Paying yourself first

As investors survey the damage caused by the financial panic of 2008 and the ferocious bear market which accompanied it, the question of what they should do differently going forward is a very significant one.

There are plenty of areas that can yield valuable insights, and we have visited this subject several times before, in posts discussing some of the problems with "modern portfolio theory," the dominant intermediary structure of the financial services industry, and the rush to "diversify" into financial products such as commodities funds, international funds, and investments tied to foreign exchange speculation.

One important area we have not directly addressed, however, is the importance of establishing a systematic mechanism for ploughing capital into savings on a regular basis.

It has been our experience over the years that this is an area in which investors -- even very wealthy investors -- often have good intentions but haphazard execution.

Systematically putting money into building real estate equity is fairly automatic -- most real estate owners establish a system for having their monthly mortgage payment happen every month without much thought. Similarly, building cash value inside a permanent insurance vehicle is also automatic -- the insurance company ensures that you make your payments in a regular and automated way, a sort of "forced savings."

But investments in the capital markets are not generally automated in the same way. We firmly believe that establishing an automatic mechanism for moving income into an account that is not used for consumption is a critical component of long-term success. That "savings" account can earn interest on its own, and be a source of funds for investment in long term capital market assets such as stocks and bonds. This has been expressed in the advice, "Pay yourself first."

We have written before about the important distinction between production and consumption, and linked to an excellent essay by economist George Reisman on the subject. Professor Reisman has also written that "Capital is accumulated on a foundation of saving," and this is exactly what we are talking about in this post.

This is especially important in light of the fact that we believe that ownership of well-run, growing businesses should be the real foundation of any long-term preservation and growth of wealth.

Ploughing money into a home remodel, for instance, can be a valid investment, and one that increases the market value of a real estate asset. However, it is our belief that investors cannot rely on real estate values to grow at a faster rate than businesses grow over a long period of years. Ultimately, real estate is either bought by businesses or by people who are paid by businesses, so it does not make sense for its value to outpace the rate of business growth for long periods of time -- a river cannot rise higher than its source, so to speak.

There have been areas and periods in which real estate values have outpaced business growth, but that cannot go on forever, and may indicate the likelihood of correction in the future.

There are many lessons to be learned from this recent bear market experience, but also important is the concept of creating an automatic system for ploughing some money into savings regularly, particularly for investors who are still actively working.

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For later posts on this same subject, see also:

• "Paying yourself first, revisited" 01/21/2010.