It is a rite of passage among personal finance bloggers to write a post that decries a Starbucks Latte-a-day in favor of saving the money and putting it towards your retirement. The key point being that this abstemious behavior, when combined with the miracle of compounding over the long-term, provides a surprisingly large sum of money.
When you forgo a $3 a day latte for 25 years, and instead invest that amount in a low cost index fund returning 8% a year, this will yield a final sum of almost $90,000. Pretty impressive huh? That’s certainly enough to prompt me to make my own coffee in the morning.
Now don’t get me wrong here, I am not turning my nose up at this type of blog post – I am not sneering in any way.
Your Starbucks Habit Just Lost You 90K
On the contrary I applaud this illustration. There is a reason this type of post is popular; it illustrates many important and valuable behaviors, such as:
- Unthinking and automatic spending can have a measurable impact over the long term;
- The power of compound interest is large;
- Frugal habits can make a difference;
- Investing your money for the long term can provide significant growth;
- Never think that small actions won’t make a difference to your wealth.
These are all important points worth making. If you can parcel all that up with a neat post about buying a Starbucks-a-day then you are doing a great service to a great many people.
So what’s my beef?
Investment Returns
The above assumes that the money saved will grow at 8% a year.
And let me be clear, I don’t particularly object to fact that the assumption is 8%.
If the assumption had been 7% per year, or 8% or 9% or whatever I would still have reservations.
Equity Returns
What we’ve done in the above example is assume that the Starbucks consumer has invested in a portfolio heavily weighted to equities and then extrapolated past experience to invoke a future assumption of 8% (or whatever).
But you knew that – what’s my point?
We have assumed that equities are guaranteed to return this amount in the future.
Don’t get me wrong here – I am not one of those perma-bears. I have a well-thumbed copy of Jeremy Siegel’s “Stocks for the Long Run”, and I have bought into equities for the long term. My personal portfolio is around 80% stocks – so I’m on-board the equity train baby!
But stocks are not like a higher returning version of bonds. They are simply more risky and they are not guaranteed to outperform bonds or cash over the long term. If equities were certain to do that then equity managers would be offering you a premium to take your money instead of you having to pay a management fee – see my last post on this issue.
If equities were guaranteed to outperform bonds over the long term then you could borrow cash and invest in equities for a riskless profit (this is called ‘arbitrage’). You would simply take out your 30 year mortgage and pay just the mortgage interest payments. Then instead of paying the principal down each month, you would instead invest in stocks. At the end of the 30 year period you would have earned enough to meet your borrowing costs, pay off the house and leave you with a tidy profit as well.
Apart from a flurry of activity in this vein in the 80’s I don’t see a lot of this type of action among investors.
Why? Coz it’s risky. That’s why.
Zvi Bodie the Norman and Adele Barron Professor of Management at Boston University and co-author of the textbook Financial Economicswith Nobel prize-winner Robert Merton, wrote that the higher expected return for stocks is a reward for taking the risk, but it is an expected return. It is not a “free lunch” or “a loyalty bonus” for long term stock holders.
Starbucks and Public Pensions
So you cannot take your Starbucks savings, invest them in equities and be certain of earning 8%.
But… I probably wouldn’t bet against it; so why am I getting my shorts in a twist?