How “Conservative” Investors Lose

In the world of investing, the term conservative is relative to your beliefs and strategies.  A retiree with all of her money in bonds may find the investment style of Warren Buffett completely reckless, and a day trader may find him utterly conservative and boring.  For our purposes here, I am going to equate the vague term conservative with the better term risk averse.  All successful investors have an aversion to risk, but they also understand that risk aversion can rise to the level of paranoia.  Our goal is to make money, and our rule is to never lose money.  Unfortunately, these ideas are often at odds.  Wall Street requires us to take risks because that is precisely what is rewarded.  Those risks must be prudent and calculated, but they must be there.  If you are not taking risks, you are violating the prime directive:  Never lose money.

Perhaps the most valuable lesson you can take away from this book is that the real value of a dollar is not fixed; the dollar is no benchmark.  It helps if you have traveled and understand that exchange rates vary because the real value of every currency in the world fluctuates over time.  If you are a traveler, you want to travel when the dollar is strong against the currency you will be spending on your trip.  This gives you the most favorable exchange rate.  This, in turn, means that you have more buying power, and the money that you have budgeted for your trip can do a lot more.

I have traveled to the U.K. when the exchange rate meant that I paid two U.S. dollars each British pound I bought.  I’ve made the same trip for the same duration when each pound only cost me $1.35.  Since my budget was denominated in dollars, the later trip was much more luxurious.  The currency exchange rates provide us with a cross-section of buying power across currencies.  The same sort of thing happens when we consider the same currency across time.  In the world of investing, time is either working for you, or it is working against you.  It is actually very difficult to sit still.

The numerical value we place in front of a currency only has meaning in the context of buying power.  Our familiarity with our own currency gives us the ability to translate those numbers into the goods and services we frequently use almost effortlessly.  When it comes to goods and services that we don’t use very often, we aren’t as good.  If I offer to sell you a hamburger for $20, you will most likely not become a patron.  If I offer to sell you an 1850 Liberty Head Gold Dollar for $100, then you are unlikely to know if that is a good value or not unless you are an avid coin collector (it is, take the deal).

Human psychology dictates that there is a definite size effect when it comes to cost that cloud our judgment.  We tend to ignore small prices and pay very close attention (and remember) big ones (I bet you remember exactly what you paid for your last car and what your mortgage principal was).  There is also a temporal effect; we tend to remember recent things much better than we do things in the past.  There is also a familiarity effect; we become grossly inaccurate when we try to estimate sums that are not denominated in the timeframes that we use frequently.

If I ask you how much money you took home last month, you can likely tell me with precision.  If I ask you how much you took home last year, it will not likely match your tax forms (unless you just did your taxes and the number is fresh in your mind).  If I ask you how much money you need to be comfortable from the time you retire to the time that you die, you will likely grossly overestimate the sum.

The aside on investor psychology leads us to a critical point:  You are not likely to realize that you are losing buying power if the numbers stay the same, or even if they grow a little.  To be successful in long-term investing, you need to think in terms of real gains, not nominal gains in your portfolio.  Economists use the term real gains to refer to the money you make after it is adjusted for inflation.  In other words, your real gains are an estimate of your increase (or decrease) in buying power.  If you do not learn to think like this, then you may think that a 2.5% return is a conservative yet profitable investment.  If the inflation rate is 1.4%, then you are beating it, but your buying power is stagnant.  If the inflation rate is 3%, you are losing buying power every day that passes.


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Last Updated: 6/25/2018