Before we consider the question, ‘Why Invest?’, let’s take a step back. A little while back we had a little look at the question “Why Save?”. I made some points and some readers came back with some even better points.
Mrs Smelling Freedom noted that we should save “Because life is full of surprises, some sweet and others bitter, and we need to be prepared to roll with the punches.” Having a bit of gold stashed away for the shittier times certainly helps.
OR mentioned that savings are currently allowing a mini-retirement, which sounds pretty ace. The positive side of savings in action 🙂
Weenie had to do battle with the beasts that are credit cards before realising living from paycheck to paycheck whilst carrying debt isn’t the best plan, as I did with an overdraft for years after starting to work.
And ZJ Thorne said “I save because I value my time in the future much more than I value fancy computers now.” Too right, as tempting as fancy consumable goods are now, they are no replacement for our own time. There’s no escaping the fact that time is our one truly limited resource.
When looking at the question, ‘Why Invest?’, let’s not consider it in tangible terms. So away with end goal driven thoughts like ‘to get a deposit for a house‘, ‘to buy a car in a few years time‘, ‘for retirement‘ or anything else that is about the destination or could be covered by the act of saving.
Saving is only the start. Instead of sneaking out at 3am and burying your savings in the garden under moonlight and the creepy green glare of night vision goggles, should you be investing the money instead?
If you peek into the murky world of investing it can seem gargantuan, and ludicrously complicated to boot. And it can be, if you try to take it all in at once.
On top of the complications you have to deal with others exaggerating their own successes, like your Uncle Barry and his stories of Under 18 trials for the county footy squad. Companies will showcase their best performing funds and fund managers over the short term, whilst burying statistics for the mundane. Individuals will spout seemingly perfect strategies towards stupendous growth rates, perhaps even backed up by the success of their own portfolio, apparently unaware of the weakness of a sample of one or the role of luck. Websites will claim to have a guaranteed investment strategy, but, wait, you gotta pay if you want to see it.
Therefore the first step in investing, before you can even consider the question “Why Invest?”, is to evolve a protective set of scales on your body that actively repels ‘Investing Bullshit’. These can be hardened by reading, the fantastic Monevator or Tim Hale’s Smarter Investing.
With you scales hardened you can now consider the question, Why Invest? To earn a return on our savings of course.
Investing comes in many forms, all the way from depositing your cash in a simple savings account up to purchasing individual stocks and altogether more exotic instruments on top of that.
By depositing your cash in a bank you are effectively lending them money, something that’s so easy to forget because we all do it. In return for this, they pay you interest, a return on our savings.
We can use the return we are generating on savings to pay ourselves an income or, the better choice for most of us, reinvest it to help our savings grow at an even quicker rate than through our own contributions alone.
Different asset types provide different rates of return. The theory is that by investing in a higher risk product we should be compensated in the long term, with higher returns.
As an example you might get a 2% annual coupon by buying some government bonds or you might expect 5% total return on an equity fund. See the sneaky use of the word ‘expect’ there, because the returns on the higher risk equity investment are more volatile (there’s a chance you could make a negative return). The additional return can be referred to as risk premium. Is the additional 3% growth worth the risk? That’s for you to decide.
We’re in danger of spilling over the edge into Dry Theory Chasm, so let’s get back on track.
So why invest? To potentially take advantage of some risk premium and to hopefully grow our savings at a quicker rate.
The 3% risk premium noted above in the Completely Fabricated Example might not seem like much, 3% of £1 is only 3p after all. The thing is, over the long run seemingly small differences in return can have drastic impacts.
There’s nothing like a graph of compounding investment growth, is there? Let’s have a quick gander at £500 saved per month at varying rates of return over 30 years;
A higher investment return means a bigger pot at the end, obvious really. But the difference between 1%, 5% and 10% over 30 years is staggering. £210k at 1%, £408k at 5% and £1.03million at 10%. Amazing really that 10%, or 0.1, has such an impact.
And that is part of the reason why we invest, to try and get larger growth our investments. If we earned no return on our savings, that £500 a month would be worth £180k. If we earned 10% on that £500 a month over the 30 years it would be worth over £1million. That’s not chump change, bruv.
It’s a question of balancing risk and reward against our own tolerance for risk, so it’s not simply just a case of plumping for the assets with the highest expected return. Investing isn’t without risk. But, that’s a subject for another time. It’s worth appreciating how much a seemingly small positive rate of growth can impact your savings.
We don’t just invest for growth, we also invest to protect. There is another seemingly small factor out there, but unlike risk premium, it acts in the opposite way, to reduce our savings. We are talking about inflation, that mystical force that increases the cost of things over time and so reduces the value of money over time.
If the price of goods increase over time and your savings aren’t growing then the value of your savings is effectively decreasing, shit-your-pants stuff, indeed.
Another beautiful graph to bring things to life. Same as before, saving £500 a month for 30 years, but this time just stashing it in account with 0% growth and we’ll adjust the value of the saving pot with varying rates of inflation, i.e. we reduce the value of the savings by stripping out the impact of inflation.
Remember, with inflation at 0% we would have £180k in 30 years time. Increasing inflation reduces the value of our savings pot dramatically, 1% it reduces to £155k, 5% to £92k and 10% to £55k.
And right there is an important lesson and an answer to ‘Why Invest?’, because to do nothing is to guarantee a reduction in value of your hard earned savings. In the long run, historic inflation has been positive, which is bad news for savings sat around doing nothing.
Investing to protect from inflation is simply a question of earning a return on savings equal to, or greater, than the current rate of inflation.
There are many other reasons to invest, but Mr Zombie believes the two most prominent are
- To earn a positive return to grow your savings;
- To protect your savings from the ravages of inflation.
Please spend your Wednesday meditating over this, then let me know your thoughts in the comments.
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