Ever since we embarked on this adventure of building a life in the mountains of Spain, mastering money has been a big priority. After all, if we don’t have the money side of the equation under control, it doesn’t matter how mindful, Instagram friendly and clutter free we are. A well-organized cupboard won’t buy us a house and a clever fitness routine will not put much food on the table. Done right though, a minimalist approach to life can, and has, worked miracles on cutting spending. We currently save 60% of what we earn each month, with a maintained, or rather increased, quality of life. What’s been missing up until now, is a strategy for investing.
Growing up, my references to sound fiscal policy was to stuff all unpaid bills into a piece of living room furniture called Ångestpuffen (“tuffet of doom” or something) and fending off bailiffs. This has made money something I’ve preferred to not think about. Just being able to pay the bills has seemed like a big win. As a consequence, formulating and executing an investment strategy has been very low on the to-do list. Until we decided to set our sights on the mountains of Spain, that is. After that decision, I’ve walked back and forth to the library with piles of dusty old books, trawled the backwaters of the internet, babbled to Emmie until her ears started bleeding, listened to hours and hours of smart-assy podcasts and drawn more flow charts and diagrams than any sane person should. All this in the search of answers to questions such as: How should we invest our money? What’s a government bond? What does diversification of asset classes mean? What’s a treasury bill? When will the next stock market crash come? What is it a bank does, now again? What the bloody hell is money, really?
I must say, getting to the bottom of these – and more – questions has been extremely rewarding. Not only because I enjoy learning new things, but mostly because it has alleviated the irrational fear of money I’ve had since childhood. The only problem was that, until recently, the most important of these questions has remained unanswered. The more I learned about how things work, the less sure I was about what to do. There was something about most of the advise out there that just seemed illogical to my engineer brain.
Let me tell you what a grand source of frustration this was! The importance of investing got glaringly obvious as I started doing the math, seeing the benefits it could have on our life. But the doubts about what to actually do about it grew at the same rate. I’ll get to what didn’t seem logical in future posts, but let us first get to the bottom of why you should invest in the first place.
The reasons for investing are called inflation and compound interest. Please don’t throw away your phone and scream out of sheer terror and boredom just yet. These things are actually quite interesting and easy to understand when explained in human language.
Let’s start with inflation. This just means that every year a specific amount of money will buy you a little bit less junk and services. Let’s say that 15 years ago, I had 1 000€ in the bank. At the time a café solo would typically cost 1€, meaning I had the purchasing power of 1 000 coffees. If we fast forward to the present, a coffee in Spain is usually around 1,25€. What this means is that all the work I put in to save those 1 000€, 15 years later has gone from affording me 1 000 to (1 000 / 1,25) = 800 cups of coffee. In other words, the purchasing power has dropped by 20%. This is what it means when people say they want to “protect their assets against inflation”. They want their money to be able to get them at least as many delicious café solos in the future as it can today. Why inflation exists is an entirely different rabbit hole I won’t dive into today.
Now that I’ve got your mind firmly on coffee, we can move on to compound interest. Apparently Albert Einstein said something about this being the eighth wonder of the world. I don’t know if this is true, but none the less, it’s a remarkably powerful phenomenon. Let me tease you with the fact that it would take a quite conservative return of investment of only 6,3% per year to afford me 2,5 times as much, or 250% more, coffee 15 years later, compared to just leaving the money in the bank. How the hell can this be, you might ask – 6,3% is nowhere near 250%! The answer is, as you might have guessed, compound interest.
Let’s move back 15 years to August 2003 and pretend that young me would have put my 1 000€ into some clever investment, with an annual return of 6,3%. In August 2004, my assets would be worth the starting 1 000€, plus the interest of 1 000 * 6,3% = 1 063€. Nothing to get too excited about. Let’s have a look at August 2005 then. My assets would now be worth 1 063 + 1 063 * 6,3% = 1 130€. The bolded number in the middle is where the magic starts to happen. The interest of 63€ that young me earned during the first year will now start to incur interest too. This is what’s called compound interest. Over longer periods of time, this will have dizzying effects. Have a look at the table below to see how this plays out over the 15 year time span.
As you can see, the starting 1 000€ would now have compounded into 2 500€, or 2 000 (2 500 / 1,25) present day café solos, meaning that current me would have 2,5 times as many Euros if only young me would have invested wisely. To add insult to injury, inflation has made coffee more expensive during these 15 years. Remember, those 1 000€ are only worth 800 coffees today. What all this means, is that I started out with a purchasing power of a thousand coffees, ended up with a measly eight hundred and missed out on what could have been two thousand.
By now, it should be put beyond a doubt that there’s an enormous potential in investing your money. Not only because they can increase substantially in value, but because they will actually lose value if you don’t.
So, what’s the catch? Well, the big one is that as well as gaining value, investments can lose it. An investment losing value has equally interesting, but not as fun, dynamics as one gaining. Let’s go back to young me and my 1 000€ and pretend I invest them wisely, according to all conventional wisdom. A few months passes by and an unforseen event, a black swan, makes the stock markets collapse and cuts the value of my investments in half. How much would the stock market have to go up again for me to recover? Well, 50% seems reasonable, right? Well, if we do the math, there’s a nasty surprise: I start with 1 000€. The stock market crashes and I end up with 500€. A 50% increase on a 500€ investment gives me a 250€ profit, landing me at a total of 750€. So, the market goes down 50%, then up 50% and I only have 750€. Ouch! In fact, to recover a loss of 50%, I’ll need the market to go up with 100% afterwards, just to get me back to where I started.
These numbers are entirely made up, but the last decades have seen scenarios like these play out a number of times. The facts are that unforeseen stuff happen all the time and that it’s very hard to recover lost investments. These are the reasons why I haven’t been able to get my engineer brain to accept the logic that conventional wisdom offers when it comes to investing. This was getting increasingly frustrating; until I read the utterly brilliant book “The Black Swan: The Impact of the Highly Improbable” by Nassim Nicholas Taleb. Finally there was a line of reasoning that I could understand, believe and accept the logic behind. I’ll use the coming parts of this blog post series to explain how this book finally connected the dots for me.
In part two of the series, I’ll get into the details of what it is that has bothered me so much about most investment advise I’ve found so far, and how astonishingly useless humanity is at predicting its own future.
Part three will cover the strategy that me and Emmie have finally arrived at after much debating. This strategy also fits very well into a minimalist framework. There’s very little reliance on complex tactics, droves of statistics and Nobel prize winning mathematical models. Instead it’s a combination of logical reasoning around the limitations of human foresight and a simple risk/reward analysis. This sits much better with my engineer brain, and if we end upp losing our savings with this strategy, I suspect we’ll have problems of zombie apocalypse proportions to worry about anyway.