A Short Guide to The World of Financial Investments. Part One
A Christmas Fairy Tale: …And After Retiring, They Lived Happily Ever After, and Died (Almost) On the Same Day
What It Is, Why You Should Do It and Where to Start
Ordinary people have been recently overloaded with a huge flow of information pouring in from all sides and literally demanding them to start investing in various financial instruments. Furthermore, explanations — what it is, why it should be done, and where to start — are often reduced to statements that it is very simple. You just need to press a few keys in your online bank or trading platform.
At times this is somewhat reminiscent of calls for mandatory self-medication when someone tries to convince you that you are extremely sick and that you simply need to purchase a whole pile of medicines, vitamins and supplements without any medical examination and tests. This does not always sound convincing because overly aggressive marketing often provokes a backlash. So why are investments in financial instruments necessary after all?
You do not need to hold a degree in economics or finance to grasp the fact that investments can be made primarily out of your savings. Certainly, part of the funds can sometimes be raised through a loan. However, this is not always possible. Furthermore, to get a loan you must invest your personal funds too, thereby reducing the degree of risk for your lender.
It is also obvious that to build your savings you should reduce your current level of consumption. At first glance, it does not sound particularly attractive. Why is it necessary at all? It is necessary because you need to start investing your savings today to enjoy a higher level of consumption in the future. Economists call this process an intertemporal substitution.
Actually, “there is no such thing as a new idea. It is impossible. We simply take a lot of old ideas and put them into a sort of mental kaleidoscope”, as Mark Twain once put it. That is why the easiest way to understand it is to imagine an ordinary situation in the context of agriculture which in the past was the main occupation of our ancestors. After the harvest is finished there is an important decision for farmers to make: how much harvested grain to divert for consumption and how much grain to use for planting when preparing for the next season. The use of grain for planting is an investment whose purpose is to ensure that there is an even better harvest next year. The more grain is used for planting, the lower the amount of this year’s consumption is, while the amount of next year’s consumption is likely to be higher.
Our needs for higher consumption in the future may result from many factors: the desire to enjoy increasingly diverse recreation and leisure activities, the need to buy a house or a car, the aspiration to give children a good education, and, of course, the necessity to build a retirement fund to enjoy a good quality of life in our old age. The last topic is the subject of particularly heated arguments.
It may be recalled that for the first time, in the modern sense of the word, the old-age pension was introduced in Germany in 1889, when, upon reaching the age of 70, people with an annual income of less than 2 thousand Reichsmarks could claim state assistance. At the same time, the average life expectancy in Germany at that time was only a little more than 40 years. Only in 1916, the age at which it was possible to claim an old-age pension was lowered to 65 years, while the average life expectancy rose to 47 years [1], [2].
Since then, pension systems in many countries have undergone major transformations. It is interesting to note that in developed countries the age when people can claim an old-age pension and when they actually retire continues to oscillate around 65 years (see Picture 1.1 below) [3]. However, the principles upon which pension systems are based have changed dramatically in most cases. In many countries pension systems have moved away from the schemes based on the principle of solidarity between generations to the schemes based on the principle of pension accumulation. It was associated primarily with the phenomenon of population ageing where the growth rate in the size of retirement-age population significantly outpaced the growth rate in the size of working-age population.
Undoubtedly, the accumulative pension systems in their current form have their drawbacks which should be “corrected” at some point in the future [4]. But this will take time and will require political will. That is why, to paraphrase Bismarck who said that “politics is the art of the possible,” we should proceed from the fact that our pension will be built on the basis of the rules that are in place now. However, we can influence this process if we are more actively involved in the investment process, thus striving to expand and deepen the boundaries of the “possible”.
It may undoubtedly be objected that this all will take place in the distant future many of us will most likely not live to see while referring to the experience of Germany more than 100 years ago with its average life expectancy (47 years) and retirement age (65 years) statistics. However, these statements have long been obsolete with the average life expectancy for both men and women significantly exceeding the average retirement age. Furthermore, this trend is likely to intensify in the future (see Picture 1.2 below) [5].
And I would like to draw the attention of those who often say that this still does not apply to men since they do not enjoy longer lives after retirement. Unfortunately, or rather fortunately in this particular case, this is a profound misconception. For example, in the United States, the average life expectancy for men at birth is only 75.5 years (see Picture 1.3 below) [6]. However, the average life expectancy for US men upon reaching the age of 65 is 18.2 years (see Picture 1.4 below) [7]. That is, an American man who has reached retirement age, on average, may expect to live up to 83.2 years. A similar situation is observed in the United Kingdom where the average life expectancy for men at birth is 78.4 years [6]. However, the average life expectancy for British men upon reaching the age of 65 is 18.8 years [7]. That is, a British man who has reached retirement age, on average, may expect to live up to 83.8 years.
The average life expectancy for women in the United States at birth is 80.2 years while the average life expectancy after reaching the age of 65 is 20.8 years. That is, an American woman who has reached retirement age, on average, may expect to live up to 85.8 years. In the United Kingdom, the average life expectancy for women at birth is 82.4 years while the average life expectancy after reaching the age of 65 is 21.1 years. That is, a British woman who has reached retirement age, on average, may expect to live up to 86.1 years.
The desire to retire early is as straightforward and easy to understand as is the desire to enjoy a financially secure old age. Is it possible? It might be possible if you start thinking seriously about it now and take the first practical steps in this direction today while you are still young and productive.
Various studies show that in developed countries people experience the greatest satisfaction with their financial situation, their looks and life in general in their 70s and 80s (see Picture 1.5 and 1.6 below) [8], [9]. You can argue that this is impossible, and you are not part of this “Christmas fairy tale” story. But human experience shows that most people regret things they did not do than the things they did, even if things they did turned out badly. To quote John Quincy Adams, the 6th President of the United States, “Try and fail, but don’t fail to try”.
References:
[1] “Otto von Bismarck. German Chancellor, 1862–1890”, US Social Security Administration History Archives, www.ssa.gov.
[2] “Life Expectancy in Germany, 1875–2020”, Aaron O’Neill, Statista, 6 September 2019.
[3] “The Average Effective Age of Retirement Versus the Normal Retirement Age, 2013–2018”, OECD.
[4] “Equities Are the Only Sensible Foundation for Pensions”, Martin Wolf, The Financial Times, 11 July 2021.
[5] “Can We Defeat Death?”, Anjana Ahuja, The Financial Times, 29 October 2021.
[6] “Life Expectancy at Birth, 2020”, OECD.
[7] “Life Expectancy at 65, 2020”, OECD.
[8] “The Ages People Are Happiest With Their Money, Their Looks, and Their Life, In One Chart”, Mark Abadi, The Business Insider, 9 December 2017.
[9] “The Age When People Feel The Most — And Least — Happy in Life, In One Chart”, Elena Holodny, The Business Insider, 14 November 2017.
