Also do you have any thoughts to share regarding the ethical ramifications of investing? I’m just concerned that I’d be making profits at the expense of others, and I don’t want ignorance to be an excuse for that, but again I have no idea about economics so I’d love to hear from someone who knows what they’re talkinga bout?
Investing is not inherently unethical. If you’re directly buying a tobacco company’s bonds, then yeah, you’re helping evil to prosper, but consider the following scenarios. (Remember that money is just a number—what it represents is that you’ve done work for other people, and in exchange other people are willing to do a certain amount of work for you. Compared to barter, money provides a magical layer of indirection as it sloshes around the economy—you may make widgets for FooCorp, and the money you earn allows you to buy gizmos from BarInc, even if nobody from BarInc has ever heard of a widget.)
You have money, but right now you’re not interested in buying anything with it. Person X doesn’t have money, but would like to have a car right now instead of waiting for a year to accumulate enough cash, or would like to live in a house right now instead of waiting for 30 years to accumulate enough cash while living in a tiny apartment. If you loan Person X money, they get to buy that car or house right now (yay for them!). In exchange for not being able to access your money for a period of time, and for taking on the risk that you might not be paid back, Person X agrees to pay you back extra money. (The original pile of cash that changes hands is called the “principal”, while the extra pile of cash is called the “interest”.) This is super awesome for you—you’ve earned extra money by doing financial work, instead of the usual physical work or mental work at your day job.
There are many other reasons why someone might want to borrow money (i.e. giving you an opportunity to lend to them). A company might want to expand its operations, but needs a temporary infusion of cash to do so. Once expanded, they predict that they’ll make more money than before, so after paying you back their position will have improved. Or perhaps a country needs to buy a bunch of tanks in order to fight Nazis, or zombies, or zombie Nazis.
There are ways to do this wrong (see the epic housing crash), but that doesn’t mean that all lending is wrong.
The machinery of lending powers apparently simple things like savings accounts—the bank isn’t paying you money to be nice. It’s because they’re turning around and loaning your money out. By offering interest on savings accounts, they can get a bigger pile of cash to loan out. They’re pocketing some (or most) of the interest, but in exchange you have the ability to withdraw money at any time (instead of in 2 years or 30 years or whenever someone pays their loan back), and you’re insulated from the risk that someone might not pay back their loan. (Once upon a time, we hadn’t figured out how to make this work, and the economy imploded. You may have heard of it: the Great Depression. That particular failure mode is no longer possible due to the wonders of FDIC insurance, although we keep trying to discover new ones.)
“Certificates of deposit”, or CDs, which are usually FDIC-insured, are similar to savings accounts. You give up the ability to withdraw money at any time—instead your money is locked up for a fixed period that you choose (e.g. 6 months, 1 year, 2 years, etc.). In exchange, you get a higher interest rate.
More volatile investments (e.g. stocks) have higher risks (i.e. the potential that you could LOSE MONEY) but hopefully higher returns.
I started off by keeping money in a savings account—this seemed pretty cool until I realized that my bank was paying me 0.25% which is basically worthless. Then I switched to ING DIRECT, an online bank (FDIC-insured just like a physical bank—I made real sure to verify that part) offering higher interest rates on both savings accounts and CDs. Several years ago they offered some of the highest rates around—nowadays that doesn’t seem to be the case, but I’ve stuck with them for convenience. I had a bunch of 12-month CDs, set up to expire once a month, so I could benefit from their higher interest rates, yet get money out fairly rapidly if I wanted to.
As I accumulated more and more money, I began to lose my fear of the stock market (acquired due to my parents suffering through the 2000-era tech crash as I was in college). This was also due to the fact that I had invested my 401k (which is a special money bucket, if you’re unfamiliar with the US system) in three mutual funds (helpfully chosen by my father when I knew nothing). I started investing in mutual funds of my own choice through Fidelity online—no more than 5 at a time. I dropped some that I became convinced were dogs (i.e. likely to perform badly in the long run—and my suspicions have been justified) and added others. Eventually I switched to putting all of my money, outside of my 401k/IRA and about 6 months of emergency living expenses in an ING DIRECT saving account, in a single mutual fund. In order to avoid a $75 transaction fee for buying this particular fund through Fidelity, I actually mail checks directly to the mutual fund firm. (I can now observe my account balance online, although I haven’t bothered to set up the stuff that lets me buy/sell shares online.) Then the economy exploded (yes—I moved into mutual funds nearly at the peak). As it fell, I shoveled more money into the furnace. At the bottom, I had lost an incredible amount of money. And then as it came back strongly, I made back my losses and more, because I had bought more shares during the free-fall. Overall, from October 2007 when I bought my first mutual fund, to today, I’ve made an annual percentage yield of 12.68%. That sounds pretty awesome (and it is), but remember that at some points that number had the same magnitude and was NEGATIVE.
I’m just an amateur investor (the whole point of buying mutual funds is to get professionals to do the work for you—or the market as a whole, if you like the idea of index funds, which I personally don’t really understand), but my recommendation is to go to Google Finance or whatever, get a graph of an index (e.g. the S&P 500) or a fund, expand it to 10 years, and consider how you’d feel having bought and sold at various points. Don’t just focus on what would have happened if you bought at the bottom and sold at the top (or kept to the current day) - consider the reverse. I moved my money into my preferred mutual fund when I saw that it outperformed the market for long periods of time, and was relatively immune to losses in value (e.g. during the tech bubble burst, it was largely flat as the indices fell). I liked that behavior, and I still do (even though it fell and rose with everything else during the Great Recession). You should find a fund or funds whose behavior you like. (Past performance is not a guarantee of future results, but it is important data.)
The only way you’re likely to be making profits at the expense of others is if you pick stocks in industries with significant externalized costs… which I admit may be hard to avoid, especially with an index fund, depending on the true impact of CO2 emissions and on the status of corresponding Pigovian taxes that apply to your investment targets.
Otherwise, for the most part you’re making profits at the profit of others. Life isn’t a zero sum game. Capital markets want your dollars because investment can help create and improve products that are worth more than their inputs plus the investment, and “worth more” is in the opinion of the people who buy those products, who after all wouldn’t have bought them if they didn’t value them more than the money they spent. Likewise for employees as well as consumers—even “sweat shops” with dismal conditions by first world standards have to supply locally-high wages to attract workers, and historically this ends up raising wages for the country as a whole.
Your profits are (infinitesimally) reducing the profits made by other investors. Microeconomics says that if you increase the supply of something, including capital, the price paid to the suppliers typically goes down. But no wealth goes away in this scenario. Other investors’ loss is exceeded by employees’, consumers’ and your gain, and since consumers and employees are on average less wealthy than investors the net gain is even greater in utility than in dollars.
Also do you have any thoughts to share regarding the ethical ramifications of investing? I’m just concerned that I’d be making profits at the expense of others,
A very basic finance book, which is also rather oldish is George Claysons: Richest Man in Babylon. It is a series of fables set in the old city of Babylon, teaching people why to save + invest in a broad sense.
To cover the ethics of investing: Imagine if you sit an hour at home doing nothing. Compare that to doing something that improves your own live like repairing something in the house, or that improves the life of someone else, like a client in your job. In the second case you did something that made a part of humanity slightly better off. If you get payed for that it is an exchange of your time and abilities against the resources of someone else, who profits from using you, and is probably as happy about the exchange as you are.
Now with the money you have the choice of either consuming it—which allows others to profit by serving you, or you can ‘invest’ it. Which means delaying your own consumption, and instead giving someone else who is in need of capital the possibility to buy an item that helps her to produce more efficiently. As a fee for your capital you either get some fixed sum, or a share of the profits, so in the end both you and the other person profit from that. That is of course a super simplified explanation of a more complicated thing.
There are companies you might not want to invest in and others that are really awesome.
Economists are broadly of the opinion that economic activity makes people better off in general. For example, if you invested in your friend’s new store, you’re helping him (try to) be more productive. He benefits; you benefit, and his customers benefit. His competitors may suffer, but the benefits to others are larger than those losses.
Unless you’re investing in something that has a large negative impact (say creating lots of smog) you are probably making the world a better place.
What you write may be true, but it’s far from certain. If you keep your money in a mattress instead of investing it, you are not hoarding any actual resources that might be put to a productive use. You are only hoarding green pieces of paper whose value and usefulness from an individual’s perspective is perfectly clear, but whose aggregate role in the economy is complicated and ill-understood. The question of what consequences for the whole economy follow when you empty your mattress and invest the dollars is not at all easy, and I’m not sure if anyone is able to give a full and accurate answer.
(Not that any of this should matter for an investor, but your reasoning in the above comment does seem fallacious to me.)
More technically, holding AU dollars instead of other financial instruments effectively raises the demand for the good used to produce AU dollars (I would guess that is AU government bonds) relative to other financial instruments, but doesn’t raise the total demand for investment directly.
but again I have no idea about economics so I’d love to hear from someone who knows what they’re talkinga bout?
Buy some books on the topic and read them. Or watch the khan academy. Economics is one of the topics everyone should have basic knowledge of.
One book that springs to mind is: ‘why smart people make stupid money mistakes’. I can not assert if it is particularly great, but it is on my re:read stack and recommended by Ramit Sethi, one of the more reasonable private finance bloggers, and an occasional OB/LW reader.
Thanks James.
Seriously considering an Index Fund.
Also do you have any thoughts to share regarding the ethical ramifications of investing? I’m just concerned that I’d be making profits at the expense of others, and I don’t want ignorance to be an excuse for that, but again I have no idea about economics so I’d love to hear from someone who knows what they’re talkinga bout?
Investing is not inherently unethical. If you’re directly buying a tobacco company’s bonds, then yeah, you’re helping evil to prosper, but consider the following scenarios. (Remember that money is just a number—what it represents is that you’ve done work for other people, and in exchange other people are willing to do a certain amount of work for you. Compared to barter, money provides a magical layer of indirection as it sloshes around the economy—you may make widgets for FooCorp, and the money you earn allows you to buy gizmos from BarInc, even if nobody from BarInc has ever heard of a widget.)
You have money, but right now you’re not interested in buying anything with it. Person X doesn’t have money, but would like to have a car right now instead of waiting for a year to accumulate enough cash, or would like to live in a house right now instead of waiting for 30 years to accumulate enough cash while living in a tiny apartment. If you loan Person X money, they get to buy that car or house right now (yay for them!). In exchange for not being able to access your money for a period of time, and for taking on the risk that you might not be paid back, Person X agrees to pay you back extra money. (The original pile of cash that changes hands is called the “principal”, while the extra pile of cash is called the “interest”.) This is super awesome for you—you’ve earned extra money by doing financial work, instead of the usual physical work or mental work at your day job.
There are many other reasons why someone might want to borrow money (i.e. giving you an opportunity to lend to them). A company might want to expand its operations, but needs a temporary infusion of cash to do so. Once expanded, they predict that they’ll make more money than before, so after paying you back their position will have improved. Or perhaps a country needs to buy a bunch of tanks in order to fight Nazis, or zombies, or zombie Nazis.
There are ways to do this wrong (see the epic housing crash), but that doesn’t mean that all lending is wrong.
The machinery of lending powers apparently simple things like savings accounts—the bank isn’t paying you money to be nice. It’s because they’re turning around and loaning your money out. By offering interest on savings accounts, they can get a bigger pile of cash to loan out. They’re pocketing some (or most) of the interest, but in exchange you have the ability to withdraw money at any time (instead of in 2 years or 30 years or whenever someone pays their loan back), and you’re insulated from the risk that someone might not pay back their loan. (Once upon a time, we hadn’t figured out how to make this work, and the economy imploded. You may have heard of it: the Great Depression. That particular failure mode is no longer possible due to the wonders of FDIC insurance, although we keep trying to discover new ones.)
“Certificates of deposit”, or CDs, which are usually FDIC-insured, are similar to savings accounts. You give up the ability to withdraw money at any time—instead your money is locked up for a fixed period that you choose (e.g. 6 months, 1 year, 2 years, etc.). In exchange, you get a higher interest rate.
More volatile investments (e.g. stocks) have higher risks (i.e. the potential that you could LOSE MONEY) but hopefully higher returns.
I started off by keeping money in a savings account—this seemed pretty cool until I realized that my bank was paying me 0.25% which is basically worthless. Then I switched to ING DIRECT, an online bank (FDIC-insured just like a physical bank—I made real sure to verify that part) offering higher interest rates on both savings accounts and CDs. Several years ago they offered some of the highest rates around—nowadays that doesn’t seem to be the case, but I’ve stuck with them for convenience. I had a bunch of 12-month CDs, set up to expire once a month, so I could benefit from their higher interest rates, yet get money out fairly rapidly if I wanted to.
As I accumulated more and more money, I began to lose my fear of the stock market (acquired due to my parents suffering through the 2000-era tech crash as I was in college). This was also due to the fact that I had invested my 401k (which is a special money bucket, if you’re unfamiliar with the US system) in three mutual funds (helpfully chosen by my father when I knew nothing). I started investing in mutual funds of my own choice through Fidelity online—no more than 5 at a time. I dropped some that I became convinced were dogs (i.e. likely to perform badly in the long run—and my suspicions have been justified) and added others. Eventually I switched to putting all of my money, outside of my 401k/IRA and about 6 months of emergency living expenses in an ING DIRECT saving account, in a single mutual fund. In order to avoid a $75 transaction fee for buying this particular fund through Fidelity, I actually mail checks directly to the mutual fund firm. (I can now observe my account balance online, although I haven’t bothered to set up the stuff that lets me buy/sell shares online.) Then the economy exploded (yes—I moved into mutual funds nearly at the peak). As it fell, I shoveled more money into the furnace. At the bottom, I had lost an incredible amount of money. And then as it came back strongly, I made back my losses and more, because I had bought more shares during the free-fall. Overall, from October 2007 when I bought my first mutual fund, to today, I’ve made an annual percentage yield of 12.68%. That sounds pretty awesome (and it is), but remember that at some points that number had the same magnitude and was NEGATIVE.
I’m just an amateur investor (the whole point of buying mutual funds is to get professionals to do the work for you—or the market as a whole, if you like the idea of index funds, which I personally don’t really understand), but my recommendation is to go to Google Finance or whatever, get a graph of an index (e.g. the S&P 500) or a fund, expand it to 10 years, and consider how you’d feel having bought and sold at various points. Don’t just focus on what would have happened if you bought at the bottom and sold at the top (or kept to the current day) - consider the reverse. I moved my money into my preferred mutual fund when I saw that it outperformed the market for long periods of time, and was relatively immune to losses in value (e.g. during the tech bubble burst, it was largely flat as the indices fell). I liked that behavior, and I still do (even though it fell and rose with everything else during the Great Recession). You should find a fund or funds whose behavior you like. (Past performance is not a guarantee of future results, but it is important data.)
ds
The only way you’re likely to be making profits at the expense of others is if you pick stocks in industries with significant externalized costs… which I admit may be hard to avoid, especially with an index fund, depending on the true impact of CO2 emissions and on the status of corresponding Pigovian taxes that apply to your investment targets.
Otherwise, for the most part you’re making profits at the profit of others. Life isn’t a zero sum game. Capital markets want your dollars because investment can help create and improve products that are worth more than their inputs plus the investment, and “worth more” is in the opinion of the people who buy those products, who after all wouldn’t have bought them if they didn’t value them more than the money they spent. Likewise for employees as well as consumers—even “sweat shops” with dismal conditions by first world standards have to supply locally-high wages to attract workers, and historically this ends up raising wages for the country as a whole.
Your profits are (infinitesimally) reducing the profits made by other investors. Microeconomics says that if you increase the supply of something, including capital, the price paid to the suppliers typically goes down. But no wealth goes away in this scenario. Other investors’ loss is exceeded by employees’, consumers’ and your gain, and since consumers and employees are on average less wealthy than investors the net gain is even greater in utility than in dollars.
A very basic finance book, which is also rather oldish is George Claysons: Richest Man in Babylon. It is a series of fables set in the old city of Babylon, teaching people why to save + invest in a broad sense.
To cover the ethics of investing: Imagine if you sit an hour at home doing nothing. Compare that to doing something that improves your own live like repairing something in the house, or that improves the life of someone else, like a client in your job. In the second case you did something that made a part of humanity slightly better off. If you get payed for that it is an exchange of your time and abilities against the resources of someone else, who profits from using you, and is probably as happy about the exchange as you are. Now with the money you have the choice of either consuming it—which allows others to profit by serving you, or you can ‘invest’ it. Which means delaying your own consumption, and instead giving someone else who is in need of capital the possibility to buy an item that helps her to produce more efficiently. As a fee for your capital you either get some fixed sum, or a share of the profits, so in the end both you and the other person profit from that. That is of course a super simplified explanation of a more complicated thing. There are companies you might not want to invest in and others that are really awesome.
Economists are broadly of the opinion that economic activity makes people better off in general. For example, if you invested in your friend’s new store, you’re helping him (try to) be more productive. He benefits; you benefit, and his customers benefit. His competitors may suffer, but the benefits to others are larger than those losses.
Unless you’re investing in something that has a large negative impact (say creating lots of smog) you are probably making the world a better place.
What you write may be true, but it’s far from certain. If you keep your money in a mattress instead of investing it, you are not hoarding any actual resources that might be put to a productive use. You are only hoarding green pieces of paper whose value and usefulness from an individual’s perspective is perfectly clear, but whose aggregate role in the economy is complicated and ill-understood. The question of what consequences for the whole economy follow when you empty your mattress and invest the dollars is not at all easy, and I’m not sure if anyone is able to give a full and accurate answer.
(Not that any of this should matter for an investor, but your reasoning in the above comment does seem fallacious to me.)
Yes, you are correct.
More technically, holding AU dollars instead of other financial instruments effectively raises the demand for the good used to produce AU dollars (I would guess that is AU government bonds) relative to other financial instruments, but doesn’t raise the total demand for investment directly.
Buy some books on the topic and read them. Or watch the khan academy. Economics is one of the topics everyone should have basic knowledge of. One book that springs to mind is: ‘why smart people make stupid money mistakes’. I can not assert if it is particularly great, but it is on my re:read stack and recommended by Ramit Sethi, one of the more reasonable private finance bloggers, and an occasional OB/LW reader.