Everyone knows what to do with money — you invest it. Few people sit back to ask the question ‘Why?’. As will be a recurring theme in the basics series, it is in answering the question of ‘Why invest?’ that you can most easily figure out how to invest.
So then, Why? Why do we invest?
The first answer that people usually come up with is ‘to keep up with inflation’, and in the long run, they are right. Savings that sits in cash will slowly become worth less and less, until it’s nearly worthless. However, inflation takes a long time (usually). For most people, their first priority has nothing to do with inflation and everything to do with getting more money so they can achieve more of their goals.
For the vast majority of people in the world, having more money means they will be able to use it to do things that give them immense pleasure or comfort. Most people don’t think about it when they are in the accumulation phase of their financial lives, but at some point, some of those dollars became the dollars that let them help their kids buy a house. Those dollars became the dollars that meant they could support their elderly parents when they needed skilled nursing care. Those dollars became the dollars that meant they could stop working and not worry about running out of cash.
Once a person (or couple, or group) has enough money that they can expect with a great degree of confidence that they will be able to accomplish all of their goals, the question shifts from how to grow their money to ‘Why take more risk?’ — the risk inherent in investing. Now, some argue that human wants are infinite, and that people can always spend more money, but I find that most people have a ceiling above which it is actively hard to spend more money without being purposefully frivolous. My theory on this is that time is actually the limiting factor, and that most of the successful people I know spend so much time doing things they enjoy that aren’t obscenely expensive, that even if they travel often, splurge occasionally, and don’t keep a budget, spending more than $20-25k/month would be a challenge.
Now, don’t get me wrong, optionality is one of my favorite things in the world. And with more money certainly comes more options. Said another way, if you start to take risk off the table because you’ve accomplished your goals, you start to reduce your ability to accomplish goals that you simply haven’t thought of yet. In most cases, the really high marginal utility goals (never have to ask the kids for money, pay for kids’ college, can stay in the home forever, can retire at a reasonable age, etc.) are pretty obvious. The loftier goals (e.g., endowing a wing at the alma mater) have a pretty low utility/$.
However, that theoretical optionality often comes with a very real cost — stress. Stress comes in many forms, and most people would (and do) pay a lot of money to reduce stress in their lives. However, stress is unique when it comes to investing because it is often the root cause of the biggest mistakes people make. Moved to cash in 2009 and are still there? You can bet it was stress. For most people, even those who have seen countless market cycles, seeing a swing of 30, 40, or 50% in the value of a portfolio (often the majority of their net worth) is a huge stressor. That stress (both the physical and psychological costs, as well as the existential threat that stress poses to an investment strategy) can easily outweigh the marginal benefit of the 99th goal on someone’s list. And that’s before even addressing the possibility that someone takes more risk than they need and actually reduces their options because markets move against them (or even just a poor sequence of returns relative to their spending).
There is a sort of zen-state that some people can reach that flips the equation on its head. Once someone has truly internalized the fact that they can easily accomplish their goals with the assets they have (think 1% withdrawal rate), even if the markets were to go against them in the worst way, there is an opportunity to break free of the stress (at least for the most part). When the true time horizon for that money becomes ‘the long run’, and the short run will never be in jeopardy, then the opportunities can once again outweigh the stress, because the stress starts to disappear (though not completely). This can create a positive feedback loop throughout a lifetime (or several lifetimes within a family). More secure finances leads to lower stress that leads to better risk/reward trade-offs of investing that leads to better returns that leads to more secure finances. And so the cycle continues.
We can see then, that the purpose of investing is not just to reach your goals, but to find the balance between reaching goals and reducing stress. Everybody is going to fall somewhere on that risk/reward spectrum, and most people will fall on different places throughout their lives. People understand this concept innately (whether or not they are practicing it correctly), and that’s why the most common rules of thumb in investing have to do with taking less risk when you have the means to accomplish more of your goals.
The purpose of investing isn’t the bottom line, and it’s not checking off item #500 from your wish-list. It’s striking the right balance that will maximize your happiness through a blend of adding things to your life that make it better and subtracting those things that make it worse.