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It is often taken for granted that one should invest as soon as one has the cash to do so. But why is that so?

Based on experience, we know that inflation, spending, and taxes reduce (the purchasing power of) our wealth faster than we often realize. Through investing we compensate for these unavoidable wealth-diminishing effects.

Mr. Jones recently inherited US$5 million in cash and already owns a fully paid-up house, currently worth US$1 million. He is 35 years old and married, with two boys, aged 3 and 7. As the money arrived at a time that he happened to face serious difficulties at work, he took this windfall as an opportunity to say farewell to his not-so-beloved boss.

But now Mr. Jones has to plan for the future. He is still young. He wants to continue his lifestyle, only do the work he likes, become a healthy old man, and, upon his demise, pass on substantial wealth – preferably US$2.5 million – to each son. This should be feasible.

With such a vast amount of money, why should Mr. Jones invest at all? That’s a good question. In this chapter we will convince Mr. Jones that apart from it being fun, investing makes a lot of sense. But before we do that, we should first agree on what investment exactly means: An investment is the purchase of an asset or item with the expectation that it will generate income and/or appreciate in the future and be sold at a higher price. Bank deposits are usually not considered an investment as no purchase of an asset is involved.

In general, the term investment is used when referring to a medium to long-term outlook as opposed to trading or speculation, which is a short-term activity aimed at high, almost-immediate returns through smart deals (objective: Outsmart the market or simply try your luck).

With this definition in mind we can have a closer look at the rationales for investing.

The Risks of Staying in Cash

Instead of bringing up convincing reasons to invest, let us explore what happens if Mr. Jones would not invest at all.

We know that Mr. Jones has US$5 million in cash, all kept safely on a bank deposit account. What happens? It is likely that both in absolute and relative terms his assets will decline faster than expected due to:

● Inflation

● Spending

● Taxes

● Foreign exchange (depending on foreign assets or activities)

What are the implications of inflation, spending, taxes, and foreign exchange on the inheritance of Mr. Jones?

Inflation

Inflation refers to the phenomenon that the cost of living becomes higher. Items like bread, milk, vegetables, cars, houses, and so on are getting more expensive. This is mostly the result of the increase (i.e., inflation) of the money supply. To put it simply: If a government increases the money supply (e.g., by printing more money), the value of money will go down (which generally speaking is a direct consequence of an increase in supply levels). With an increase in the money supply, everybody will end up having more money, as there will be more money flowing through the economy. However, as the increase in money supply is not accompanied by an increase in production, we end up with more money relative to the goods in the economy and hence an increase in the demand level. This causes the value of money relative to the goods to decline. Therefore, the sellers will respond by increasing their prices, thus causing inflation.

The opposite of inflation is deflation. This happens when credit supply and credit demand falls. In practice this means that people don’t want to borrow and banks don’t like to lend, ultimately leading to a slowdown or even standstill of the economy as people postpone their spending and factories reduce or postpone their production. As a result of the fall in demand levels, overall product prices will decline.

Governments in more developed nations typically aim for an inflation rate of around 2 to 3 percent. There are a few reasons for this. First, it is good for the psychology in the country to instill a sense of growth (e.g., through regular salary increases). Second, it fosters economic activity (e.g., companies will not be too concerned to keep stock, banks will be less reluctant to lend, etc.). Third, it makes it easier for governments to service their own loans, as loans are getting “cheaper” when the value of their money declines over time. If I have a US$100 loan and due to inflation the (equivalent) value reduces to only US$80, I effectively reduced my loan by 20 percent, just by reducing the value of the money.

Throughout history we have witnessed some extreme cases of inflation, also called hyperinflation. In the 1920s in Germany, for example, people ordered two cups of coffee in a restaurant as the price of coffee would have been doubled by the time they finished their first cup. A more recent example we can find in Zimbabwe where the inflation increased from 7 percent in 1980 to 89,700,000,000,000,000,000,000 percent (no typo!) in November 2008, forcing the government to print notes worth US$100 trillion.

These are obviously extreme situations, but the fact remains that in developed economies and over a longer period of time we should anticipate an inflation percentage of 2 to 4 percent. With a steady 2 percent inflation, the value (i.e., purchasing power) of your money will reduce by 40 percent over a period of 25 years. In other words, of the original US$5 million, Mr. Jones would only have an equivalent of US$3 million left if he does not touch his money at all. US$2 million will just evaporate. If the inflation rate is 4 percent, Mr. Jones would effectively lose 50 percent of his purchasing power in less than 20 years.

According to Ibbotson Associates (now Morningstar), a widely recognized financial research and information firm, the average inflation rate in the United States between 1926 and 2007 was 3 percent per annum.6 It should be noted, however, that during that period we saw some fluctuations: There were 10 years with deflation and 4 years with double-digit inflation. In other words, the inflation rate is volatile, which makes it tough to anticipate. If we forget about all the fluctuations and just focus on the average inflation over the mentioned period, it is concluded, as said, that the inflation rate was 3 percent per annum. To be concrete, this means that every 23 years a cash portfolio loses effectively half of its value. Your purchasing power reduces by 50 percent: In year 23 you can buy with US$5 million what you could buy in year 1 with US$2.5 million. The purchasing power has been reduced by 50 percent, as shown in the graph in Figure 2.1.

Figure 2.1 Purchasing Power of Cash over Time

The figure shows that after 25 years at age 60, Mr. Jones still has his US$5 million. He did not lose a single cent. The only problem is that with that US$5 million, he can only buy what he could buy in year 1 with US$2,407,090.

From this point of view, the impact of inflation is as devastating as a market crash. And where stocks have a tendency to recover – as long as you have the ability to hold on to your positions – “losses” caused by inflation tend to be irreversible, also in view of the fact that deflation happens only rarely.

Inflation, therefore, complicates retirement planning: To pay for the same quality of life you need quite a bit more money in absolute terms. Or, to put it differently, due to inflation your savings today will buy you less tomorrow.

Even if you don’t exactly understand all the technicalities of inflation and deflation (e.g., what are the exact causes, why does it reach a certain percentage, etc.), the point to remember should be that inflation is there and negatively affects the value of your savings significantly.

Spending

It is not only inflation that eats into your assets. You need to live, preferably in an enjoyable manner, so you look for a lifestyle you feel comfortable with. To do so, you spend. The moment people have more money, they tend to like to live in a bigger house, which is not only more expensive but also comes with higher maintenance costs. The moment people have money, they wish to buy a bigger car, preferably with the latest gadgets. The moment people have money, they enjoy Michelin-star dinners. The moment people have money, they like to travel to the more exotic corners of our planet. The moment people have money, they like to dress themselves more exclusively. It is all human nature. For most people, it is expensive to be rich.

How about Mr. Jones? He is spending his money wisely. He takes proper care of his family (his wife and two boys). The Joneses like regular short holidays and the occasional dinner out. Apart from these luxurious treats, the Jones family may be considered frugal. On average they spend US$150,000 per annum.

If they just wish to maintain this lifestyle, they have to correct this yearly budget for inflation (if applying the average inflation rate of 3 %), which means that the expenses in the second year will increase to US$154,500 and in the third year to US$159,135, and so on. Effectively they have to spend more every year just to maintain the same lifestyle.

With the overview in Figure 2.2, where we assume that Mr. Jones enjoys 2 percent interest on his cash,7 we can demonstrate the impact of spending on cash.

Figure 2.2 The Impact of Spending on Cash over Time

From this figure, we can draw an interesting conclusion: Even though Mr. Jones enjoys 2 percent interest income on his bank deposit, he will have outlived all his money within 30 years. This is mainly due to inflation, which forces Mr. Jones to increase his spending from US$150,000 in the first year to US$304,000 in the twenty-fifth year, necessary to just maintain his lifestyle.

In 30 years, when Mr. Jones turns 65, all the cash will be gone. Mr. Jones, however, is an optimist: He wants to plan till age 85 as he is confident that with his lifestyle it is reasonable to expect to live until that age.

Taxes

But that’s not all Mr. Jones has to consider. He will most likely be subject to taxes. Governments impose taxes to enable them to finance all governmental activities and subsidies. Generally speaking, governments are held responsible for the infrastructure in a country, for schooling, for health care, for (Social) security, for pensions, and so forth. The list of responsibilities would not fit on this page (or even in this book, for that matter). The more responsibilities a government has, the more money it will require to perform all its duties according to the expectations of the public. And that is where all the taxes come in.

To what extent taxes affect one’s wealth varies by jurisdiction. Every country has totally different views on and ways of imposing taxes and earning revenues. A few examples of personal taxes (we don’t consider corporate taxes here) are:

● Income tax

● Capital gains tax

● Wealth tax

● Real estate/property tax

● Road tax

● TV/radio tax

● Gift tax

● VAT/GST

● Succession/inheritance/estate tax

● Dog license tax

● Social Security tax

● Road tolls

It is virtually impossible to avoid taxes in life.

Let us assume Mr. Jones lives in a jurisdiction where wealth tax is 0.5 percent and any income – also interest income from cash and deposits – is subject to 17 percent income tax. For his house (fully paid-up and worth US$1 million) there is a property tax of 20 percent on the assumed rental value of the property, which in this case is set by the government at US$2,700 per month or US$32,400 per annum.

6

Ibbotson SBBI 2013 Valuation Yearbook, “Market Results for Stocks, Bonds, Bills, and Inflation 1926–2012.”

7

In general, interest income on cash or deposits is lower than the inflation rate.