Saving vs investment

Pragmatic Capitalism: What every investor needs to know about money and finance, by Cullen Roche

PRAGMATIC Capitalism is not an introduction to managing your money; it is a very valuable insight into building a financial portfolio for people with at least some experience. The value lies in finding out more about what you presumed you already understood.

If there was one inescapable lesson from the great financial crisis of 2008 is was that the world is now a global economy.

There are estimates that 71% of the movements in the financial markets are the result of macroeconomic trends, making the understanding of the global economic machine more important than ever.

The author, Roche explains: “One of the big lessons of this book is why I think the macroeconomic matters more than ever.” He also notes that some 69% of all people participating in the financial markets have a local market or a company-specific focus. A microeconomic view is grossly misleading.

Successful local companies rapidly aspire to become national companies, and then multinationals. This aspiration has played out in most businesses - from pathology laboratories to supermarkets, to manufactures. The US-based S&P 500 index is no longer a US index; it has become a global index. To understand the companies and their performance today requires a global, high altitude understanding.

Saving and investing

There are only three things you can do with your income.  You can consume it, you can invest it, or you can save it. Roche offers important, clarifying insights into each of these uses.

Consumption is the final sale of goods and services. You will do nothing more with what you have purchased than own it, enjoy it, or use it up. This is probably the most obvious use of your income.

Investment is spending your income on something that will create future production. The most valuable use of your income is in the investment that generates the greatest returns. This investment, Roche believes, is the investment in yourself. The overwhelming majority of the wealthiest people in the world achieve this position through personal expertise.

“If you’re a doctor, you should invest in becoming the best doctor. If you’re a teacher, you should invest in becoming the best teacher,” says Roche. Making a sound investment in your primary expertise is usually the best way to maximise your income.

The third way to use your income is called saving. Savings is money set aside for your future requirements and must be available at that time. As such, you will need to ensure that your savings are in safe places to ensure that they will be there when you need them.

Buying shares in listed companies is not investing; it is merely a form of saving. The only time it is an investment is when you are providing funding for future production, and this only occurs when the company lists for the first time. Buying shares in the company after that, “simply changes the legal ownership of the… stock from one person to another. An exchange or reallocation of savings has occurred, but no funding of future production has occurred.”

The goal for our investment portfolio is to help maximise future production. The goal for our savings portfolio is to protect our saving from a loss of purchasing power (or from being lost completely.)

A particularly interesting chapter in this book is the one dedicated to dispelling some of the more common myths around portfolio building. I have selected five of the eleven.

You too can become Warren Buffett

The media commonly portrays Buffett as a folksy, clear-thinking, stock picker. The reality is that Buffett, like others on the Forbes list of the wealthiest people, is an entrepreneur. His wealth was not created by allocating funds. The shares for which he is best-known constitute only 28% of Berkshire’s assets. His most famous holdings, Coke, American Express and Moody’s constitute only 8%.

If you wish to emulate Buffett, focus on developing your business acumen, as Buffett did, not on stock picking.

You get what you pay for and high fees mean good value

Money managers rarely do better than indexed funds as evidenced by numerous studies. Indexed funds do better mainly because they attract a fraction of the fees of a money manager.

Passive portfolio management is better than active portfolio management

Passive investing involves allocating your income to an asset and just leaving it there. This is to avoid the risks involved in forecasting market moves. However, even passive management is a form of prediction; you are predicting that the movement in the market over time will be upward.  The difference when actively investing is that that you predict the future each time you move.

Both carry risk.

The stock market will make you rich

Roche is very firm in his belief that your primary source of income, your trade or profession, is how most people get rich. It is possible that you might get rich through buying shares, but very few do. Focusing on your primary source of income is a far better bet. Buying shares is only a way of saving.

Your house is a great investment

Over a thirty-year period housing in the US has given a return of just 0.74% after expenses such as repairs, taxes and interest. Over the same period, shares in large US companies have given a return of 5.79% and government bonds 3.38%.

What I have described in this piece is only some of the most accessible insights of this book. There are many more that will challenge your thinking, and you will be better at managing your portfolio for that.

Readability    Light ---+- Serious
Insights        High -+--- Low
Practical       High -+--- Low

- Fin24

*Ian Mann of Gateways consults internationally on leadership and strategy and is the author of Strategy that Works. Views expressed are his own.

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