History as a Guide

The last two posts have covered a simplified history of investing.  However, it is important to remember that investing does not simply happen on its own.  It is an active choice to make with many options once that decision is made.  When a person decides to invest, that decision primarily says, “I am willing to forego consumption today for future consumption.”

People work mostly to fund their lifestyles.  This has been true for most of recent history.  Saving for future consumption, however, is a newer goal for most people when we expand the time horizon. 

Throughout most of history people were more concerned with survival.  “Future consumption” was not only unnecessary to plan for but also highly unlikely to be needed.  As we have progressed and experienced fewer extreme events such as wars or famines, an extended period of retirement became much more likely.

Of course, financial innovation kept up with this change in likelihood.  Investment accounts such as the Individual Retirement Account (IRA), work-sponsored 401k/403b retirement plans, or Roth IRAs became common.  These allowed people to build wealth and accumulate money in tax-advantaged accounts.  These accounts also offered investment options that allowed people to invest their money in the market. 

Mutual funds have been the most common form of investment in IRAs and company-sponsored retirement plans.  Mutual funds not only allowed smaller investors the ability to diversify their money but also investors to earn a dividend.  Because this money is held in tax-advantaged accounts with penalties on early withdrawals, the money typically stays invested and continues to earn the dividend.  This is how the money compounds.

Compound interest has been referred to as “the eighth wonder of the world” by Albert Einstein. [1]

Compound interest is typically achieved in retirement accounts by reinvesting the dividends received.  This means that the dividends received then also receive dividends.  Over time this leads to a significant increase in the value of the account. [2] 

Dividends are a component of the return of the investment.  Some investments such as AT&T and Chevron have a higher total return that is driven by a high dividend.  Other investments that do not pay a dividend are a “valued on their growth potential”.  Investments such as these include stocks like Amazon.com, Facebook, or Netflix. 

Stocks, mutual funds, exchange-traded funds, and bonds have been investment staples for many years, and with relatively little recent innovation.  A new financial innovation, cryptocurrencies, have gained significant popularity.  Where exactly do cryptocurrencies fit relative to the other investment choices?

The growth of cryptocurrencies has been staggering.  This growth has mostly been through individual (retail) investors who are buying the cryptocurrencies without much intent to sell.  Most of the cryptocurrencies do not pay interest or dividends.  This means that they are valued solely on their growth potential. 

Returning to history, cryptocurrencies have some similarities to early forms of currencies.  There are many cryptocurrencies, each created with a unique purpose and by a separate entity.  The biggest step that led us to modern, government-controlled currencies was the creation of a central bank saying that all other currencies could not be legally accepted.  This sort of power from a central bank will not be given up easily.  This means that cryptocurrencies are less likely to be decentralized (a current selling point for cryptocurrencies).  It also means that cryptocurrencies will experience some consolidation before there is a widely accepted cryptocurrency.

Cryptocurrencies will continue to gain popularity, but their long-term viability is still unknown at this point.  If history is any guide, some form of cryptocurrency will have a place in some investor’s portfolios.

The decision to start investing may be an easy one, however, there are many investment choices that can be difficult to analyze.  The creation of new investment choices like cryptocurrencies creates a new layer of analysis.  A helpful tool in beginning that analysis is a financial plan.  Most Registered Investment Advisors (RIAs), such as Sculati Wealth Management LLC, utilize financial plans with their clients.  The next series of posts will help explain what an RIA is, and what they do.

[1] https://www.inc.com/jim-schleckser/why-einstein-considered-compound-interest-most-powerful-force-in-universe.html

[2] https://www.thebalance.com/the-power-of-compound-interest-358054