, or who choose not to do so.
Sign of wisdom: I've read that the ability to defer gratification is a hallmark of higher intelligence. Basically the ability to model or predict the future, plus the discipline to be patient, allows a person to "forward time average" their resources; and to be rewarded by others for doing so.
Sidenote: I don't know how to apply this model to animals that gather and store food for future consumption, other than to guess it's an evolutionarily emergent property that increases survival on average. I speculate they would not save any excesses if hungry in the moment. They just have the ability (at certain times of the year anyway) to gather (and externally store) calories faster than they burn them in the present. Whereas most people can do much more complex internal modeling and calculation to reach their ongoing balance points between immediate consumption and future investment.
Debt: In principle the smartest people are those who pay cash for everything and never go into debt. One financial company's slogan is to help people become "debt-free and financially independent." In practice there's a lot of what's called "smart debt" where even wise people choose to owe money, and pay interest, to receive gratification sooner than they nominally can afford it.
Housing: In particular it's considered normal to use a mortgage to buy a primary home. Why should it even be necessary? I think many years ago, and still in some parts of the world, it was routine for children to live with their parents until they inherited the family home, and/or had resources to build their own separate homes. Now in an (unsustainable) expansion phase, we literally mortgage the future to have more sooner.
Unrealistic expectations: Every dollar you can afford not to spend today but instead bank for the future "should" gain in purchasing power over time. We tend to think it's not enough to "just" work, earn, save, and invest to enable our retirement, but that we're still failures if our investments don't grow well beyond their cost bases.
Social contract: Since money is an illusion, an informal social contract (albeit with very formal rules in some contexts like annuities), saving and investing for the future assumes that goods and services will be available "from society" later to pay back on the investment. In other words, the systems providing those goods and services must be mostly stable. Certainly there's a lot of economic volatility in various "markets", but humans focus on the waves while ignoring, or assuming the presence of, the underlying ocean. And that's usually a successful strategy: "The race is not always to the swift, nor the battle to the strong; but that is the way to bet." -- Hugh Keough
Stability: When I read frequently about savings rates, total values of 401k's, pension plan assets, etc, I ponder the stability of "the system". The authors never seem to ask, "what's the true future value of these investments if the available supply of goods and services generally shrinks?" (For whatever reason.) In a smooth system free of severe shocks, the best case scenario under declining resources (relative to investment liquidations) is still increased inflation. This is a market or Federal Reserve force that devalues pools of savings to approximately match the estimated total future value of all available resources.
Nominal versus real: It's important to know and keep in mind the difference between nominal and real returns. Positive nominal returns (or even flat annuity-type payouts that promise to continue as long as you live) make people feel good because their net worth increases (or their income is assured), even if they're actually (really) losing buying power to inflation.
Tracking inflation: I believe that on average over wide spans of time and space, relatively risk-free investments can only track inflation, not really beat it. This even applies to real estate, even though "they aren't making any more" (well at least land if not structures), because the cost of owning or renting property is a core part of inflation itself (on average).
Approximation: By the way, inflation itself is an approximation because every well-defined measure (such as the US CPI = consumer price index) includes some kind of "vector math" that maps actual prices, in some selected subset of time and space, into a trend. The result depends heavily on assumptions about which goods and services people need, in what proportion, and how flexible (fungible) are their choices in the face of price variations between substitutable or non-mandatory resources.
No free lunch: Reading and musing on "The Intelligent Asset Allocator" by Bernstein it became clearer to me that low-risk vehicles (like savings accounts, money market funds, CDs, and short-term US or high-quality corporate bonds), over the long term average can only nominally pay a positive return, but not really. Where nominal means in literal dollars, but real returns are after correcting for inflation.
Bid-ask: How can this be? Now I think it's a form of bid-ask spread: The bank or equivalent institution pays depositors less than inflation in real dollars, charges borrowers above inflation, and pockets the difference for their services. (Free donuts on Saturday are not free.) Of course it's well-known that financial institutions operate this way, but what's novel to me is that their "bids" for deposits are generally below inflation! (Sort of necessary on average over time and space.) It feels good to see your interest payments grow your accounts... But it's only nominal, not real, and even more imaginary after you pay income taxes.
Interest-rate risk: This is why risk-averse, "conservative" investors face "interest rate risk" and long-term loss of buying power. It's why anyone with a long-enough time horizon is urged to move to longer bonds, and/or stocks, and/or other weirder vehicles.
Income versus wealth: Another observation is the difference between income and assets that is often blurred in daily life (although often mentioned by writers of financial advice):
Work for hire: At least in principle, anyone being paid for their services (including providing goods) earns their profits fairly, otherwise the free market would eventually cease rewarding them. Of course in today's complex world it's possible to work very hard for a long time with good pay, and still not be sure at the end how much benefit you were to society! Anyway the underlying concept, worthy of understanding, is called "human capital." I won't say more about it because I have no profound thoughts about it (grin).
Giving back: There are many intangible ways (not measured by dollars) to "benefit society" during your life, while employed or retired. This includes being of service to your own family, and doing volunteer work for strangers.
Why government: I learned long ago, and still believe, that the only real justification for a government, or governing body of any kind, to exist is to enable public goods, that is, to "regulate the commons." Public goods are resources available to all citizens of the governed group (such as military protection), disproportionately to their voluntary "payments" into supporting those goods.
Government consumption: In order to accomplish its mission, a government needs a share of the goods and services available to its society. It must divert and consume some resources in order to exist and function.
What fraction? How does any government obtain the resources it needs do function? The simplest way is to just take (requisition) them by (implied or direct) force. Of course almost no one wants to live in a system like this. We prefer peaceful and predictable production and consumption.
Metered power: Given its existence (as a social consensus), money can be used as a tool to "meter" the government's power, to ensure it doesn't consume an undue (self-defeating) share of the total resources available to society. -- Of course whenever a government runs a long-term deficit resulting in an increasing public debt, in the same proportion it abrogates its responsibility to live within its means! But anyway --
Creating money: A direct way for a government that controls the printing presses (real or virtual) is to create more money for its own use. Ideally this would still be only to a "metered" extent authorized by its constituents. This is actually simpler and more efficient than any meta-system of taxation.
Why taxes: So why don't we just have, say, the US government print all the money it needs, and stop worrying about taxes? I believe this could work, but it would be high-inflationary because it requires increasing the money supply faster than the amount of goods and services. This would not be desired by asset-rich people for whom inflation is more of a problem than those whose paychecks tend to rise with inflation. Also lower-level governments without central banks would be left moneyless.
Taxes inefficient: So paradoxically we suffer with a variety of taxation systems that ultimately waste real resources (goods and services) in order to meter government consumption without necessarily unduly increasing the money supply.
Pools and flows: In basic terms it's possible to tax either pools (assets) or flows (income and sales). At various government levels in the US we have many examples of varieties of all of these. And the combination of all of them, experienced by one person with income and assets, can be quite onerous. It's even said that poorer people pay an unfair share of their resources in overall taxes compared to richer people.
What to tax? One common problem in any tax system is precisely defining the pools or flows being taxed so the system remains simple and fair. The devil is always in the details (and the tax code grows accordingly over time) as you try to define what exactly is a taxable asset, income stream, or sale.
Increasing complexity: I observe that tax systems nearly always increase in complexity until they are revamped or fail -- often along with the underlying government itself, which is a real hardship for its society. Ideally we'd be smart and disciplined enough to simplify our tax systems even as we learn from our mistakes or are offended by unexpected emergent properties (such as abusive tax shelters).
Status quo: In practice people and their business entities are clever enough to game (optimize) any system and "flood the space" with various strategies. As one result, any change in tax rules is harmful to someone, who usually squawks loudly about it. And since humans naturally tend to be innumerate and to think anecdotally, we often give disproportionate attention to these situations, hindering real progress towards long-term simplicity and fairness.
My opinion: I believe that we should keep the IRS -- on the whole they serve a useful purpose and do a pretty good job with limited resources -- but abolish the US income tax system (all flavors). Then replace it with a national sales tax using processes already in place almost everywhere. (Also called a "FairTax" system.)
Tax consumption: This change would more directly tax consumption than production, which is an improvement. However it's seen as effectively regressive because it impacts poorest people hardest. That's relatively simple to fix by deciding on a national, flat, per-capita tax-free spending allowance, and sending everyone (or their guardians or estate) a periodic (monthly or annual) rebate of the taxes that this level of spending would entail.
Asymmetries: If someone chooses to live in a more expensive part of the country, that's their choice. If someone doesn't even consume/spend the allowance amount, so they come out ahead, more power to them.
In this section I drifted somewhat away from pure philosophy and more into giving free advice...
Elevator speech: What I tell random people who ask how we retired at age 57 is this: "If at all possible do not live up to your income. Save and invest the difference, starting as young as possible so compounding has time to work. Invest in broadly-diversified, low-cost index funds. Keep it simple, boring, and stable through ups and downs." As Allan Roth said, "Investing isn't a game, and doing it right really isn't any fun."
Asset allocation: Once you start saving and investing, the next most critical decision you must make and revise over the years is how to allocate (and reallocate) your assets. I won't belabor this here, but advise readers to do their homework and learn what this means. There are many, many great sources of information on this seemingly simple question that leads to intricate knowledge.
Entire portfolio: Keep track of the entire forest even as you wander through the trees. This means: Make all of your major financial decisions in the context of your entire portfolio, including illiquid assets like home equity. Beware "penny-wise but pound-foolish" investments or allocations that skew your grand plan in unexpected ways.
Stocks versus inflation: Why are stocks supposedly "inflation-proof", and in fact return a lot more than inflation, including dividends? Because over broad space (diversification) and time (buy and hold -- but readjust to your asset allocation):
All stocks? So does this mean you should be 100% in equities? Not unless you have 20-30 years to wait, and have a strong stomach for volatility, and trust that the future will at least somewhat resemble the past. (In early 2016 there are rumors of fundamental shifts that could lower stock returns in the decades ahead.) Remember, "the worst year in the bond market is better than the worst day in the stock market."
Real estate: So why not real estate? My narrative on that, coupled with disappointing personal anecdotal experiences, is that over the broad span of space and time, real estate cannot grow beyond inflation. It's a key part of inflation. Even if we ran out of room and materials ("they're not making any more land"), there's a limit to the fraction of each person's resources that can sustainably be spent on "housing" and related costs.
Beware anecdotes (and resulting greed): Of course in many times and places you can, and many people do, make a killing with savvy real estate investments. Perhaps because in some ways the asset class is more predictable than stocks or bonds. Plus rental real estate pays whopping "net dividends" if you are lucky. Personally, though, no joy.
Outliers: One fun narrative is that we're all easily swayed by attractive outliers. We judge ourselves as failures if Jones over there sold his swampland property at a killing compared to our meager returns, or if Smith did really well in the stock market, compared to us, using his "secret formula." Despite being risk-averse, or perhaps because we unduly fear "underachieving," we're prone to chase hot sectors, buy high, sell low, and hide our failures out of embarrassment. Worse, we are easily suckered into various get-rich-quick schemes.
Be conservative: All of which is to say, I think it's fine to be rather conservative with your retirement investments. Once you retire, or are close, stop gambling with your future, or comparing your returns to those made by some other people. But do hold the money you don't need "soon" (opinions vary on how long) in a mix of bonds and stocks (or equivalents) in a broadly-diversified, low-cost way, but only at a level where you don't lose sleep over big stock downturns (recessions).
Diversify: Bernstein explains with numbers and plots how adding some stock to an all-bond fund can decrease the risk = volatility, while increasing returns; and adding some bonds to an all-stock fund can also decrease the risk while not sacrificing much returns. This is due to imperfect correlation between the classes, which is desirable.
Satisfyce not maximize: Why do so many people think they are above average and "deserve" to beat the game? Aspirations are wonderful, but karma paybacks are hell (grin). Boring long-term investing plans (turtles) can win the race (early and secure retirement) compared to gambling (rabbits).
Sponging: One concern I still wrestle with is the "fairness" of living off your savings and "sponging off society," without being productive, while unemployed or retired. Most people think I'm nuts for even worrying about that, after all we mostly respect "rich" people, especially if they "earned their own wealth." Ah well, ultimately it's about enjoying life as much as possible while you're alive, and being as good to everyone else as you reasonably can too.