Savings Bonds

"Saving for security is easy! Here's a savings system that really works—the Payroll Savings Plan for investing in United States Savings Bonds."

This quotation is from an advertisement by the Treasury Department of the United States Government, published in the Federal Reserve Bulletin in September 1954. It is a pity that such lovely sentiment, coming from such a prom­inent source, need be subjected to cold-blooded analysis.

Our Federal Government is doubtless the strongest finan­cial organization in the world. For secure investment opportunities, an owner of a U.S. sav­ings bond can rest assured that whenever he wants cash, the Government will be able and willing to redeem the bond, strictly in accordance with the schedule of dollar values printed on the bond. But now, is this all that is meant by "security"?

Only a miser accumulates savings to count a box full of bonds or a big roll of money the limit of his investment opportunities. Ordinarily a man makes the sacrifices involved in accumu­lating savings so that at some future time he or his family will be able to buy food, clothing, shelter, or something else that is useful or interesting to him or to them. The government statement quoted above seems to imply that if a father's earned income is cut or stops, then his owning of savings bonds will pay the family's living expenses, thus providing "security" for their home.

Does a savings bond say that when it is cashed it will buy specified quantities of food or other goods? No; the only promise is so many dollars. Suppose that in 1936 a man put $1,000 into savings bonds similar to the present E bonds. As his bonds matured, he reinvested both the original amount and the appreciation in more bonds. In 1956, twenty years after he bought the first bonds, ap­preciation had raised the dollar value of the bonds to about $1,800. But with those dollars he could not pay for as much ordinary living expenses as the original $1,000 would have covered twenty years earlier. To keep up with the rise in cost of living, in 1956 he needed about $1,950 just to match what he paid for the original bonds, let alone receiving any interest for the Government's use of his money. So if "security" means reliable buying power, or protection against a rising cost of living, then U.S. sav­ings bonds are not the answer.

The Government says: "Saving for security is easy!" Does this mean that if a man consistently saves a reason­able portion of his salary, and with those savings buys savings bonds, he will accumulate enough capital so that in old age he and his wife can live comfortably on the income from those bonds? In considering this question for investment opportunities, let us for the moment forget the trend in cost of living.

Suppose a man earns a salary at the same rate for forty years, from age twenty-five to sixty-five, and each payday he saves one tenth of his salary. For instance, out of a salary of $500 a month, he saves $50. All of his savings he puts into E bonds. In real life, of course, salary and savings are not so uniform, but a simplified example helps to focus attention on the point at issue. As the bonds mature, he reinvests their entire value, including apprecia­tion, in more bonds. At the age of sixty-five, when the man's salary stops, the total value of his bonds has grown to about 75 times his annual saving, or 71/2 times his annual salary. He now begins to spend the appreciation on his bonds. This gives him and his wife an income of about one fourth as many dollars as the 90 per cent of salary that they were spending before retirement. Is this sort of income what the U.S. Government means by "security"?

Small as these bond results are in dollars, their buying power is pretty likely to be still smaller. The dollars that the saver puts into E bonds probably will lose considerable of their buying power by the time he retires, and as he grows older, after retirement, the buying power of a dollar is likely to shrink still further. By limiting his investments to E bonds, a saver does not obtain security in old age; on the contrary, he is pretty sure of facing poverty.

Cost of Living

Are you old enough to remember the cost of food, clothing, and housing back in the 1930's, the years be­fore World War II? If so, you know that prices in the late 1950's are a great deal higher. If your memory does not go back that far, you had better find out what happened to the buying power of a dollar, especially between 1940 and 1950, before you select investments.

Here are some highlights in the trend in cost of living, which is something to consider when thinking about the viability of investment opportunities in the long term, Bureau of Labor Statistics, a part of the U.S. Government. In the comparatively prosperous 1920's, after World War I, the cost of living was about four fifths higher than in the prewar years 1910-14, when business was rather poor. Then in the business depression starting in 1929, the cost of living dropped considerably, but in the late 1930's it was still about two fifths higher than before World War I. During and after World War II, starting in 1941, the cost of living rose rapidly, and the Korean War caused another spurt in 1951. By 1957, the cost of living was twice as high as in the late 1930's, and about three fifths above the 1920's.

Thus the cost of living has had spells of moving down­ward as well as upward, and sometimes for several years it changed only slightly. But the ups and downs did not balance out; the ups were considerably larger than the downs. Comparing the two low periods, the early 1910's and the late 1930's, the rise averaged a little less than 2 per cent a year. And comparing the two high periods, the 1920's and 1957, the rise averaged about the same rate per year.

A saver, although well aware that a dollar now will buy considerably less than it did several years ago, is apt to forget all about this when selecting an investment. Or may­be he assumes there is nothing he can do to protect him­self against a continued decline in a dollar's value. The Government's talk about "security" encourages him to continue in his delusion.

What is going to be the future trend of cost of living? This book does not indulge in forecasting, except to say that the general trend of the past is the best guide to the future. Of course, an estimate of future cost of living can­not be accurate. But judging by the record of the last forty years, on the long-term average the cost of living will rise about 2 per cent a year. This means that if you put a $100 bill into a safe-deposit box today, in ten years its buying power will be $17 less than today; in twenty years it will be $29 less than today, and so on for longer periods.

Instead of just holding the cash, suppose a saver buys an E bond for $750, and redeems it in nineteen years. In­cluding appreciation, he will receive $1,347. But most of the appreciation will be offset by the estimated 2 per cent annual rise in cost of living. In buying power, the $1,347 will be worth only as much as $825 was on the day he bought the bond. Similar results are to be expected from any of the popular "safe" investments, such as life in­surance and deposits in savings institutions.

Anyone limiting himself to fixed-price investments, no matter how sensible and conservative he feels, is actually gambling that the cost of living is not going to rise, and over the long term, he is likely to obtain sorry results.

Profits and Cost of Living

Now let us consider how equity types of investment opportunities behave in relation to the cost of living.

Suppose a man owns and manages a retail store. His sales average $1,000 a week. The cost of goods he buys, plus all expenses, including his own salary, averages $950 a week, leaving an average profit of $50 a week. Then suppose that over a period of years all of his costs, prices, and expenses are exactly doubled, while the physical volume of his sales is unchanged. He takes in $2,000 weekly and pays out $1,900, leaving a profit of $100. In dollars, his new profit is twice as large as the old one; but if he spends that profit, the physical amount of goods it will buy is exactly the same as with the original profit.

When prices are rising, usually a skilled business man­ager can increase his sales dollars faster than his expenses rise. Modifying the above example, suppose that while his expenses have doubled, to $1,900, his physical volume of sales rises slightly, so that his sales dollars become $2,100. This gives him a profit of $200, four times as many dollars as originally, and with twice the buying power.

When prices are dropping, all of these tendencies are reversed.

An owner of a share of common stock in a business corporation is in the same position as the owner of the retail store just discussed. When the cost of living rises, the dollar profits of a corporation tend upward; conse­quently the company pays larger dividends, or the market value of a share of its stock rises, or both. Correspondingly, when the cost of living falls, corporate profits, dividends, and share values go down.

In any one-business concern, small or large, and over a short period of time, the trend in profits may bear little resemblance to the change in cost of living. The similarity is clearer in a well-managed investment fund that owns com­mon stock in a broad diversification of companies, and with results measured over a fairly long period of years. In such a fund in the late 1950's, the dollars of divi­dends and market value per share were at least three times as large as in the late 1930's, before World War II, while between these same periods the cost of living was doubled.

Common stock and other equity investments naturally make their best showing when business is growing more prosperous and the cost of living is rising. And savings bonds and other reliable fixed-price investments are nice to own when business profits and cost of living are going down. So if "security" means that an investor's future is protected no matter what happens to profits and the cost of living, his savings must be invested partly in fixed-price and partly in equities.

"If "security" means that by saving and investing over many years, a man can expect that upon retirement, the income from his accumulated capital will be large enough to justify his efforts, he had better have most of his capital in equities, for two reasons: First, when the cost of living and business profits are not changing, the income from a dollar invested in equities, plus growth in market value, averages larger than in fixed-price items, and by reinvesting this larger income, he accumulates capital faster. Second, during a long period of years the cost of living and business profits are likely to rise. It is the compound effect of these two aspects, each boosting the other, that enables equities to show long-term results far superior to fixed-price invest­ments.

If the writer displays strong feeling over the misleading use of the word "security," when looking at investment opportunities, he does so because, when pre­paring for the ending of his earned income, he carelessly accepted the idea that for retirement income he should buy only "safe" fixed-price investments. After a few years, he discovered that although at the beginning of retirement he had adequate income, he and his wife were drifting toward trouble on the rising cost of living. Fortunately he then was able to switch considerable of his capital into equities. But he still sees red when anyone claims that savings bonds or savings deposits or life insurance or annuities give "security."