Investing is a popular argument. Yet, with the huge amount of sophisticated terminologies and investment opportunities advertised out there (especially on the web) it is very easy to get lost. At the same time, you might have some money in your piggy bank, stagnating in a hidden corner of your living room. If your savings had feelings, they might not be happy sitting there.
Throughout this article, we will go through the main advantages of investing, let’s make your money happy again! We will also dig a bit into some basic terminologies: the core points necessary to understand important concepts for the household investor in the sophisticated world of finance.
Glasses on and coffee ready? Let’s start.
The Time Value of Money
Money has a time value. You have probably already heard this before, but what does it really mean?
The answer is actually straightforward: it means you would rather receive £X today than £X tomorrow. Let’s dig into this deeper.
Assume your bank offered you a yearly 3% interest rate on the amount you leave in your savings account (currently, interest rates can be much lower, but more on this later). Also, for simplicity, let’s assume that there are no banking fees, taxes, and/or other related costs.
Say now that your uncle, Uncle Joe, made you a gift of £1,000 today. You receive it and put it in your savings account. You’re very busy with work though, as your fame as a monkey dentist is increasing, so you quickly forget about Uncle Joe’s loving donation. 1 year later though, you find out Uncle Joe has been arrested for forgetting to pay the restaurant where he was having his habitual brunch. You are worried, so you take a look at the bank account where the money had been deposited. In opening it, you are very surprised to find out that instead of there being £1,000, there are £1,030. Luckily nobody finds out about your connection with uncle Joe, and you get to keep the money.
What if, Uncle Joe had promised you the money, but given his forgetful way of being, he only remembers to transfer you the money one year later? You would open the bank account, and there would be £1,000.
From a purely financial sense, what scenario would you prefer the most? Certainly, the first one (sorry Uncle Joe!). This is the power of the time value of money. Let’s look a bit better at the mechanism behind these results, and let’s explain better the concept of interest rates.
In scenario one, as you might have conceived, the money increases by £30, thanks to the 3% interest rate applied to your initial saving of £1,000. More generally, the amount of money you can expect to have in your account “t” years into the future is a function of your initial savings and the interest rate. There are many ways this could become more complex, by adding money to your account once in a while or through interest rates that have different compounding cycles, but we will not dig into these too much.
Interest rates play an important part in this real-life game. Before depositing Uncle Joe’s gift in your savings account, you might have had the choice between various banks. Bubble Bank might have offered you a 3% interest rate, while Happy Bank might have offered you a 5% interest rate. All other things being equal, you would go for the latter, as saving your money in Happy Bank would yield you £50 rather than £30. The assumption here though, is that both savings accounts offer the same “risk”. While we generally expect savings accounts to be riskless, it might be very difficult to find accounts that offer high interest rates at the moment. This is the real reason for which investors should look into more complex investments: savings accounts right now are nearly yield less. The concept of risk is vital for every investment decision and will touch upon later in the series.
The Effect of Compounding Returns
Another important argument is that of compounding returns. This represents the fact that you can gain additional interest from the interest rate you received the year before. Let’s look back at the first scenario. Imagine now, that Uncle Joe managed to get away with not paying the restaurant in the first year. His forgetful self though does not change and he commits the same mistake exactly one year later. Under the same dynamics, you get worried and check your savings account. There are now £1060.90. This is better explained in the following scheme. 90 pennies might not seem like a lot of money but think about it long term, what would happen if you left the money in the account for 30 years? Your initial £1,000 would now turn into £2,427 with compounding - it would more than double! With no compounding, you would simply get £30 per year, and your investment would have increased to £1,900 in the same 30-year period. Now, imagine the same effect for ALL your savings and you will understand the tremendous power of compounding effect! Download the excel file attached to this article to play around with rates and see for yourself how strong an effect it could have.
Investing as a Source of Passive Income
It is important to consider that investing is a source of passive income. Passive income is the concept that as the web-famous Robert Kiyosaki stated, “money works for you” instead of “you having to work for the money”. During your ordinary job, you typically work for 8 or 10 hours per day and you get paid for the hours you provide. In many cases, the more hours you put in, the more you get paid. But here is a natural limit over the number of hours you can put in. Now, think of investments. Your investments work for you, to potentially earn you additional money over time, no matter what you do on your daily routine.
When you save money in a bank account, you are not working a 40-hour week to get the interest rate payment; it is passive, and you will receive it even (as in the example) if you forget about it. Careful attention though should be positioned on what kind of investment you make. Certain investments, which can be considered riskier, require more careful monitoring. Nevertheless, investing remains a passive source of income.
Another example of a passive income investment is real estate. If you buy a property and rent it out you are not doing any work, but you are being paid the rent money! Of course, there are many more complexities: you need to have the cash to make a down-payment for the investment, you need to make sure that the rent income you receive is greater than the amount you pay for the mortgage, you need to administer the property, and find tenants. In these regards, investing in the financial market is much more of a passive investment. Your invested money works hard to potentially earn additional income for you.
The Effects of Inflation
Finally, you should keep in mind that in our economic systems, inflation exists. Inflation is defined as the appreciation of goods. This is related to the reason for which you would rather have £X today than £X tomorrow. If today you consume £100 worth of food, and there is a yearly inflation rate of 2%, next year the same amount of consumption will cost you £102. That’s why your money might not be happy sitting there, uninvested! It is losing value: £100 are not worth the same in the two different years (assuming positive inflation rates).
We have not been living the inflation problem much in the last decade. After the great recession, developed economies have been price stable, if not in deflation. This means that at the moment, inflation is less of a problem, yet there have been moments in history where inflation was a full-on public enemy, and chances are that this may happen again in the future, perhaps earlier than we might expect.
We have seen that some of the core properties of money, which in themselves are also at the basis of our economies, are significant in our saving or investment choices. The time value of money, along with the compounding effect of returns and the source of passive income are a few major arguments in favour of investing. This is only the start though! In the next articles, we will go through the basic types of securities, to answer the question “What are your available options when it comes to investing?”. Your investing journey has just started.