Money. As the universal medium for the exchange of value in our society, it has wide utility. One may gift it to their loved ones or people in need, hoard it under the mattress or in a bank, lend it out, use it to get an education, spend it on a million different goods and services, or pay off debt.
Since two large problems inevitably come about in the life of every ‘ordinary citizen’ – the fight against inflation, and financial safety in retirement, which in the end are are intertwined – another great usage of money is to try to front-run these problems by actively multiplying one’s money.
Compared to gambling in a casino or other less-than-witty endeavors, a relatively safer way to do so is financially investing it. Of course that doesn’t mean you can’t lose every last penny if you don’t know what you’re doing and not managing risk properly. The terminology of the word ‘investing’ is misleading such as for stocks or luxury goods and the term ‘speculation’ would apply, but I will still use ‘investing’ here as it is the commonly used term in such context.
Why we ourselves need to take care of our financial safety
For many people, the end-game of investing is to build a large ‘war chest’ of capital over time that will in later in life be spent or enable them to own assets and get a steady passive income. Prominent income streams are rental proceeds from real estate, dividend yield from appropriate ETFs/stocks, or interest payments from the fixed income market (bonds, money market funds, deposit certificates, etc).
And there is a need to generate such income streams by ourselves. The times are over when we could rely on an employer pension to fund our retirements, and today’s pensioners are already facing problems achieving even relatively comfortable lifestyle with the new generation of retirement plans. High earners of course might amass a comfortable nest egg with 401(k) plans … but most people aren’t high earners – and even then, it’s not guaranteed to get you through the rest of your life.
Relying on government social security to keep us afloat when we’re old won’t work well either. On average, western population life expectancy is increasing – people are getting older. That means they live a longer unproductive span of their lives, all while each successive generation proceeds to have less children (see chart below for the US population growth rate). That results in a trajectory of less people working whose sinking tax revenue is spent on benefits and healthcare of older people that live longer. Today already, the average social security benefit payments are only a little more than $1500 per month, barely enough to get by, not even to mention living comfortably. The system is failing quickly. No sunset retirement on a beachfront property.
What’s a good income for retirement?
The onus for financial safety in your retirement is on you. The problem is, if you don’t want to resort to continue working until the day you die, you need to have a large lump sum or passive income that can sustain your living.
A retiree spends about $50,000 per year in expenses – for an average retirement, no great comfort, no expensive journeys traveling the corners of the world.
Putting social security and retirement payouts together, most people that have some savings barely achieve even that. About half of all US pensioners have no retirement nest egg whatsoever, and a large portion of the other half has accrued only minimal savings. Many people do not or can not stick to consistent saving, bleeding their retirement plans early, others’ income is just not sufficient to build a large retirement balance. For different reasons, retirement plans continue to fail the average citizen.
Working could be an option. But active income from running your own business in retirement has its own drawbacks. Although this can be highly rewarding and produces the best payoff in the world of finance, you need to work for it. Constant effort, time and commitment to work against the forces of a unrelentingly competitive marketplace are required. This is not the dream of every retiree, and owning a business is preferable to running it, which brings us to back to assets.
To be able to live comfortably and assuming you don’t want to be employed until you keel over, we need a consistent strategy of wealth building. We need to be able to buy or own assets during or near the end of our working lives, that generate enough payout for a passive stream of income that can be subsisted on.
Looking at rental incomes, dividend yields or bond payments, I estimate you would need about $1-2M or more when retiring to produce a passive income stream that can supplement retirement and social benefits enough for you to live a reasonably comfortable life, enabling one to spend somewhere between $80,000 to $150,000 or more annually on enjoying life and traveling. This number of course varies massively on location and lifestyle, but you get the gist.
Banks are not the solution
Can we save our way to financial security? Yes and no. Yes, it was possible … once. But no, today, and especially since the millennium, there is as good as no opportunity left in that arena.
In the times of our parents, you could compound money out well in a bank. The interest rate on the 3-month certificate of deposit (CD) in a bank was approximately averaging 8% throughout the 1970s, ’80s and ’90s, and at times as high as 18% (!!). Today, these numbers are unheard of in traditional finance, and only an extremely high-risk junk crypto token that might be de-listed in a few years will offer this today and at the cost of high volatility.
Most people put money in their piggy bank. I buy a goose that lays golden eggs over and over again. That’s what an asset is.
Robert Kiyosaki
Interest-bearing CDs in the last 20 years have only offered a long-term average annual interest of about 2.5% (see chart below). For a thought experiment, let’s be lenient and assume that the Fed will reach their inflation goal of 2% annually in a swift manner, and monetary policy will not pivot right back to ultra-loose low-interest rates in the next few years (a large concession, since there is every indication that central banks will again come around to low-interest Valhalla near whatever the next economic or political crisis will be).
In that case, an adolescent whose parents today put $5000 into the bank, tie up that money over 50 years (!!) and add $1200 a year ($100 per month), the child will have only made a $69,167 profit from interest – a ridiculously low 106% return over 50 years. Together with the principal of $65,000, and barely even enough to own a very small flat in the outskirts in most parts of the western world or to live off sustainably for more than two to three years.
But that’s not even what’s really there. Purchasing power is the true yardstick of money … adjusting for inflation, the child would after 50 years of saving and hoping only have a tiny true profit of $9,390. With an average 2% long-term annual inflation rate and an average 2.5% interest, you effectively have only 0.5% interest. That is, if my concessions to the monetary environment and interest will manifest.
Come even mildly lower rates and borderline higher inflation, real interest becomes null or negative and you effectively lose money saving. Even bond coupon rates or money market funds give you a better return than saving in a bank account, but there your money is tied up and you can only access it in case you need it for an emergency at a heavy cost. You can lose substantial amounts of money when forcing the sale of a held-to-maturity bond on the secondary market before maturity, potentially nullifying and even exceeding any interest gained.
Plain hoarding of money is an uphill battle against the ever-looming threat of decreasing purchasing power. It would require that you set aside much large swaths of money, producing over time a large lump sum that then arguably would remain somewhat valuable even after inflation adjustment. But saving $500 to $1000 per month over 30 to 50 years is not a viable solution for the average employee citizen with a family, expenses, holidays, rent or mortgages to pay, etc. The large majority of people would not be able or willing to meet this goal.
Building wealth through capital gains of assets
The question remains, how can one generate a moderately large lump sum over a course of a few decades?
The case that I want to make here is that, apart from actively running and growing your own business, the stock market is a superior vehicle for passive, semi-active or even active appreciation of capital to build a critical lump sum for retirement. This can then be spent slowly or swapped for income-generating assets. Even when only achieving market-rate returns with a passive long-term strategy, the compounding effect can work true miracles over a course of 2 to 5 decades.
Stocks as an asset have a number of advantages over other asset classes when it comes to the purpose of generating capital gains (i.e. I won’t be talking about bonds here). These are a low requirement for starting capital, extremely high market liquidity, and top-tier rates of risk-adjusted return.
In the box of stock investments for capital gain, I include active speculation, buy & hold investing, and passive investing, but I exclude leveraged derivatives such as options. While active speculation offers premium returns, the passive and buy & hold investing can work well for compounding returns over a long time frame – but only when adhering to specific rules. However, leveraged derivative trading is not to be trifled with for the amateur and casual investor, and will more likely lead to poverty for those.
Starting capital requirements
The beauty for the beginner is that any amount of money can be invested in stocks.
There used to be a time where commissions for an order were as high as $50 to $100, which made especially active trading near impossible for the small operator, and was even by long-term buy & hold investors only begrudgingly accepted. Nowadays, low- to no-commission brokerages, and the possibility to buy fractional shares of more expensive stock have leveled the playing field for the very small and young investors.
Today, you can start with less than a hundred dollars and invest in the stock market. Of course, even massive relative returns only generate minimal absolute gains if the principal is small. A phenomenal 100% return on $50 invested still produces only another $50. I’d estimate if you’re young and ambitious, you can start with as few as $1000-$5000 to fund an account around the age of 16 to 20 and start compounding returns over your life. In such a way, there is not need for the small amateur investor to dabble with leveraged derivatives, where about 95% of traders do not make net profits or lose their money rapidly.
The only other now-popular asset class that tolerates such a low entry capital availability is crypto, where tokens can be owned in smaller quantities as low as a few pennies (e.g. bitcoin is split into 100 million ‘satoshi’), with as good as no commissions. This is one of the many reasons why cryptocurrencies are popular with the younger population. However, the long-term up-trending price trajectory of the crypto market has to be normalized to its excessive volatility and risk (read below). I include NFTs in this category as well.
A bit more expensive but still manageable in smaller quantities are popular physical commodities such as the precious metal gold. To get a small 1oz bullion, you’ll have to fork over about $1800 at the time of this writing. If that is a problem, almost anyone can invest in gold with smaller capital buying gold ETFs in the stock market. Gold can be a valuable long-term investment with a relatively low threshold of required entry capital, but a problem for profitability lies in a very slow long-term trajectory of gold prices.
This is in stark contrast to trying to own physical real estate for capital gain. Even the smallest apartments in most parts of the western world in at least borderline metropolitan areas start at about $120,000 dollar – most quality real estate that can command higher rental income will come with 3 to 5 times that price tag. And that doesn’t even include the large sales commissions, which tend to be nauseating in some marketplaces. Most people would need to take on mortgage debt to acquire such properties – a liability, not an asset. Equally, most people are unaware of the more complex dynamics of housing prices that can quickly uproot the ambitions of an unwitting investor, while those that possess property can tell you a thing or two about the financial, bureaucratic and mental burden of owning and maintaining rental properties.
Real estate can be highly rewarding as a vehicle for capital appreciation, but it has a high threshold cost of entry, and even many experienced landlords lose money net due to not understanding boom and bust cycles in housing markets.
As a bit of a rare “hobby”, collection of luxury goods for capital appreciation has a somewhat higher starting capital requirement than stocks, crypto or precious metals, though not as high as real estate on average. The cheapest old-timer cars (but also the least likely ones to appreciate strongly) start at about $20,000. Sometimes these can sell for monumental amounts of money down the road, but the necessary cars for such a collection just about start upwards of $50,000-$100,000. The average Hermes bag is easier to acquire, starting at about $5,000 but quickly rising to upwards of many millions. However, the law of supply and demand will not bring the price of the more widely-produced ‘lower’-priced luxury items or more ‘mundane’ brands up that much over time, unless they were already rather expensive almost unique to begin with. A capital-intensive market indeed.
Liquidity
Liquidity, for the purpose of long term investing, is the ability to buy and sell at at a given time at a desired price. The enemy of liquidity are thinly traded dry markets, where few transactions happen at a given price level, and there are relatively few buyers and sellers. This leads to an effect called ‘slippage’ – the difference between the price you wanted to buy/sell at, and the price you eventually accepted just to get the transaction going. Borrowed from stock- and forex markets, this term applies everywhere in principle.
Real estate is one of the most illiquid asset markets known to man. If you’re in a good market in an economic and housing boom and in a good location, this will be less of a problem for sellers, as buyers fall over each other to acquired property to inhabit, rent or speculate with. Slippage becomes a problem for the buyers, who outbid each other and sometimes have to pay substantially more than they wanted to, as there is usually always someone willing to pay a higher price if they hesitate to buy on the spot. Insiders and well-connected businessmen and -women can get preferential rates of course – but we’re talking about the everyday citizen here.
Come a market top or a bust, the buying dries up and sellers abound. Now, the opposite takes place. Too many houses flood the market, too many people are desperate to raise cash. You might have to wait for years for someone to be willing to pay the price that you want, as the market price averages for your type of property can drop quickly and might only return to higher levels a decade or more later. The difference between what people want to sell at and what they are offered can be gigantic, and if selling becomes a must, housing prices can crash quickly as history has taught us. Slippage is high, because there is always someone willing to sell for less than you are asking when the going gets tough.
In the housing markets, illiquidity-induced slippage of 10-50% is not unheard of, before even taking the market trend into account. Real estate, similar to the capital goods and inventories of the business world, is of limited convertibility due to a small and rather dry market. People and businesses most of the time only have high pressure to sell their house or liquidate capital assets when economic tensions mount – and that is the exact time when everybody else wants to sell as well and few people are looking to buy.
Of course, there are areas in the world (national capitals or otherwise sought-after local regions) where there are constantly more buyers for real estate if one needs to sell, a continuously ‘higher-liquidity’ housing market. But nothing comes for free – there, purchasing prices, upward slippage and waiting times to acquire the same prohibit most young and under-capitalized people to join the market, the very stratum of the population that are in need of low-capital thresholds and leveraged opportunities to appreciate their money and for whom this article is written.
On the other hand, gold, crypto and especially stocks are extremely liquid. In fact, equity is, after the forex and bond markets, the most liquid marketplace in the world. Any time you want to sell a stock, you can sell it with the push of a button on your phone. Execution in a second or less. Brokerage software is accessible from as good as everywhere in the western world, and US exchanges trade over $500 billion worth of stock every single day. It almost doesn’t get more liquid than that.
The same goes for crypto – any time you want to sell crypto, you connect your wallet to your PC, log into your exchange account and within a second you have a trade confirmation.
Of course, we could argue that there are lower-liquidity stocks and lower-liquidity crypto tokens, which don’t show this ease of transaction. But there are minimum quality criteria to which you have to adhere in any market to succeed, and that has to be normalized for comparison. You wouldn’t build a $1 million house on an eroding cliff that will collapse in the next 20 years, and be surprised when nobody wants to buy it from you. In the same way, a serious investor does not buy Italian penny stocks or stocks that trade 10 shares a day, and then expects that he will be able to exit this market quickly in a heartbeat without getting stuck in a vortex of down-spiraling price. Equally, you shouldn’t buy into the average junk crypto token recommended by the Kardashians on social media or anything that trades at a thousandth of a dollar. Stick to the top 5 capitalization tokens.
Selling gold in physical form will take a few hours or so, depending on where you are. This is still reasonable compared to selling a house. But of course, gold can also be traded using ETFs on the stock market, with the same exact returns and instant trade executions.
Coming back to the comic relief … how about liquidity in selling odd luxury items or old-timers? Well it really depends. An online auction of high-demand handbags can be done within a few days, whereas an expensive historic car or the high-end handbag will take longer than that and likely require a real-life auction. The limiting factor again is demand, and that depends on the item itself, market saturation & demand, and it’s perceived value. As a rule, don’t expect to be able to sell at the level that you really want to, unless you got something really rare.
Liquidity is a big one – it enables you to manage risk properly, as the amount of risk you can or want to take on is a function of where and how fast you can leave a market if price trajectory starts moving against you.
Risk versus reward
When comparing rate of return, it is not just about the percent made over x years, but the volatility one would have had to endure and the potential draw-down one would have had to take if one had to exit at a given time. This is often described using risk-adjusted metrics such as the Sharpe ratio, which tells us about the excess reward one would gain from enduring volatility in an asset.
However, we’re talking about long-term holding of gold, real estate, or stocks here. I’m not a fan of long-term non-monitored investing, but then the discussion of volatility is also not really important if you truly commit to long-term investing, thus I won’t discuss it. For true buy & forget decade-long holders, the question whether to listen to your fear at market bottoms and sell in panic should not come up, thus volatility becomes irrelevant over an ultra long-term time frame. I’ll just assume that you understand the tenets of long-term investing, which are the same for all asset classes. They are plainly something you have to commit to, if such is your chosen path. And for those seeking to actively speculate in stocks – well, truth be told, you shouldn’t be in the position of having to endure a market draw-down in the first place.
If you really want to talk about risks of passive long-term investments, look at young people owning property. Until you’ve paid off a mortgage, the property doesn’t belong to you … in reality, it belongs to the bank. If you don’t think so, you’re fooling yourself. Many yuppies have bragged about their new shiny home, just to see it repossessed a decade later as they lost a job or for some other reason could not meet their mortgage payments.
Anyway, let’s focus on return. During the first 20 years of the millenium, the S&P 500 returned 120%, whereas the Winans Real Estate Index has merely returned 38%. Going further back, since the 1950s, stocks have returned 5 times as much as capital gains than real estate. A clear picture so far. Of course, a skilled full-time real estate investor can extract higher returns from the market. But that does not apply to the average 20-year old passive long-term investor who is not experienced in the nuances of the housing business, economic cycles and the boom and bust pendulum.
These numbers of under-performance fall in line with the other drawbacks of real estate for the small investor. There is a compromise however. As for physical gold and gold ETFs on the stock market, you may consider a real estate investment trusts (REIT) traded on the stock market. These are essentially pools of different property types and strategies bundled into a company that is traded on the stock exchange. They offer great returns, low-capital entry threshold and high liquidity. For example, the REIT ETF ‘IXRE’ measured from Lows of the financial crisis in 2009 has returned almost equal gains as the S&P 500. But then … might as well buy stocks.
Active stock picking can outperform passive strategies by wide margins, if done correctly and not based on misguided principles. The best stock speculators can produce returns of 150% to 200% in great years, but these come along only so often. But looking at consistent profitability annualized over a decade or so, a 30-50% return is reasonable to expect if one knows how to latch onto winning stocks and manage risk.
However, as described above, even just owning the right mutual funds or a passive ETF portfolio would outperform inflation by a much larger margin (e.g. the S&P 500 has returned about 12% annualized since 1957) and handily outperform real estate, gold, bonds or bank deposits.
Using such a return, the child from the story above would sit on $1.98M after 50 years, inflation-adjusted. That’s more of a return on investment than the chump change from bank deposits.
Of course, temporary draw-downs can be heavy when following buy & hold or passive strategies in stocks, but again, for a long-term holder that should not be a problem in any case. The problem is that most people can’t commit to holding and sell at the wrong time.
Crypto markets, as a nascent branch of financial markets that has just about started its course of price discovery, has produced much higher returns to date which will come massively down over time when adoption and regulation picks up. Bitcoin has an annualized return of about 1,500%, a ridiculously high number – but again, it’s a fringe investment, and this opportunity will fade over time. However, it’s also an unheard-of phenomenal return that can reward those willing to take the risk.
And the risk is massive. While stocks have regular draw-downs, severe pullbacks of 40-60% are rare and happen only every couple of decades, and such declines can be mitigated by owning mutual funds to about half that percentage. Not so in crypto, which is as volatile as venture capital. If your savings are in bitcoin, be ready for a 40-70% pullback every 1 to 2 years, and 80-90% declines for the regular ‘crypto winters’ that come to haunt this asset class every 4 to 6 years or so.
Of course, needing to cash in crypto for a real-life application in years of crypto winter is not an option. There is large opportunity, and volatility over time will subside in this marketplace, but one has to be able to stomach it. And the fact remains that even most self-declared ‘long-term investors’ do puke and panic-sell for a heavy loss at the bottom, otherwise market cycles as we know them would not exist.
Let’s turn to precious metals. Physical gold has on average returned 4.5% annually over the last 100 years, and it’s sister metal silver 3.5% per year. Gold is, after bitcoin, the hardest and most sound money known to man, especially when compared to the ever-devalued fiat currencies issues by today’s governments that are bleeding us all dry financially, but holding gold as a store of value is not without its drawbacks.
Though the above numbers sound enticing, they are heavily skewed from 3 periods of time (1930s, ’70s and early 2000s) where prices appreciated rapidly, while they lay flat for decades in between. For a substantial part of the last 100 years, gold actually made you a loss from the perspective of converting to cash & buying power. From 1934 to 1971 (that is almost 40 years !!), sitting in gold actually continuously lost you real money by more than 50%. From 1981 to 2001, a period of 20 years, you would have lost about 75% in buying power. No one lives long enough to buy and hold gold for 100 years, rather 30-50 years tops before one would need to cash in that investment. If you happen to be in one of those environments, it’s like watching a train derail in slow motion.
Here, the gold price of the last 100 years:
Now, there is no free lunch – other asset classes also show flat periods for lengthy amounts of time. For example, stocks were virtually flat for about 16 years in the 1960s/’70s. But these periods are shorter and rarer, while upswings are more frequent, long-lasting, and return more than gold
Considering all, stocks make the best overall performer
Comparing all categories, investing in stocks resides within the top tiers regarding risk-adjusted returns, liquidity and capital requirements. I believe they are the best choice anyone can make when aiming to build a reliable nest egg for one’s future, and I strongly affirm that every parent should start putting money for their children into a passive index-tracking ETF or hand it to a well-performing mutual fund manager.
Don’t get me wrong, every asset class has pros and cons. Real estate for example is a great store of value for those that already have a lot of money. But it’s certainly inherently prone to high risks and mismanagement, and sports a steep learning curve, capital requirement and and a willingness to endure stress, if one opted to employ it for capital gains purposes.
Considering everything, stocks stand out in every direction for the average under-capitalized and moderately risk-hungry youngster just starting out her life and wanting to enjoy the later days of it in comfort, security and carefreeness.
