saving

Economics as a discipline really likes to boil things down to their essentials. There are plenty of examples. How many goods can one consume? Just two, bread and not bread. How can you spend your time? You can labor or leisure. How do you spend your money? Consume or save. It’s this last one that I want to emphasize here.

First, all income ultimately ends up being spent on consumption. Saving today is just the decision to consume in the future. And if not by you, then by your heirs. One determinant of inter-temporal consumption decisions is the real rate of return. That is, how many apples can you eat in the future by forgoing an apple eaten today? The bigger that number is, the more attractive the decision to save.

Further, since most saving is not in the form of cash and is instead invested in productive assets, we can also characterize the intertemporal consumption problem as the current budget allocation decision to consume or invest. The more attractive capital becomes, the more one is willing to invest rather than consume. The relative attractiveness between consumption and investment informs the consumption decision.

How attractive is investment? I’ll illustrate in two graphs. First, if the price of investment goods falls relative to consumption goods, then individuals will invest more. The graph below charts the price ratio of investment goods to consumption goods. Relative to consumption, the price of investment has fallen since 1980. Saving for the future has never been cheaper!

https://fred.stlouisfed.org/graph/?g=1p0C7

Of course, as in a price taker story, I am assuming that individuals don’t affect this price ratio. Truly, prices are endogenous to consumption/investment decisions. For all we know, it may be that the prices of investment goods are falling because demand for investment goods has fallen. But that doesn’t appear to be the case.

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Hopefully by this time we all know about index funds. The idea is that by investing in a large, diversified portfolio, one can enjoy the average return across many assets and avoid their individual risk. Because assets are imperfectly correlated, they don’t always go up and down at the same time or in the same magnitude. The result is that one can avoid idiosyncratic risk – the risk that is specific to individual assets. It’s almost like a free lunch. A major caveat is that there is no way to diversify away the systemic risk – the risk that is common across all assets in the portfolio.

We can avoid the idiosyncratic risk among assets. But, we can also avoid idiosyncratic risk among times. Each moment has its own specific risks that are peculiar to it. Many people think of investing as a matter of timing the market. However, people who try to time the market are actively adopting the specific risks that are associated with the instant of their transaction. This idea seems obvious now that I’m writing it down. But I had a real-world investing experience that– though embarrassing in hindsight – taught me a heuristic for avoiding overconfidence and also drilled into my head the idea of diversifying across time.

I invested a lot into my preferred index fund this past year. I’d get a chunk of money, then I’d turn around and plow it into the fund. What with the Covid rebound, it was an exciting time. I started paying more attention to the fund’s performance, identifying patterns in variance and the magnitude of the irregularly timed and larger changes. In short, by paying attention and looking for patterns, I was fooling myself into believing that I understood the behavior of the fund price.

And it’s *so* embarrassing in hindsight. I’d see the value rise by $10 and then subsequently fall to a net increase of $5. I noticed it happening several times. I acted on it. I transferred funds to my broker, then waited for the seemingly regular decline. Cha-ching! Man, those premium returns felt good. Success!

Silly me. I thought that I understood something. I got another chunk of change that was destined for investing. I saw the $10 rise of my favorite fund and I placed a limit order, ensuring that I’d be ready when the $5 fall arrived. And I waited. A couple weeks passed. “NBD, cycles are irregular”, I told myself. A month passed. And like a guy waiting at the wrong bus stop, my bus never arrived. All the while, the fund price was ultimately going up. I was wrong about the behavior of the fund. Not only did I fail to enjoy the premium of the extra $5 per share. I also missed what turned out to be a $10 per share gain that I would have had if I had simply thrown in my money in the first place, inattentive to the fund’s performance.

Reevaluation

I hate making bad decisions. I can live with myself when I make the right decision and it doesn’t pan out. But if I set myself up for failure through my own discretion, then it hurts me at a deep level. What was my error? Overconfidence is the answer. But why did it hurt me?

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