Understanding why to invest through the financial goals spectrum

· 556 words · 3 minutes read Investing

I’m currently reading Pragmatic Capitalism and the author comes up with a simple way of framing the reason why someone ought to invest his savings. I think you’ll find it as insightful as I did!

The financial goals spectrum

The thinking goes as follows. When you invest your savings, you have two overarching goals:

  1. Protection against loss of purchasing power. You invest in stocks, bonds or other assets because you want to earn a good return. At the very least, you want to beat inflation because it will maintain your future purchasing power.
  2. Protection against permanent loss. On the other hand, you don’t want to run the risk of losing most of your savings. You are going to need your savings at some point, for instance at retirement, or to buy a house. It would defeat the whole purpose of saving if you would lose a significant portion of your saved up wealth just when you need it. There is a possibility you can earn an outsized return if you decide to short Tesla today. but the possibility is also there that you’ll lose your investment (and more) by doing that.

These two extremes are conflicting and thereby form a spectrum. You can plot the various assets that we invest in, stocks and bonds, along this spectrum:

The financial goals spectrum

The financial goals spectrum

Starting at the bottom and going up, we have:

  • Savings account. The least risky, meaning that we have the most protection again permanent loss but also the least protection against loss of purchasing power.
  • Developed markets government bonds. TIPS, intermediate German bonds, etc… Over the long-term, these earn a low return.
  • Investment-grade corporate bonds.
  • Emerging markets bonds. Bonds issued by emerging countries are riskier than US or German bonds.
  • High-yield corporate bonds and REITs.
  • Developed markets equities.
  • Emerging markets equities.

We can go beyond and look at riskier assets but I don’t think these have a role in the passive investor’s portfolio.

Also, note that this ordering is an approximation. It hasn’t even been constant throughout time. You can find periods where the ordering was slightly different, for instance developed markets stocks performing better than stocks from emerging markets. But over the very long term, the ordering is more or less correct.

A savings account does not protect your purchasing power

It becomes more interesting when you map each asset class to its real return. In contrast with the nominal return, the real return takes into account inflation. Governments usually aim to keep inflation at around 2%. So an asset class with a nominal return of 8% will have a real return of 6%.

Government bonds like TIPS allow you to earn a return that is slightly higher than the inflation rate. So I drew the 0% real return line just below the developed markets governments bonds.

What is important is that anything below that line, meaning a savings account, has a negative real return. Concretely, this means that the money on a savings account loses value every year due to inflation.

Anyone who is not invested in the markets is there and unfortunately, this is the majority of the population. Keeping your money on a savings account protects you from permanent loss but fails to protect your purchasing power. To protect your purchasing power, you need to be invested at least in government bonds.