3. Invest (Part 1)
Why you should invest.
Posted November 2, 2024
This blog is a continuation of Starting Personal Finance.
Saving and paying off debt provide the foundation for wealth, but they alone will not make your net worth grow. Here we will talk about why investing is important.
Saving is not enough
Some people believe that if they save enough leftover money from their paycheck, they will be able to build wealth. Those people are wrong. There’s a reason why McDonald’s got rid of its Dollar Menu, and that reason is called inflation. As time passes the money supply (the sum of all money in circulation) increases, which means the purchasing power of each dollar decreases.
In other words, THE MONEY YOU SAVE BECOMES LESS VALUABLE EACH YEAR.
Alice’s Piggy Bank
Let’s illustrate this by looking at Alice. Alice puts $100 each month into her piggy bank starting at the age of 25 and checks how much money she has 40 years later at the age of 65.
Alice ends up with $48,000 (must be a pretty large piggy bank), but if we account for an inflation rate of 3% per year, we actually end up with $27,782.02. Alice LOST MONEY (-42%) by doing nothing with her money.
Bob’s Savings Account
Bob also saves $100 a month for 40 years, but he’s a little smarter and decides to put his money in a savings account earning 3% interest.
Bob ends up with $91,718.99, but accounting for 3% inflation the total interest rate is 0%. He ends up with $48,000. No more, no less.
Is this the best we can do? Simply keep pace with inflation with no meaningful growth?
Why invest?
Many people believe that investing is reserved only for the wealthy. The truth is that investing is HOW people generate their wealth, and you only need a few dollars to start investing.
Simply put, investing is the best way to beat inflation. The S&P500 index tracks 500 of the largest American companies and is widely used as a benchmark for the stock market’s performance. It has an annualized return of 7% per year from 1974 to 2023, and this is already adjusted for inflation. The returns from investing grow faster than inflation!
Now, you might think that a 7% annual return doesn’t seem worthwhile. Even if we beat inflation, our $100 would only grow to $107 after year 1. But this is where the magic of compounding interest comes in (earning interest on your interest).
For year 2, we would earn 7% on our original $100 AND the $7 we earned year 1, bringing our total to $114.49. Year 3 would earn 7% on the original $100 AND interest from years 1 and 2, and so on and so on.
After 10 years, we nearly doubled our $100 to $196.72, all just from 7% (to estimate how long it takes to double your investment, check out the Rule of 72). Through the magic of compounding interest , the money you invest can grow exponentially more than what you’ve initially put it.
Carol’s Early Investment
Carol invests her money in the S&P500 with 7% annual return (inflation-adjusted). She also sets aside $100 every month for 40 years.
Carol ends up with $247,154.20. Now compare this to Bob’s $48,000 (again, accounting for inflation).
Dave’s Late Investment
Dave also invests in the S&P500 but he doesn’t start until he’s 45, 20 years later. To compensate, Dave increases his contribution to $200 a month for the remaining 20 years.
Dave ends up with $101,507.28. Even though he contributes the same amount as Carol, he falls far short of Carol.
Even if Carol invests for the first 10 years and stops contributing for the remaining 30 years (¼ of Dave’s contribution), she still comes out on top with $130,208.92. When it comes to investing and the magic of compound interest, time is everything. This is why it’s so important to start investing as soon as possible, no matter how much money you’re making.
Hidden cost of investing
The markets will be volatile and there will be periods where your investments can be down 30% or more. No one knows where the market is gonna go, and it is a losing game to try and time the market.
The important thing is knowing that this will happen, continue to invest on a regular basis (Dollar Cost Average), and DON’T LET YOUR EMOTIONS GET TO YOU. Have faith in American capitalism and productivity, the market will eventually go up again.
Your emergencies are covered by your emergency fund back in section 1. Increase your emergency fund if you feel uneasy or nervous.
If you want to understand your money psychology better, read The Psychology of Money by Morgan Housel.
Isn’t this all gambling?
Although investing involves risks and doesn’t guarantee returns, it is fundamentally different from gambling.
In gambling, outcomes are limited to a specific event, often with rules set by a controlling entity that stands to benefit, creating an environment designed for them to profit over time. Gambling is a zero-sum game, meaning that for one person to win, another must lose.
Investing, however, is overseen by regulators (government and industry bodies) whose goal is to maintain fair, orderly markets rather than to profit from participants. Investing isn’t zero-sum; if assets increase in value over time, everyone can benefit, provided there are no disruptions like bubbles.
Here is an article that goes deeper into the differences between the two.
Continue to Part 2.
Back to Starting Personal Finance.