With interest rates on the rise, why would anyone take market risk and invest their money? Great questions, but I have 3 important reasons why:
- Take care of your future self
- Preserve your money against inflation
- Replace your human capital with financial capital
The common theme to all these reasons is that you are taking care of the future, not the present.
Taking care of your future self
As hard as it may be to imagine, we will all get to an age where we cannot work or continue to earn income as we did in our working years. Without our ability to work to earn income, we need to have a pool or other source to draw from for our living expenses. The only way to do that is to set aside a portion of what we are earning now to create the pool.
Preserve your money against inflation
Over the last 3 months, inflation has become more and more relevant to the day-to-day for Canadians. Rising prices are eating into Canadians’ income — making it more challenging to purchase the same amount of goods/services than in previous years. If income is not increasing at the same rate as the price of groceries, fuel, utilities, and other things, then your family will have to learn to survive on less.
At 3% inflation, it will take approximately 23 years for prices to double. At 4% inflation, it will take approximately 17 years for prices to double. The Bank of Canada targets long-term inflation at 2 – 3%. Not protecting your income against inflation will drastically affect your quality of life. For example, if you retire at age 60 and have a life expectancy of age 95, then you should be ready to cut your expenses in half at 2/3 of the way through your retirement. This will be increasingly difficult given that expenses could go up due to medical costs in that period.
Historically, stock markets have outperformed inflation over the long term. Thus, protecting a retiree’s income needs.
Replace your human capital with financial capital
We discussed earlier that sound investing through the help of a financial advisor allows you to take care of your future self. As a working individual, your biggest asset is your ability to earn income. You have skills, knowledge, and time, which make up your human capital. You don’t lose skills or knowledge as you age, but you will lose time. You need to build up financial capital to replace the time lost due to aging.
To replace your human capital, you need to quantify it. Your first step is to determine the present value of your future earnings. For example, if you earn $50,000 a year and work for 40 years, the future value of your human capital is $2,000,000. To determine the present value, you must use a discount rate between 1 – 3% (the rate used by personal injury lawyers). At a discount rate of 3% (target inflation), the present value of your human capital is $1,200,000. Therefore, your financial capital equivalent is the same.
The goal should be to accumulate the present value of your human capital through investing. For example, if you save 10% of your income ($5,000/month) for 40 years, your investments need to earn 7.7% to accumulate $1,200,000. The rate of return is 4.7% above the inflation rate.
Keeping money on the sidelines, and not earning an inflation-protected rate of return makes for a comfortable life in the present time. The longer you feel comfortable in the present makes it a worse lifestyle for your future self.
