In this part, we follow a step-by-step approach to unmask the secrets behind investing. This approach doesn’t make investment necessarily an easy thing to do, but it will help you to be much better prepared for your meetings with investment advisers.
The first step is to begin with the right question. Rather than asking, “How should I invest my money?” we recommend you to first spend some valuable time understanding why you should invest. As long as you don’t know why you invest, don’t invest.
We assume that everyone agrees we should not invest just for the sake of it, nor just to amass as much wealth as possible or to legitimize the existence of our banks. Investing should have a purpose for you. Why would you invest? We address this question in Chapter 2.
Only once you grasp the rationale of investing does it make sense to have a closer look at the investment process itself. It should be noted that with regard to investments, it is not sensible to take a one-size-fits-all approach. As you can’t approach investments in generic terms, the second step in the process toward investing is to define your personal financial situation as well as your investment personality. The more accurate this definition, the higher the likelihood that you will invest in a manner that really suits you and your situation. This second step, better known as risk–return profiling, is the subject of Chapter 3.
The main objective of the risk–return-profiling step is to understand how much risk you are able and willing to take, and how this relates to the expected return. As a rule, the more risk you are prepared to take, the higher the expected return. However, the reverse also applies: The more risk you take, the higher the potential loss. This explains why it is essential to have a basic understanding of investment risks as well as of the ways these risks can be mitigated. That is why in Chapter 4 we focus on investment risk.
We are still not ready to invest. Chapter 5 addresses the importance of discipline. To ensure investment decisions are not dependent on your mood or on the mood of your investment manager, you agree on a certain approach. These are effectively the rules and principles guiding the investment process, thus making it more transparent and predictable.
As an investor you have different options. You can make your own investment decisions or rely to a greater or lesser extent on the expertise of specialists. Whatever you decide, you’ll have to select an institution to work with. In Chapter 6 we share considerations with regard to deciding on your desired level of involvement in the investment process, as well as on the selection of the most suitable service provider.
Once you have walked through these steps you should be well-equipped to get the most out of the investment management relationship with your private banker.
Chapter 2
Why Should I Invest?
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