Investing Terms: Why Investing Money is Important
Everyone on TV says we need to invest. It seems like every other commercial is imploring us…“Invest your money and you can walk on the beach when you’re 65!” They make investing sound easy, but it isn’t.
I’m a firm believer in teaching people the “why” behind doing anything with their money. If you don’t understand what you’re doing with your money and why you’re doing it then you’re going to end up making costly mistakes.
In Part 1 of this multi-part series “Investing Terms” I’m going to explain to you why investing is important. This may be basic for some of you. But I find it’s always a good idea to go back to the basics so you understand why you’re doing what you’re doing.
The Purpose: Why Invest?
You may have heard people say “let your money work for you” when it comes to investing. When people say this they are referring to the concept known as compound interest.
I’m old enough to remember going to the local bank as a kid and having them explain to me what compound interest meant. Suppose a savings account paid 5% interest per year (back in the old days, they did pay this much!). I’d deposit $100 into the account and a year later I’d have $105. If I left the money in there for another year, I’d have $110.25. That extra $0.25 I earned in Year 2 was the interest on the $5 of interest I earned in Year 1 ($5 x 5%). Interest on interest.
“Compounding” means letting your money earn interest on interest over a long period of time.
Compounding: A Retirement Example
Let’s take this concept of compounding and apply it to a retirement example. Suppose Jane Smith wants to have $1,000,000 of retirement savings in 25 years. She can either invest those savings or not invest them. If she invests the savings into the stock market, we’ll assume she can earn investment returns of 8% per year, on average.
Scenario 1: Jane is very risk averse and wants nothing to do with investing. So she’ll stick all her savings in a safe in her basement. In this case, she will have to stick $40,000 per year into her safe. After 25 years, she will have $1,000,000 saved up.
Scenario 2: Jane wants to let her money “work for her” and invests her money in the stock market, which will earn 8% per year. How much would she have to put into this account each year? The answer: $13,679.
In both scenarios, Jane ends up with $1,000,000 in 25 years. But by investing her money and letting it ‘compound’ each year, she only needs to save $13,679 per year instead of $40,000 per year by sticking the cash in a safe. That’s the power of compounding.
Investing Can Be Risky
Looking at the example above, you might be tempted to think that investing means that making money is easy. Nothing could be further from the truth. In fact, investing can be a very emotional experience. The reason is simple: you can lose money by investing. No one likes to lose money they’ve worked long hours for.
You may be wondering where I came up with that 8% stock market investment return assumption. It comes from examing various academic studies that have looked at historical stock market returns going back 100 years or more. These studies have concluded that on average, stock returns average anywhere from 8-10% per year over the LONG term. For the sake of this argument, let’s stick with 8%. [Please refer to my financial disclosures here – there are no guarantees with investing!]
The S&P 500 is an index of the 500 largest stocks in the United States. In the graphs below, you can see how the stock market has done since 1945. I’ve also ranked the yearly returns from lowest to highest (second graph) so you can see how volatile the stock market can be from one year to the next.
You can see that while there have been a lot of good years, there have also been a lot of bad years! In fact, the worst year the stock market has had since 1945 was just 11 years ago in 2008 when the S&P 500 was down a whopping -38%. (for those that are curious, the best year was 1954, when the S&P 500 rose 45% in just one year!)
Remember that I said that average historical stock market returns are anywhere from 8-10%? I’ve put a red box around the returns that were between 8-10%. Surprisingly, only 5 years have produced investment returns of between 8-10%. That’s 5 out of the last 73 years. It’s a good reminder of how volatile the stock market can be over short periods of time.
The points I want you to understand from this are: 1) the stock market is volatile and can be risky, 2) it’s rare that your investment returns will match the long-term average of 8-10%. This is why it’s important to work with someone (like me!) that has experience investing in up and down markets. It takes a lot of emotional discipline to ride out the highs and lows of the market.
NOT Investing Can Also Be Risky!
Now you might be thinking to yourself, “Investing doesn’t sound like a lot of fun. Maybe I should avoid it.” But there is one big reason why NOT investing is also taking a risk. In one word: Inflation.
My #1 candy weakness is eating Reese’s Peanut Butter Cups. I remember pedaling my bike down to the local Ben Franklin store (it was a Twin Lakes, Wisconsin thing) to buy my candy. Back in the mid-’80s, Peanut Butter Cups cost me 25 cents. Today when I buy them at the grocery store I’m paying $1.05.
Inflation is a silent ‘money killer’ and affects almost everything we buy, not just candy bars. Long-term inflation rates in the United States has averaged about 3% per year, as seen in the graph below.
You might not notice 3% inflation from year-to-year, but it adds up quickly. In just 10 years, the value of the dollar bill in your pocket will lose about 30% of its value.
Investing helps you overcome the effect of inflation. This is especially important when you’re saving for a long-term goal like retirement, which can be 10, 20, or even 30 years away depending on your age.
Two Takeaways About Investing
We’ve talked about two big reasons why you should invest.
First, investing helps your money ‘work for you’ through the power of compounding, as we saw in the example of Jane Smith above. This works best for longer-term goals, such as retirement or saving for your child’s college education. The real benefit of investing for the long-term is that it reduces the burden of having to save money today. Remember that Jane ‘only’ needed to save around $13,500 a year in order to have $1,000,000 in 25 years because she invested it. By not investing, she would’ve had to save $40,000 a year.
Secondly, investing helps you overcome the scourge of inflation, which “robs” 3% of your money’s purchasing power every year, on average. I’ve met people who are very risk averse and say, “I just want to keep my money nice and safe in the bank where I can’t lose money.” The problem with this thinking is that they are taking another risk: having their money lose purchasing power due to inflation.
Conceptually, here is how I like to break down the long-term 8% return from the stock market:
The 8% return helps you overcome the effects of inflation AND helps your money ‘work for you.’ That, right there, is the benefit and power of investing for the long-term.
Next week, I’m going to talk about something called ‘asset allocation’ and why it’s important to understand as you invest your hard-earned money.
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