“I came upon a bar-room full of bad Salon pictures, in which men with hats on the backs of their heads were wolfing food from a counter. It was the institution of the “free lunch” I had struck. You paid for a drink and got as much as you wanted to eat. For something less than a rupee a day a man can feed himself sumptuously in San Francisco, even though he be a bankrupt. Remember this if ever you are stranded in these parts.”

- Rudyard Kipling

Saving and investing is all about trade-offs. At the most basic level the trade-off is between consumption today and putting money away and growing it for the future.

There are further trade-offs. To choose an investment strategy is to accept that there will be inherent advantages and disadvantages to that strategy. To spend more on a car means spending less on leisure.

This mirrors life. We travel a pathway guided by the intentional and unintentional choices we make and the corresponding trade-offs we accept. Some large and consequential. Some small and meaningless. Many with surprising and unexpected outcomes.

In economic theory trade-offs are encapsulated in the saying ‘there is no such thing as a free lunch’. The phrase refers to the once-common practice in US bars of offering a ‘free’ lunch if you purchased a drink. Inevitably the food offered would be extremely salty which induced bargoers to buy more drinks. As the drinks kicked in that often meant even more drinks.

The beauty of the free lunch promotion is that customers didn’t understand the trade-off they were making. They would walk in thinking they were getting a free lunch in exchange for buying one drink. Many of them would stumble out paying far more for their ‘free’ lunch.

When I was younger I made far too many choices without understanding the trade-off I was accepting. It isn’t surprising that many of those choices were poor. I’ve outlined two choices I’ve made with my own portfolio and the corresponding trade-offs I’ve accepted.

Hopefully this helps you to understand your own conscious and unconscious choices and how they are impacting your life. I’ve also offered some suggestions on how to better use your financial resources to get what you want out of life.

Trading lower returns for experiences

I’m an income investor. I don’t believe that is the only investment strategy that works. I don’t even believe it is the best investment strategy. However, it is the best strategy for me given what I want out of life and my personal circumstances.

I feel an intellectual alignment with income investing. I try to ignore what that says about me when most professional investors consider income investing simplistic. The point is that my intellectual alignment with my investment strategy makes it more likely I will stick to it over the long-term. And pardon the pun, but that pays dividends.

I’ve started to spend the income from my portfolio. The benefit of having more money to spend is obvious. The trade-off I’m making for increased spending is significant and unappreciated by many investors.

The long-term returns that are publicised for indexes, ETFs and funds assume that dividends are reinvested. These are known as ‘total’ returns which differ from ‘price’ returns that don’t reflect the reinvestment.

As income is reinvested the position size increases. The impact of the larger position is flet when prices increase. That is the impact of compounding.

A simple example demonstrates how this works. If you start with $100,000 and save and invest $10,000 over 20 years with an 8% return you end up with $923,000.

That is true if the return comes just from price increases or is split between price increases and reinvested dividends. I am ignoring the impact of taxes on dividends and assuming the entire amount gets reinvested. Taxes matter but I’m trying to keep this consistent with return data on indexes, ETFs and funds.

Things look different if you spend the dividends instead of reinvesting them. In a scenario where 4% of the total return comes from dividends which are spent and 4% comes from price appreciation the portfolio would only grow to $516,000. The total amount available to spend over the 20-year period is $225,000.

The gap between $923,000 and $516,000 is more than the money available to spend. You are missing out on $407,000 in portfolio growth to spend $225,000. That is the impact of compounding.

The impact of reinvested dividends on publicised returns is far more than just the dividend yield. It compounds. You may see this in your own portfolio on individual positions where you are not reinvesting the dividends. The publicised 5 year ‘total’ returns on a fund or ETF may say 10% a year. Your annual ‘price’ return over 5 years on an ETF without reinvestment will be far less.

In my case I am trading experiences I can have now for a smaller portfolio later. By spending the money I am dampening the impact of compounding. That is my trade-off. I wasn’t always in the position to make this trade-off but decided to do it a few years ago. Regardless of what happens I made the decision understanding the consequences of my actions.

My portfolio is boring and less manic than Mr. Market

I’ve designed an investment strategy around my goal of generating a growing stream of passive income. Included in my strategy is criteria to select investments.

I focus on buying established businesses with low business risk, sustainable competitive advantages and strong balance sheets in non-cyclical industries.

My portfolio is mostly made up of large multi-nationals that sell non-discretionary products and services. Some may describe this as boring. I’m ok with that.

My portfolio tends to respond in predictable ways. In heady bull markets my portfolio grows far less than the market. In 2024 that was certainly the case. The non-reinvestment of dividends and spending of that income play a role. But the make-up of my portfolio matters as well.

This year my portfolio is significantly outperforming the market. The ‘defensive’ assets I hold are what the so called ‘smart’ money is rotating into. A few months ago the ‘smart’ money was betting Trump was going to be good for the same-old list of names that took off in 2024.

This is the game that I’m avoiding. But in doing so I need to acknowledge that my strategy will do well in some environments and poorly in others. That is the trade-off in having a consistent investment strategy. This occurs regardless of the strategy you pick. In the long-run this works far better than chasing returns.

Actions and consequences

There are two areas that investors often go wrong by not appreciating the trade-offs they are making.

Ignorance is bliss

To evaluate a trade-off requires understanding both what you are getting and what you are giving up. This is an area of our finances where many people fall short. Far too often it is clear what you are getting but there is little understanding of what is being given up.

I see this constantly. I see people not saving small amounts of money when they are young and having to save large amounts of money when they are older. In some cases people can catch up. In many they can’t.

I see people avoiding the discomfort of volatility in the short-term by investing conservatively and giving up their long-term goals by not getting high enough returns.

This contrasts with the behaviour of Warren Buffett. He famously put off buying a house for years because he was positive he could earn higher returns investing. He talked of his $300,000 haircut to demonstrate the power of compounding.

To avoid falling into this trap read my article on compounding to understand the trade-offs you may be inadvertently making with saving / spending decisions and investment decisions.

Buffett understood the implications of his current choices on the future. You should too.

The danger of thinking you can have it all

You may think that the idea of a trade-off sounds like a bad deal. I agree. I would much rather get something without having to give up anything. Add it to the list of reasons that life isn’t fair.

Bad outcomes occur when people decide that they don’t have to give up anything. In the context of investing this often happens when investors believe they can deftly navigate any investment environment by constantly adjusting their portfolio.

This is a fool’s errand. Investing success comes from selecting a strategy that aligns with your goals and temperament and focusing on minimising mistakes. There will inevitably be times your strategy works well and times that it doesn’t.

Trying to have it all leads to debt, an unsustainable lifestyle and poor investment performance.

Read my article on how investors underperform the investments they buy and sell to learn more about the consquences of chasing the market.

Final thoughts

My challenge to readers is to think about the trade-offs you are making with your own finances. If you can’t think of any you aren’t trying hard enough. They are there.

There is nothing wrong with trade-offs. That is just life. And it is impossible to fully understand the implications of trade-offs on an unknowable future, However, it is worthwhile attempting to figure out what you are giving up and what you are getting.

Once you’ve identified the trade-offs you are making see if they align with your goals, values and the things that brings you joy in life. If they aren’t in alignment it might be time to make some changes.

Please share any thoughts or topic suggestions with me at [email protected]

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What I’ve been eating

Charcuterie is a French word derived from ‘chair’ which means flesh and ‘cuit’ which means ‘cooked’. Traditionally charcuterie is only pork products. But traditions are made to be broken and below is an order of Wagyu Bressaola I had at Cibaria in Manly last week celebrating a friend’s birthday. Cibaria is an Italian restaurant and they didn’t refer to their cured meats as charcuterie. I took some creative license to tell you about the origins of the word. You will thank me the next time cooked flesh pops in your head when a friend orders a charcuterie platter.

Charcuterie