In August of 2017, the largest individual lottery prize was awarded in US history. The prize was $758.7 million. The winner had a two options as are given to every multi-million dollar lottery winner
- Take $480.5 million today or
- Take $758.7 million in equal annual payments over 30 years or $25.29 million every year for 30 years.
Have you every wondered why is it that you only get the full advertised jackpot over 30 years and only a portion of the jackpot if you take the money right away? This is because money has a guaranteed ability to grow over time. For example, if I had a $100 in my pocket today, I could open up a certain money market account that gives a 2% APY annually, and put the $100 in it. If I do not touch the money for the next year, I would have in my account $102. The year after, I would have $104.02 ($2 for the original $100 and $0.02 for the $2 interest payment from the prior year). The additional 2 cents are because I received a 2% interest payment on the interest payment I received for the prior year. This interest on interest is known as compounding and it is the most powerful phenomenon in investing.
The above lottery example is the exact inverse of the subsequent interest example. In essence, if you take the annuity option vs. the $480.5 million in cash, the lottery is taking your $480.5 million and investing it somewhere where they can get at least a 3.5% return on investment annually and paying you the $25.29 million every year. This way, by the end of the 30 years, they will have not put another penny out of their own pocket into the initial $480.5 million but would have paid you the full $758.7 million over 30 years.
You could have just taken the smaller amount up front and if you were not absolutely stupid with your money, you could very easily get more than the 3.5% on your money that the lottery officials were giving you by investing it yourself which is why most experts will tell you to take the lump sum if you were so lucky to will a multi-million dollar lottery (I am definitely not motivating you to invest in lottery tickets here).
This entire exercise is supposed to demonstrate that money needs to grow over time. The federal reserve of the United States targets an inflation rate of 2%. This means that everything that costs $100 today should cost $102 this time next year (at least that is the goal). Hence, if all your savings are in your checking account and earning no interest, the buying power of those savings is decreasing everyday. In essence, you are becoming poorer by the minute. The target growth of any savings you have should be at least 2% if you live in the United States and any decent Money Market account will get you 2% while even letting you write a few checks out of it every month. These accounts are also risk free which means you cannot lose money unless you write too many checks which then entitles the bank to charge fees.
Lets assume you are willing to absorb some risk – meaning you are ok investing in something that will give you higher returns while making peace with the fact that the returns are not entirely guaranteed. You then invest in US Treasury bonds. These are considered one of the safest investment in the world since they are backed by the full might of the US Government. But if the US Government refuses to service its debt, you could lose your returns and possibly the principal (however we’d have much bigger problems than losing some money at that point). These bonds were returning around 4% around September 2018 according to Treasury Direct. So you see how adding a little bit of risk can increase returns.
The possibilities are endless in terms of financial instruments you can invest in depending on the level of risk you are willing to absorb and the returns you expect. The list below classifies some of these investments in order of increasing risk and increasing returns.
- Savings/Money Market accounts
- US Treasury Bonds
- Blue Chip Bonds
- Mutual Funds / Diversified ETFs
- Individual Stocks
- Venture Capital
- Angel Investing
- Bitcoin and Cryptocurrencies*
*I wrote Bitcoin and Cryptocurrencies up there as a high risk investment because some people have made a lot of money by purchasing and later selling Bitcoin at the peak of the market but I want to make it very clear that in my opinion, Bitcoin and all Cryptos are inherently worthless. The underlying technology in blockchain certainly has value but as a currency, Bitcoin has absolutely zero value. No government will ever and should legitimize a currency whose availability they cannot control. Anyways, I will leave that for another post that I’ve already started writing.
All the discussion above then indicates that having money can make you more money if you invest it. It will also reflect that all investors have different levels of risk tolerance and their expected returns will depend on how much risk they think they are increasing by investing in a certain vehicle versus their risk free return. For example, if I purchase Apple stock, my expectation would most certainly be that it should return more than a Savings account, US Treasury Bonds and some of the Diversified ETFs that give approximately 7-8% annual returns. If I was to give my money to startup, I would expect extremely high returns on my capital since startups are extremely risky and there is a good chance I am going to lose all of my money.
This investor expectation is what drives the need for businesses to achieve or beat growth expectations. Otherwise, investors take their money and run elsewhere leaving the company with no cash to run day to day operations. This is exactly what is happening to Sears right now. The one time successful retailer is now fighting for survival because investors are not finding the returns they expect and the stock is taking a beating. It is on the brink of liquidation of its assets and when that happens, the bond holders (debtors) get paid first. The stock holders (partners) in the company are the last ones to get paid which means they likely get nothing when the company goes under.
On the other hand, companies like Netflix until recently had consistently exceeded growth expectations giving their shareholders a lot of belief in the volume and likelihood of future cashflows of the company. This in turn prevents investors from wanting to sell the stock and increases the willingness of new investors to invest in the company driving up the stock price. I will be writing a separate post about valuing companies but in its most basic form, the value of a company is determined by the present value of all of its expected future cashflows (like we did for the lottery above) multiplied by a factor that determines the likelihood that these cashflows will materialize. This factor is also known as the discount rate. In case of the lottery, this rate was 1 because the money is pretty much guaranteed every year for 30 years but if you were investing in a company, it would be less than 1 because a business can run into a lot of problems preventing it from achieving the expected cashflow resulting in lower returns for the investor.
In essence, there are a few points to take away from the above discussion.
- Money today is more valuable than the same amount of money tomorrow due to effects of inflation.
- All savings should be at least invested to beat inflation or you are doing yourself a disservice.
- Every investor has a risk tolerance level and they should adjust their expectations based on the level of risk they are willing to tolerate
- As you get older, you should lower exposure to riskier investments since you have less time to recover from losses.
- Businesses have an inherent commitment to provide returns to their shareholders since they are the reason the business exists
- Bonds are always safer than stocks because when a business liquidates, the bondholders are paid before the shareholders
- The higher the risk in an investment, the higher the expected return should be. Do not let anyone tell you otherwise.
- Money has an opportunity cost associated with it. Hence anyone vying for your money has to prove to you why they are a better investment than the million other investments out there.
- Choose your investments wisely and the likelihood of loss that you willing to accept to increase the gains you receive if you succeed.