Introduction
Investing can seem like a complex task, especially if you’re new to it. However, there are several reasons why investing is essential for your financial well-being. In this article, we’ll explore the reasons of investing and encourage every American to invest early and enjoy the benefits of compounding.
The Cost of Not Investing
Before we dive into the reasons why investing is important, let’s first examine what happens if you choose not to invest. Let’s assume that you earn $5,000 per month, and you spend $3,000 on your day-to-day expenses, such as housing, food, transportation, shopping, medical expenses, etc. This leaves you with a surplus of $2,000 each month. For the sake of simplicity, we will ignore taxes in this discussion.
Assumptions:
Your employer gives you a 10% salary increase every year
The cost of living goes up by 8% each year
You are currently 30 years old and plan to retire at 50, giving you 20 years to work
You don’t plan to work after retirement
Your expenses are fixed, and you don’t anticipate any other expenses
You keep the $2,000 surplus in cash
Using these assumptions, here’s what your cash balance will look like in 20 years:
If you analyze these numbers, you’ll quickly realize that this is a concerning situation. After working hard for 20 years, you’ve accumulated $1.7 million. Since your expenses are fixed, your lifestyle hasn’t changed over the years, and you may have even suppressed your lifelong aspirations for a better home, car, vacations, etc. Assuming expenses continue to increase by 8%, your retirement corpus of $1.7 million will only last for roughly 8 years. After that, you’ll have no savings left to support yourself.
What will you do when you run out of money in 8 years? How will you fund your life? Is there a way to ensure that you have a more substantial sum of money at the end of 20 years? You may argue that these assumptions are oversimplified, and that real life doesn’t work like this. It may be, but the key point to note here is that no investments were made, so the cash you kept had a flat or zero growth rate.
The Benefits of Investing
Now, let’s consider another scenario. Instead of letting your surplus cash sit idle, you decide to invest it in an option that grows at 12% per year. For example, if you invest $24,000 (the amount of your surplus for the first year) at 12% per year for 20 years (19 years assuming you invest at the end of the first year), you’ll have $206,706 at the end of the 20th year.
Don’t worry about the math at this point. Here’s what the table looks like if you choose to invest:
By deciding to invest your surplus cash, your cash balance has increased significantly. Your balance has grown to $4.2 million from $1.7 million, a staggering 2.4 times more than if you had chosen not to invest. Clearly, investing puts you in a much better position to handle your post-retirement life.
Why should you invest?
Fight inflation
By investing, you can deal with the inevitable reality of life – inflation. Inflation is the gradual increase in the cost of living over time. It can erode the purchasing power of your money and make it difficult to maintain your standard of living. However, investing can provide a relief against inflation. When you invest in assets such as stocks, bonds, or real estate, you can earn returns that are higher than the rate of inflation. This means that your money can grow over time giving you a stress-free life.
Investing is not a short-term strategy. It requires discipline, patience, and a long-term outlook. However, the benefits of investing can be significant. By investing early and consistently, you can achieve a comfortable retirement and a better quality of life.
Create wealth
By investing, you can build a larger corpus by the end of your target period. In the example above, the period was up to retirement, but it can be anything – your children’s education, marriage, house purchase, retirement holidays, etc.
Factors such as time horizon, investment amount, and asset allocation can affect your ability to create wealth. The longer your investment horizon, the more your money will grow. Investing a larger amount of money can also increase your potential returns.
Better life
Investing can help you achieve your financial aspirations in life. Financial freedom means having enough money to support your lifestyle without having to work actively for it. Whether it’s buying a house, paying for your children’s education, or taking a dream vacation, investing can help you achieve these goals faster. There are many successful investors who have achieved financial freedom and a better quality of life through investing, and you can too.
Where to Invest: Exploring the Different Asset Classes
After understanding the importance of investing, the question arises, where should one invest and what returns can be expected? The answer lies in choosing an asset class that aligns with an individual’s risk and return profile.
An asset class can be defined as an investment vehicle categorized based on its risk and return characteristics. There are several popular asset classes to consider, including fixed income securities, equities, real estate, and commodities like precious metals.
Fixed Income Securities
Fixed Income Securities are investment avenues where the principal amount invested is considered safe. The entity pays interest on the principal amount, which can be received quarterly, semi-annually, or annually. Bank certificate deposit schemes are a simple example of a fixed-income security. The typical return from a fixed-income security varies between 5-6%. Government bonds offer about 5.5%, and some corporate bonds offer nearly 7 or 8%. The return rates vary because of the associated risk. Government bonds are the safest investment option with zero risk to your investment, whereas corporate bonds are riskier.
Equities
Equity investment involves purchasing shares of publicly listed companies. Stocks of U.S. and foreign companies provide returns in the form of increased stock prices and/or dividends. Investing in equities comes with no capital guarantee. However, the returns from equity investments can be much better than fixed-income instruments, with an average of 15-20% compound annual growth rate (CAGR) over the past 10-15 years. Identifying the right investment opportunities requires skill, hard work, and patience.
Real Estate
Real estate investment involves buying and selling commercial and non-commercial land, such as vacant plots, apartments, and commercial buildings. Rental income and capital appreciation of the investment amount are the two income sources from real estate investments. The rental yield typically varies between 5-6%, which is not very attractive. The appreciation in land prices is limited to specific areas and is not uniform. Real estate transactions can be complex and require legal verification of documents. The cash outlay for real estate investments is usually high, and there is no official metric to measure returns.
Commodities
Commodities like bullion, specifically gold and silver, are considered popular investment options. Over the long term, gold and silver have appreciated, yielding a CAGR return of approximately 5-8% over the last 20 years. One can invest in bullion by purchasing jewelry, Exchange Traded Funds (ETF), or Sovereign Gold bonds, popularly known as SGBs.
Choosing the Right Asset Class
Everyone has a different appetite for risk; some may prefer high-risk investments, while others may want moderate or low-risk investments. It’s important to diversify your portfolio across different asset classes to minimize risk and maximize returns.
Investing in equities tends to provide the best returns, especially with a multi-year investment perspective. If an individual had invested in fixed income at an average rate of 9% per annum, equities at an average rate of 15% per annum, or bullion at an average rate of 8% per annum for 20 years, the corpus would have grown to $3.3 million, $5.5 million, and $3.1 million, respectively.
Things to note before investing
Before starting your investment journey, there are several things that you should keep in mind. Here are some important notes to consider:
- Risk and return are closely related. Higher risk investments generally offer higher potential returns, while lower risk investments may offer lower returns. It is essential to understand the level of risk you are willing to take before making any investment decisions.
- Fixed income investments can be a good option if you want to protect your principal amount. They are generally less risky than other investment options, but you may still lose money when you consider the impact of inflation on your returns. For example, if inflation is at 10%, and your fixed deposit is giving you a return of 9%, then you are losing 1% in real terms. Investing in corporate fixed income instruments can increase the level of risk.
- Equities or stocks can be an excellent investment option, as they have historically generated higher returns than other investments. Over the long-term, equity investments have returned around 14-15%. However, they can be risky, and the value of your investment can fluctuate based on market conditions.
- Real estate investment can require a significant amount of capital, making it challenging to invest with smaller amounts of money. Additionally, liquidity can be an issue with real estate investment as it may not be easy to buy or sell properties when you want.
- Gold and silver are generally considered safe investments, but the historical returns on these investments have not always been significant. It is essential to do your research before investing in precious metals.
- In conclusion, before you start investing, it is crucial to understand your investment goals, your risk tolerance, and the various investment options available to you. By doing so, you can make informed investment decisions that align with your financial goals and objectives.
Key Takeaways
- Understanding your risk tolerance and investment goals is the most important factor to consider before investing.
- There are various types of investments available, including fixed income investments, equities, real estate, and precious metals.
- Choose an instrument that best suits your risk and return appetite.
- Equity should be a part of your investment if you want to beat inflation in the long run.
- A good investment practice is to build a portfolio that mixes all asset classes.