No matter how high your income is, we’re all faced with the same four choices of what to do with our hard-earned cash. We can all either save it, spend it, invest it, or donate it. Saving in a bank account is relatively easy, spending is covered in a later post, and I’m not going to presume to give advice on how best for you to donate. The purpose of this post is to focus on the third option – why should we choose to invest our cash?
If you’d lived in Germany in 1920, 1 loaf of bread would have cost you 28 German marks. But if you’d decided not to buy that loaf of bread, and instead held those 28 marks from 1920 until 1923 (3 years) they would have bought you 0.000000001 loaves of bread – 1 billionth of one loaf. In fact, the mark was so worthless in the early 1920s that Germans began using the currency as a substitute for firewood and coal, since the currency was cheaper to burn.
This is an extreme example, but highlights the devastating power that inflation can have on the value of money. At the height of the inflation in Germany, the monthly inflation rate reached 29,500% (October 1923). Inflation today is nowhere near that level, but even low rates of inflation can eat away at the cash held in a bank account over time. So beating inflation is the first reason that people choose to invest.
After 40 years, the initial £100 can only buy goods that would be worth just under £45 at today’s prices. You’ve effectively lost over 50% of your wealth by just leaving the cash in the bank, and watching as prices of goods and services rise.
How can we beat inflation?
The only way to beat inflation is to invest in assets that generate a return in excess of the inflation rate. If the inflation rate is 2%, then investing in an asset that generates 5% return a year will mean that your purchasing power grows at 3% a year.
One of the most common ways to grow cash in excess of inflation is to invest in the stock market – otherwise known as equities. Below is the same graph as above, but with the added option of investing in equities, which are assumed to grow at 7% a year, so 5% a year after inflation:
The cash ends up being worth £45 after 40 years, as we’ve seen, but thanks to the returns from equities, the initial £100 is now worth over £700 in today’s terms for the stock market investor. That equates to a 55% loss from cash versus a 600% gain from investing in equities. It’s clear that investing in something other than cash is important if we want to have a chance at beating inflation.
Why do we care about beating inflation?
Why not just spend the cash now? Why should we invest on the vague possibility of beating inflation in the future, when we have the certainty of being able to buy things now?
This is probably the most difficult question most people face when deciding whether or not to invest. It’s easy to imagine what £100 could buy us now, but difficult to imagine what £100 could buy us if it was invested and realised at some later point in the future. It’s therefore no surprise that most people tend to favour spending over investing.
However, all of us have big expenditures that we know will occur at some point in our future. Whilst most people’s happen at different points and will be different in value, all of us will have to at some point pay for things like house deposits and retirement, and some will also have to pay school fees and healthcare costs.
An important consideration in whether to spend or invest is the idea of compounding. If we want to maximise our chances of being able to meet these future liabilities, compounding is an amazingly powerful way helping us achieve this. The graph below shows the value of £1 growing at either 1% (assumed cash returns boosted to 1% for illustrative purposes), or 7% (equities) over 40 years:
The £1 can either be worth £1.49 after 40 years if invested in cash, or over 10 times that amount if invested in equities, thanks to the power of compounding.
Investing instead of spending therefore maximises the future value of the cash you have today, and minimises the chances of not being able to afford your spending in the future. An increasingly popular motive for investing instead of spending or saving is the potential for dedicated investors to even retire early.
The idea of compounding works backwards too, and is known as the time value of money. This is the idea that receiving £1 today is better than receiving £1 in the future. The £1 received today can be invested and grown (through compounding) to more than £1 in the future. This makes the £1 received today worth more than the £1 received at some future point.
For those who know what the value of their future liability will be (school fees, for example), this can be an incredibly useful concept. Using the time value of money, we can work out the amount we would need to invest today to meet these costs in the future.
Let’s say you want to become a millionaire before you retire. The graph below shows the amount required to meet your hypothetical £1,000,000 goal in 40 years, by either investing in cash (1% assumed return), or equities (7%):
This is where the time value of money comes in. By investing in equities rather than in a savings account, you need only invest around £67,000 today to meet your £1,000,000 goal (i.e. the £1,000,000 in 40 years costs you £67,000 today), but you’d need to invest £672,000 if you saved in cash (the £1,000,000 costs you £672,000 today).
The power of your equity investment compounding every year at a higher rate of return means that your investments do all the heavy lifting in growing your initial investment. You can therefore minimise the amount you need to invest today, by 1) maximising the returns from your investments, and 2) investing as early as possible.
Of course, the more you invest, the better chance you have to being able to meet the future goal (your returns may not be as high as 7%), so erring on the side of caution and investing more than the maths dictates can never be a bad thing.
By either saving or investing instead of spending, you’re able to spend more in the future. By investing rather than saving, you’re able to greatly increase the amount you can spend in the future.
But the real world is never that simple. These examples simplify things by assuming that equities produce a constant 7% return per year every year. Whilst the above would indeed be an easy choice to make if we could be sure that equities would return exactly 7% a year, every year, returns from the stock market are, in reality, much more variable. I explore this in my next post.
So how much can I make from investing?
Over the long term, the amount we can expect to make from the stock market is driven by 3 things – risk, time, and fees. Each of these has a dedicated post of its own, but it’s the intersection of all three factors that determines our ultimate returns. A person with a high risk tolerance, who invests for a long time, and pays low fees will earn more than someone who has a low risk tolerance, who invests for a short time, and pays high fees.
The art of investing is deciding how much to invest, in what assets, and for how long. The ultimate aim of which is to beat inflation, meet future liabilities, and maximise returns given an investor’s constraints.
The next three posts cover the three factors that determine how much we can expect to make from investing. Read on for the first part of the series, on risk.