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Under the Macroscope - Musings on markets, investing and risk management with a quantitative twist.
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  • Why Bother Investing?

    An Investing Odyssey

    "How do you invest in this market?" I often hear this rhetorical question from fund managers, usually accompanied with a shade of resignation, relief, disgust or despair depending, of course, on that day's or month's performance. Friends and acquaintances, who don't invest as a career, ask a similarly unanswerable question: 'What do you think I should invest in?' To tackle a tough problem with a new perspective, I've learnt to break it down to its core. It's clear that without clarifying our investing goals, it's only a half-question and our answers will be superficial at best and completely wrong at worst. So before we answer how to invest, let us ask: why do we even bother investing?

    From academics to doomsayers, we hear talk about the financialization of the world. In relation to growth of financial services, we often hear how countries are on the wane because they don't make anything or make anything real, implying that financial economy is an illusion. But if so, why do we spend so much of our collective time, energy and resources on financial matters? Why does it capture TV screens and internet bandwidth? Why do presidents, senators and congressmen hold press conferences and craft policy based on whether the market zigs or zags? Whether right or wrong, the numbers say that a large portion of our productive capacity is being allocated to financial matters. So, what is the importance of investing?

    Original Debt

    We are, all of us, original debtors. We start our lives as helpless babies, depending on someone else to feed us, clothe us and take care of us. We may choose to couch it in emotional terms and it may be hard to value, but it certainly can be priced and we most certainly start with a negative balance on our productivity account. The total cost of raising a child is estimated to average between $200,000 and $500,000 per child from birth till 18 years of age in the US. We grow up draining the resources of a society, and hope to grow old, likely once again consuming more resources than we produce at that stage. But the saving grace is that we also can turn these investments and those of our care-takers into productive lives, and create a lot more net "stuff" in our highly productive middle years than we consume at either end.

    Polonius was dead wrong. We are forced to be lenders and borrowers - from ourselves and from each other. Not only do we have little choice in the matter (and I haven't seen independent income-earning productive babies being born somewhere) but as a society, as a civilization and as human beings, we function only and we function better because collectively we can maximize our potential through this process of borrowing and lending.

    But this is no free ride. Borrowing MUST match lending. This is an accounting identity. And lenders will only lend sustainably if borrowers generate enough savings to cover the liabilities of these loans. No one in this world is rich enough to issue a truly unlimited credit-line.

    In this politically charged environment of fiscal cliffs and sovereign downgrades, it is important to state this again: We can borrow from others, we can borrow from the future, but over the long term, a society will continue to function only if we produce at least as much as we consume during our finite lifespan. Our politicians and cultural norms can dictate how we redistribute the costs and rewards. We can decide whether we waste resources or build savings, whether we over-consume or fuel growth via R&D, and even whether we can temporarily force our neighbors or our grandchildren to pay for our liabilities. But the mathematical reality remains that over time these two sides of our society's balance sheet must match.

    Raison d'etre

    We are thus forced to invest because we are stuck with a classic asset-liability matching problem. We must gather assets or save to fund the periods when we will experience net outflows. Hence saving and investing is simply the bridge that allows us to match our assets with our liabilities. As individuals or societies, we must invest these excess savings in order to avoid the risk of not meeting our future obligations. In a way, it is the only sensible goal that we can sustainably have for our investments in a closed system.

    Investments take many forms. Some are intended to grow your assets, while others reduce your liabilities. Many of them can be implicit. These asset-liability matching games are played, consciously or subconsciously, on many levels and multiple times every day. For example:

    · Families in less developed or agrarian societies often choose to "invest" by having many children, maximizing their labor assets to grow their productive capacity and to meet their liabilities in old age.

    · US Employees often invest a portion of their pay via 401K plans to meet liabilities they will incur during retirement. Certain sectors lure employees by promising to meet their future liabilities in the form of pensions or medical benefits.

    · As per the latest figures, US tax-payers spend an aggregate of $800 billion on education. Today, even a "moderately"-budgeted US college education costs between $21,500 and $42,200. Students, parents and governments make these investments because they hope it maximizes individual and collective productivity leading to higher compensation, lower poverty and unemployment and healthier, longer lives.

    · To create a moral, a more compassionate, or some cynics may say placated society, many nations invest in social program, which maximizes overall productivity and reduces the cost of social ills.

    · Many central banks recently have enacted expansionary policies and courted inflation and moral hazard risks, presumably to avoid the liabilities that come with the economic shock of a recession or a depression.

    So the right answer to our original question is: Invest in a way that meets your future liabilities.

    This anti-climactic answer is vague and non-actionable enough to be almost useless. Take the example of meeting our future healthcare needs. It's easy to see that many of these liabilities are uncertain or unknown. Even if known, they can be hard to estimate. Worse, we encounter path dependence. Even to get the opportunity to fulfill a particular liability, we must first meet every other liability along the way. Yet, even if it doesn't provide a magical solution, when faced with uncertainty and volatility this answer serves as a very good compass for our financial and emotional well-being.

    Will your investment choices cover your liabilities?

    Next…

    Part 2: Practical Guidelines for Investing

    Part 3: Performance Measurement and Risk Management

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: retirement
    Jan 03 3:55 AM | Link | Comment!
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