When I was a young entrepreneur, everything seemed simple. I paid 5 cents for candy bars and sold them for 10 cents. The math was easy. As you get older, financial numbers get bigger and more complicated. Rates of return become affected by interest rates, taxes and inflation. A persons’ portfolio may have $50,000 more in it than the year before, but actually be worth less. So, did the person “make money” or not? By my definition, a good investment should increase in value over time, not just in dollars. The two are not the same.
As I pondered this thought I asked Google to look up the beautiful “Dream Home” my grandparents built in California in 1940. The ocean view house cost them a whopping $8,000. It’s value today is listed at around $1.25 million. That wonderfully large gain hides the many years their homes’ price went down during difficult markets. Volatility is the very nature of investing.
I wondered, if my family still owned that home would it have constituted a good investment? Some quick math shows the annualized return on that $8,000 to be about 6.3%. Since historic inflation is typically about 3.5%, it could be said the home was a good investment because its price, relative to inflation, actually increased. If your investments don’t keep up with inflation, even though the dollars may get larger, the value is going down. Imagine if my grandparents instead had invested that $8,000 in something earning only 3%? Their “investment” today would have grown to about $90,000. That’s a large “dollar” gain, but they would struggle to buy a house with it.
I share this story because during times of stock market volatility the so-called “safe money” salespeople come out of the woodwork. Offering their “no-risk” investments they play on the fears created by the daily news cycle. They put out claims about their financial skills such as “None of our clients have ever lost a penny in the stock market,” of course without pointing out that none of their clients have made a penny in the stock market either. Ironically, when my grandparents sold their dream home it was during a severe downturn in the real estate market. Yet they still made a handsome profit with which they were able to buy their next dream home.
We need to lose the concept of thinking an investment is good just because it doesn’t lose you any “dollars.” Even increasing in dollars isn’t adequate. Investing is about maintaining and increasing “purchasing power,” otherwise you are going backwards. In order for me to have the same home my grandparents had, their $8,000 has to become my $1.25 million. Otherwise, I may have increased “dollars” but lost “value.” Keeping ahead of inflation in your long-term investments requires taking some risk and dealing with some volatility. There really is no other way. Those who preach “risk-free” investments are at best kidding themselves and at worst, being unfair to the people who trust them. Nothing in life is risk free.