Invest Early and Retire Rich

I couldn’t begin to count the number of articles and TV pitches I’ve seen in the financial media urging Americans to start investing young in order to take advantage of compounding over 30, 40 or more years to retire rich.  Usually the subtext is that they should be buying stocks, and advisors frequently recommend a 60%, 80% or even 100% stock allocation for people who have many years to go before retirement. 

But be skeptical, because there is a hole in this pitch big enough to throw your million dollar portfolio through.

And yes, it’s right to regard it as a pitch, because somebody’s trying to sell you something.  Wall Street wants to sell you its stocks.

The hole?  Unless you’ve been blessed with a trust fund, if you’re in your twenties or thirties you probably have a lot of debt.  If you’ve been fortunate, your student loan debt hasn’t prevented you from being able to take out a mortgage.  You probably have one or the other, if not both.  In which case I’m here to tell you you don’t have money to invest in the first place.  It’s already been pledged to someone else.

If you weren’t in debt, would you go out and borrow a lot of money to buy stocks?  If you wouldn’t, you’re making virtually the same decision by opting to buy stocks instead of paying down debt.  You end up in the same position either way, with a pile of debt and a portfolio of stocks.  Your portfolio is only above zero as long as your stocks are worth more than your debt.

In rare cases these pitches may acknowledge debt and intimate that you will make more money in stocks than the debt is costing you.  They cite statistics on how well stocks have done, since, like, 1926 … a nearly century long time frame.  Do you have a 92 year investment horizon?  More importantly, do they tell you how cheap stocks were in whatever year their return figures start, compared to today, when by most measures US stock valuations are in the neighborhood of where they were at the tops in 1929 and 2000?  As every investment prospectus tells you, past performance is no guarantee of future results.

If you’re honest with yourself, you have to admit you just don’t know what stock returns will look like over the next several years, in particular whether they will return more than your debt is costing you.  If you’re tempted to think it’s a slam dunk, then ask yourself why someone was willing to lend you money at the rate you’re paying instead of putting that money in the stock market for themselves.  Do you know something they don’t?

Actually I agree with the usual recommendations of financial advisors about people with decades to go having a higher stock allocation when they’re young.  But better yet, let’s assume you do; that you’ve decided that due to your age and other factors that 60%, 80%, or even 100% of your portfolio in stocks is right for you.  If you have no debt, setting aside $100 or whatever every month from your paycheck to buy stocks will get you the 100%.  If you bought $20 worth of bonds and $80 worth of stocks, you’d be starting out with an 20-80 bond-stock allocation.  Likewise, buying $40 worth of bonds and $60 worth of stocks would start you at a 40-60  bond-stock allocation.

But wait … owning bonds is the same thing as lending money.  Borrowing money then is like taking a negative position in bonds.  If you have $100,000 worth of, say, student loan, car, and credit card debt, $40,000 in bonds and $160,000 in stocks, is your bond-stock allocation really 20-80?  Your total portfolio is $100,000.  Your effective bond position is $-60,000 and your stock position is $+160,000.  In percentage terms, your bond allocation is -60% and your stock allocation is +160%.  If this is what you intended, fine, but be very careful in comparing it to allocation benchmarks that don’t take debt into account.  In my book, such a leveraged portfolio – shorting one asset to buy another –  isn’t investing, it’s speculating.  You’re gambling that stocks will return more than what you’re paying on your negative bond position between now and the time your effective allocation reaches your intended 20-80 target. 

All while your lender is betting the other way.

What if you have $200,000 worth of debt, $2000 in bonds and $8000 in stocks?  Your total portfolio is $-190,000.  Your bond position is $-198,000 and your stock position is $+8000.  This leaves your stock allocation so high in relation to your bond allocation you can’t even calculate a percentage that makes sense.  Yet that’s what those who might mindlessly follow popular financial media advice about getting money into the stock market would be doing if they don’t first actually have money to invest. 

Realistically, there can be merit in starting a saving and investing habit before you have your debt paid off, if only to learn about the basics of investing and perhaps take advantage of employer matching or tax benefits in accounts specially designed for that purpose.  But remember debt costs compound just like asset returns, so there is no magic secret to wealth hidden in buying assets while ignoring debt.  If the Wall Street sales pitch has you ignoring debt while vigorously buying stocks it can easily set you back on your pursuit of your retirement dream.  No one goes bankrupt without having debt, and getting net worth – the total of all debt and assets – above zero is a necessary part of getting it large.



5 thoughts on “Invest Early and Retire Rich

  1. jk says:

    i agree with your analysis but i would add one consideration that might be germane to some young people: liquidity. if money is used to pay down a mortgage or student debt it is not possible to reborrow that money should some need arise. e.g. one might choose to build a liquid emergency fund before paying down debt. however, if one is refraining from paying down debt in order to maintain liquidity, it would be foolish to “invest” that money in a volatile asset.

  2. jk says:

    one other comment- long term fixed rate debt is an inflation hedge. since your post is addressed to early investors, they are not likely to have a big enough portfolio for that to matter, but for those of us further along in life it could matter a lot. i have deliberately not sought to pay off my mortgage because – within the context of all my assets- it helpfully diversifies my inflation hedges.

    1. Bill Terrell says:

      That would fall into the category of a negative position in bonds we addressed above. The principal concern here is for folks who may have an effective asset allocation that differs greatly from their intent. Sophisticated investors who take a leveraged tack for a special purpose consciously and with an appreciation of the risks involved are excepted with the remark “If this is what you intended …”. The rest of us are best off keeping it simple and safe.

  3. C says:

    “If you’re honest with yourself, you have to admit you just don’t know what stock returns will look like over the next several years, in particular whether they will return more than your debt is costing you. If you’re tempted to think it’s a slam dunk, then ask yourself why someone was willing to lend you money at the rate you’re paying instead of putting that money in the stock market for themselves. Do you know something they don’t?”

    If that someone is a bank, the reason they might lend is because they get to create out of thin air the money that they lend you. Now, the FED can create “thin air money” to buy stock, but I don’t know that individual banks can.

    1. Bill Terrell says:

      True the Fed can create money out of thin air, and with our fractional reserve system banks can effectively as well. But that’s a topic for another post.

      For this one, don’t overlook the part “… instead of putting that money in the stock market for themselves”. Regardless of where it got the money, the lender lent it to the mortgage borrower instead of buying stocks with it. And most money that is lent this way comes from other investors, for example via “mortgage backed securities” (MBS), which they may be lending through in mutual funds and ETFs. Even if the mortgage is originated by a bank, it’s likely been sold on the secondary market and securitized. So if you have a mortgage and also shares in one of these funds, you could be lending money to yourself … and paying a lot of middlemen for the privilege.

      As a rule investors reading this won’t find they can borrow at one rate and invest at a higher rate with any assurance … unless they are a bank!