Financial Security is achieved by Wisely Investing not Speculating

By, Bob Peters || September 5, 2021

The difference between Wisely Investing and Speculating

Financial Security is achieved by earning more than enough to cover your basic needs, having sufficient savings (liquidity) to cover a loss of employment or other unexpected or infrequent needs and Wisely Investing regularly.  What does wisely investing mean?  While there is no one definition of Wisely Investing let me take a stab in the context of what is needed to achieve Financial Security.

Wisely Investing means earning a rate of return that substantially minimizes the risk of losing your capital while maximizing potential returns.

It’s worth repeating:  Wisely Investing means earning a rate of return that substantially minimizes the risk of losing your capital while maximizing potential returns.   

On the other hand, Speculating means you have put your hard earned capital towards something in which you have no sense of the intrinsic value and where you can lose substantially all of your capital. 

You lack the basic knowledge to determine intrinsic value if you have not pursued the Field of Study of Accounting and Finance.  Alas, you do not need to pursue the Field of Study of Accounting and Finance to be a wise and successful investor as long as you do not purchase an individual stock.

Minimizing the loss of capital:  What is in your control and what is not

You can minimize the loss of capital by understanding what is in your control and what is not in your control. 

Your decision to invest, what you invest in and the ability to stay invested are in your control.  You can’t control if the business you invested in goes bankrupt, losses its competitive advantage and, as a result, has a permanent loss of value or whether you lose your job thru no fault of yours due to a recession. 

Here are a few examples of how you can think about what you can and can’t control:

1) You could likely lose your entire invested capital if you invest in the common stock of an individual business and the business goes bankrupt.  Rather than investing in the common stock of one or a small number of individual businesses, you could instead buy an Exchange Traded Fund that owns a small piece of a very large number of businesses. 

While there will be a few businesses that go bankrupt, you will also own a small piece of the very best companies and history suggests that this strategy, over a long period of time, will generate good investment returns.

2) You could lose your home to foreclosure, if you lose your source of income to pay your mortgage and do not have sufficient savings (liquidity) to pay the mortgage before you are able to replace your income. 

Before you purchase a home assess both the security of your job, the likelihood of getting a new job that pays you the amount of money required to pay your basic needs including the mortgage and the amount of savings (liquidity) you will have after you pay the down payment and the closing costs.

3) You could go backwards in your goal of achieving Financial Security if you sell your investments because you have anxiety when the stock market declines or you need to replenish liquidity to support basic needs.  The human brain is wired for “fight or flight.  When we fear something we want to get away from the cause of the fear.  In the world of investing this translates into individuals selling when prices are low.  One of the worlds’ all time great investors, Warren Buffett, said, “Be fearful when others are greedy and be greedy when others are fearful” which, said another way, “Buy low and sell high.” 

If you can be excited, rather than fearful, about the opportunity to increase your diversified investments when the price of your existing investment portfolio has gone down 20, 30 or 40% you are well on your way to “being greedy when others are fearful” and “buying low”…good habits for a successful investor.  This advice works for a diversified portfolio, not necessarily an individual stock as permanently impaired businesses can go bankrupt.

 4)  If you confuse savings (Liquidity) from investing and are forced to sell when the market price is low.  Savings is the amount you would have to support your basic needs (and debt obligations) for some number of months including some amount that you can use for unanticipated one time expenses (like a big medical bill or an expensive car repair.)  The number of months of savings you should have depends upon your employability or how quickly you can get a similar job with similar pay, the monthly amount of your basic needs and whether you have friends or family able to assist with your basic needs. 

Maximizing Potential Returns…don’t forget…while Minimizing the Loss of Capital

You will observe that there will be individuals who have earned very high rates of return on the common stock of a particular business, the purchase of a piece of real estate or crypto currency and just like our brains are attracted to sugar, salt and fat you will also have an impulse to join in on the party.  Hindsight is always perfect and it will take self discipline not to get pulled into speculating, especially when you hear others share their good fortune.

The long term investment returns of the stock market are somewhere between 8-10% (depending on the time period and the particular market segment.)  The long term returns of commercial real estate is approximately 9.5%.  If you buy an individual stock or a piece of real estate with a large loan, you might double your capital or lose it all.  Pursuing the fields of study in Accounting and Finance will be helpful to determine the intrinsic value of an investment opportunity but it will not insulate you from the risk of loss. 

By the way, there is no intrinsic value to cyrpto currencies.  While they may have a price that reflects what people are willing to pay at any given date, there is no underlying value in the crypto currency and thus does not pass the wise investment test…crypto currencies are speculative and thus you should only invest in them if you are prepared to lose substantially all of your capital.