There are 3 levels of investment success that investors can achieve:
1 - Preserving the real value of their savings (2-3% pa growth)
2 - Grow the value of their savings in real terms (4-7% pa growth)
3 - Become rich through investing (achieving 8+% pa growth)
Many investors are fixated on becoming Level 3 investors, but the reality is that a large number of investors fail to even achieve Level 1 outcomes. They take on risks and leverage subscribing to the "no risk no gain" mantra. Some succeed (sometimes by luck, sometimes through skill), but others end up sustaining losses which set them back permanently.
Investors should figure out how to achieve Level 1 returns before thinking of higher level outcomes. Then when they decide to go for Level 2 and Level 3 outcomes, they will be able to only undertake "risks" that even if things don't work out, will allow them to achieve a minimum of a Level 1 outcome. This is essential, because inflation is here to stay, and is the enemy that every saver faces. There is nothing more tragic than watching the value of your savings slowly disappear before your very eyes.
Inflation, the enemy of savers, is inherent in contemporary political-economy
Why? Because:
- In an economy where money supply is free to grow (e.g. in a fiat money economy, or even in a gold back monetary system if it is in a period where new gold is constantly being discovered and dug out of the ground), it is practically impossible for cash savings (stored work) to maintain or grow its purchasing power. Why? Because in contemporary economic systems, there are always new claim checks (credit) being created for which work has not yet been done. The fractional reserve banking system always extends credit (i.e. creates money via the money multiplier effect) before the underlying productive capacity is created to back this new money that has been created. In such a system, purchasing power is highest for people creating economic value in the here and now. The purchasing power of unclaimed stored work done in the past (i.e. cash savings) is bound to deteriorate over time.
- Further, in fiat money economies with societies where the interests of all sectors of society are represented by politicians facing periodic re-election, political forces and human nature tend to create inflation over the long run. Money creation will like be invoked repeatedly to hide the true cost of government deficits, and smooth over financial losses incurred at various times by different segments of society.
This of course, does not mean that deflation will never occur. It can occur over short term periods of monetary destruction, for example when a large number of banks fail because they made bad loans, or when people withdraw their deposits out from the banking system and convert it into cash which they stuff into their mattresses. Deflation can also happen during periods of major changes in the structure of economic production. For example, the adoption of new technologies like the steam engine which cause the cost of individual items to drop and overall productivity to increase, which general keeps wages constant so that people end up consuming a larger overall basket of goods (in a sense, this isn't “true deflation” - rather it is a failure of measurement - i.e. it only looks like deflation because the price level is the only thing we are measuring).
2 Strategies to Preserve purchasing power of Savings
under two types of Inflationary environments Because inflation is inherent, the challenge for savers is that they need to become investors in order to preserve the purchasing power of their savings. The way to do it is conceptually simple but difficult in practice: hold cash during deflationary periods, and hold assets (whose nominal value grows in-line with the inflation rate) during inflationary periods.
The former is simpler to do: simply convert all assets to cash during deflationary periods. This requires us to identify inflection points between periods of deflation and inflation, which requires us to apply qualitative judgment.
The latter is more challenging: we need to figure out what kinds of assets will hold their real value in inflationary periods. Inflation occurs when the money supply changes are not in line with changes in underlying economic production, by exceeding the amount needed for the upcoming amount of production. (I subscribe to the theory that inflation is a monetary phenomenon. Inflation occurs where there is a sustained rise in the general price level. We are not talking about changes in relative prices which are caused by localized supply/demand changes, or changes in the demand/supply chains arising from technological or structural changes; for example the advent of containerization made it cheaper to import tropical fruits, and reduced the price of exotic produce in supermarkets.)
Investors need to respond differently depending on the environment in which inflation occurs:
- Money supply increases in excess of increasing population/economic production. In this type of inflationary environment, one of the safest things to do is to hold a share of the profits accruing to the economy's underlying productive capacity. We can do this either by owning a share of all the companies in the economy, or own the land which is required to house the population and capital assets in the economy. This of course, assumes that the land in the economy is limited, and that you are not in a wild-west frontier town where available land is in abundance. (This refers to actual land on which we can create value; not an apartment or some strata-titled portion of a building whose earning power depends on factors beyond its control)
A passive index tracking fund is the easiest way to buy a representative share of all companies in the economy. It saves you the trouble of having to buy shares in individual companies in the economy. (If you did this, you would have an additional problem: some of the companies would inevitably go bust as their products become obsolete. New companies with new products would come up. You would have to constantly rebalance to get the money from your existing investments to buy shares in these new companies. A stock index, by periodically dropping off declining companies and adding in new up-and-coming companies, solves this problem for you. It is roughly equivalent to only holding companies that are in their middle age. Dying companies are sold off as they shrink, but before they go bust, and the proceeds are used to buy shares in up and coming companies which are past their youthful growth and maturing into middle-aged big company status.)
As the economic pie grows bigger, your assets will not just maintain their purchasing power, their purchasing power will actually grow in real terms. The only thing that will destroy this real return is if you either (a) buy the stock index at an unreasonably high a price, or (b) the economy structurally changes and permanently reduces the corporate sector's profits as a percentage of GDP.
- Declining population/economic production; with money supply not declining in line with declining production: Investors in such economies face an insurmountable barrier. Holding cash is futile because inflation diminishes its value, while holding a share of the economy's productive capacity would be futile, since economic production continually declines. To see how this works, imagine that the economy is that of an isolated island. If the people on the island are slowing dying out, then the amount of goods that are being produced will also slowly drop. You could hold 100% of all the profits accruing from economic production, and it wouldn’t mean much over time. Likewise, holding a factor of production like land is also futile, unless you can sell it to foreigners looking for a second home. Investors would do best to move their savings to a country where the population is not shrinking.
Even if deflation were occurring in this dying-out island, investors holding cash would only be delaying their day of reckoning. While their cash holdings would enable them to buy more and more of the local produce, the amount of local produce would eventually drop to a level where it falls below the critical mass needed to support the specialization of labor required for many of the complex products in modern living. Unfortunately, this isn't just an academic exercise - there are many countries in the world where the population is already declining (e.g. Japan) or are soon to decline.
The corollary of this analysis is that investing in a passive index-tracking fund, often touted as a simple and safe way to invest over the long run, is actually a bet on macro-economic outcomes. Long term investors of such funds are making macro-economic bets, and it is wise to keep in mind that predicting macro-economic trends is a difficult task.
Investors in small countries need to preserve the
International Purchasing Power of their Savings
by Investing Internationally Investors living in small economies, where the economy is not broad enough to provide all the goods and services desired for modern living, need to invest internationally to preserve the purchasing power of their savings. (For example, if you are living in a small economy which only produces widgets, it's not a good idea to only buy a share of the profits of local productive capacity, unless you're very sure that widgets will continue to be in demand for the next 100 years. Instead, you'll also need to buy a share of the farming capacity of other parts of the world, a share of the economic production of countries which make bricks, computers etc.)
But investing internationally presents another challenge: foreign exchange exposure. How should we think about this?
Currencies will undergo bouts of over and undervaluation, and in practice, it is incredibly difficult to know whether a currency is over or undervalued, and when this will change. There are a lot of variables involved, and over/undervaluation can persist for decades. For example, growing current account deficits in themselves do not necessarily indicate that a currency is overvalued, since in the world of free flowing capital, the desire for a currency as a safe haven can cause this over valuation which in turn causes a current account deficit by making imports "too cheap". A mercantile explanation for currency movements and current account deficits doesn’t capture the reality of the present economic and financial architecture. With free flowing capital, it's difficult to tell if the tail is wagging the dog or vice versa. (Some would even say that it's hard to know which is the dog and which is the tail!)
There are 2 broad strategies that can be employed to preserve the international purchasing power of savings:
- Buy the profits of every economy. You can buy a share of the profits of the productive capacity of all countries at the same time, so that over time, overvalued and undervalued currencies cancel each other out. This works as long as long as global production continues to grow (i.e. the global economy continues to grow).
- Buy the profits of international products/commodities. You can also buy a share of profits of the productive capacity of an internationally used (and internationally traded/shipped) product or commodity. It is important that the product or commodity chosen be one that will continue to be in greater demand over time. For example, you can buy a share of oil production, but you wouldn't buy a share of natural gas production because natural gas tends to be difficult to transport and is often used locally where it is found (at least until the global infrastructure for handling LNG is built up). For internationally transported products and commodities, the price level is constant across the globe, and real (not nominal) producer profits will generally be unaffected by changes in the value of individual currencies.
There will also be situations where a company operating within a foreign country looks undervalued (or an entire corporate sector, e.g. the S&P 500, looks undervalued). The question then is: is the currency of the country of the intended company undervalued or overvalued? If it is overvalued, then any investment there may be a Sisyphean one - when the foreign currency drops from its overvalued position, any gains in foreign currency terms could be negated in international currency terms. For example, buying a share of the electricity production of an island nation that only exports bananas won't help you if bananas experience a permanent drop in value in the global market (perhaps because scientists discover that eating bananas causes premature aging). You'd be a prominent “tycoon” on that little island and the villagers would fete you like a king to keep their electricity supply on, but it wouldn't give you the means to buy cars from Japan, wine from France, a trip to San Francisco, and so on.
Making investments in a foreign country requires a qualitative assessment of the country: its social, legal and economic structure, and its long term economic relevance to the world. You'll also need to determine the probability that the currency is over or undervalued, the forces driving the apparent over/under valuation of its currency, and what will probably cause this to change.
No country is truly self sufficient, so Investors in big countries should also think about preserving International Purchasing Power
There is a case to be made that no country in the world today is truly self sufficient. Given the extensive specialization and division of labor, and large scale of production needed to support the complex products and technologies that we use in daily life, it is entirely possible that our modern standard of living can only be accomplished if all of humanity is involved in its production (so that we can achieve the needed scale of size and specialization). So preserving the international purchasing power of savings may be a concern of all investors, not just those living in seemingly small economies.
When buying assets (to preserve purchasing power of your savings), only buy at a fair/cheap price
This entire discussion presupposes that investors only buy those assets we've discussed when their prices are at fair-value or lower. No matter how intrinsically good an investment is at preserving real purchasing power, buying it at an overpriced level can make it an unprofitable venture. Buying at a fair price is an essential rule for successful investing.
Image by Martin Kingsley, via Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License