The name Alain Greenspan may not ring a bell to you, but I can assure you that the guy was pretty powerful.
He was the president of the Federal Reserve, the central banking system of the United States of America.
As you can imagine, this is not the kind of job that you can randomly land.
You need to be a great tactician, politician and have a strong understanding of economics and the investment world.
Theoretically, this person should have a “Master of the universe” understanding of investing and economics.
And still, this person managed to lose a lot of money with a wrong investment.
“C'mon! Everybody can lose money with the wrong investment, sometimes it’s just bad luck.”
But that investment was the pyramid scheme of Bernie Madoff, the most famous financial fraud of our time.
The funny thing was that Madoff didn’t promise stellar returns.
He promised the same returns of the US stock market (around 10%) but with much less risk.
You can see in the image how smooth the graph looks, and how easy seemed to make money, until it wasn't (Madoff returns are represented by the red line)
At the beginning of the Great Financial Crisis of 2007, all the gains evaporated, the scam was discovered and the value of the fund went straight to zero.
A lot of people were suspicious about Madoff's smooth returns, so how comes that one of the best financial minds of our times didn’t realize that it was a scam and lost a lot of money in the process?
Here is what Greenspan said about it:
In my own case, the decision to invest in the Rye fund (a feeder fund invested with Madoff) reflected both my profound ignorance of finance, and my somewhat lazy unwillingness to remedy that ignorance.
To get around my lack of financial knowledge and my lazy cognitive style around finance, I had come up with the heuristic (or mental shorthand) of identifying more financially knowledgeable advisers and trusting in their judgment and recommendations.
This heuristic had worked for me in the past and I had no reason to doubt that it would work for me in this case.
Apart from the false modesty (you can’t be that ignorant in finance and be the head of the FED), the real problem of Greenspan was his laziness.
He blindly delegated his financial decision to an advisor, which turned out not to be trustworthy enough.
Do you have any way to avoid this fate and become a better investor than a FED previous chairman?
Yes, you do.
You need to take control over your investment decisions and make an investment strategy that will help you get what you want when you want.
Making a plan that clearly defines your life goals, and when you want to achieve them, figuring out how much money do you need for it and how to get the amount you don’t have yet.
This is an example of goal-based investing, the main principle we use in Simplinvest to help people creating their own financial plans.
"Why investing is so important?
Can't I just leave my money on my bank account and enjoy them when I am going on holiday?"
Although this is an option, it doesn't consider that the money left in your bank account is losing value every year, because of inflation.
Inflation is a concept that is not familiar for a lot of people, especially the ones who don't have a background in Economics.
Here is a definition which we can use to start.
Inflation is the rate at which the general level of prices for goods and services is rising
(kudos to Investopedia for being the best investing definition platform ever).
So, if you buy some bread for 2 Euros, and the yearly inflation is 2%, in one year you can expect the bread to cost 2 Euros +2*0.02 = 2.04 Euro
(Side note: I am well aware that inflation is not so simple and not every product's price is raising as much as the inflation, but let's keep this easy definition for now)
So, because of the inflation you will actually end up 2% poorer every year if you don't invest your money.
Not investing your money is an investing choice, usually a losing one.
Let me put it into a better perspective.
Because of the inflation the prices will go up, while your money will stay the same.
So 100.000 Euro today will have a purchase power of 98.000 Euro one year from now.
Now it doesn't look like a small amount anymore, right?
This situation can happen as well, and it's called deflation.
The central banks from all over the world are trying to avoid this situation, because It's very bad for entrepreneurs and companies.
If a product can be less expensive tomorrow than today, people will wait until the last moment before buying it.
And the companies will have to pay a lot of costs in inventory and to get rid of unsold products.
They will get less profits and they will need to lay off people.
Which means less customers in the future and a negative spiral that is hard to stop.
Inflation is a necessary evil we need to cope with to keep our economy going.
If you want to be protected against it, you need to invest in financial products that gives you a higher return than the inflation rate.
People have different ideas about what investing means.
For somebody, you need to be extremely wealthy if you want to invest some money.
For some others, investing is a loser game where you will end up losing your money.
Finally, for somebody else, investing is a way to protect and growth your capital.
I am a proponent of the last one, obviously, and with this blog I want to show you why.
To begin with, let's start with something that looks easy: the definition of investing.
Take a few minutes to think about it and give your best shot.
Write it down somewhere, possible.
Great! Now let’s see what is the definition of "invest" in the Oxford Dictionary:
Close enough to what you thought?
If that's the case, I have bad news for you: this definition of investing is wrong.
I don't care that is taken from the Oxford Dictionary.
This definition put on the same level the guy that is buying a lotto ticket with one who is carefully analyzing a company before buying some of its shares
Which means it puts investing and speculation on the same level.
Look what happens when on the same dictionary I look for the meaning of speculation:
For the Oxford dictionary, investing and speculating are almost synonyms.
In the case of speculation, it put an emphasis on the losses, while when investing on the gains, but that’s it.
Both investing and speculation are seen as a way to put some money somewhere today and get out more money tomorrow.
And this is the first reason why people lose so much money in the financial markets.
They take a lot of risks buying financial products they don't understand, and they think they are investing.
Instead, they are speculating and gambling their money, hoping that Lady Luck will come and rescue them.
Before talking about anything else, we need to find a better definition of investing and differentiate it clearly from speculation, so there will be no room for mistakes.
Here is one that I like more:
Investing is a process that protects and grows your net worth over time so that you can reach your financial goals and sleep well at night.
As you can see, this definition is a bit more complex than it was before.
I added a few key concepts:
If you are not sure if so far you have been investing or speculating, I prepared a table which shows the main differences between these two concepts.
Investing is deeply connected with planning and be aware of your overall financial situation.
You don't need to have a super-detailed plan (an easy version of it can stay on a napkin), but it needs to be there any time you are buying a financial product.
If you can't answer the question "Why am I buying this financial product?" and you don't have a different answer from "I want to make more money" you are speculating, even if you think that you are investing.
And, because you are not a professional trader you don't know the rules of speculation and you will just end up giving money away to the people who are more expert.
So, at least at the beginning of your investing path, stay away from speculation and focus on creating a good plan and a solid process for your investments.