Why one must “save” & “invest” “early”?
“Why should I save money? I am just 25. I am so young, I have my whole life. Why should I bother with all this saving & investing thing now?” asked a friend.
Frankly, It’s a good question. When it was asked, I didn’t really have quality points to explain the importance. Sure, I rambled a few points on compounding & inflation. But, I have to admit, it wasn't convincing. Surprisingly, it’s something I have hardly thought about. To Indians it’s obvious right, save money. This article addresses the why behind saving money.
Why save money is perhaps be easier to explain to an adult with financial responsibilities. But, the thing about young age is, it’s goal-less. We don’t really have any long-term plans for our money. Not too many responsibilities. So, it's actually tougher to convince young adults to save. Nevertheless, let me try to give rational reasons. This article is divided into 3 sections,
A. Why save any money?
B. Why invest the saved money?
C. Why invest early?
A. Why save any money?
There are broadly two reasons for savings money,
- Guaranteed long term expense: Retirement
- Uncertain future expenses
I will address them individually.
- Guaranteed long term expense: Retirement
Let’s begin this section with the following information:
- Average Life Span of Indians is 70* years.
- Average Retirement age is slowly falling from 60 to 50 years.
It can be estimated that an Indian will spend 20 years in retirement. During these 20 years, how can basic needs of life (such as grocery) be covered without any prior savings? Given, the huge time difference between the start of retirement & end of life: Retirement needs savings!
Of course, some will die much before hitting retirement. But, as we are unaware of the exact age of death, a rational strategy would be for us to be conservative & save for it.
Retirement is an inevitable long-term expense. One needs to save for it!
In my opinion, very little is discussed about retirement. In India, retirement planning is almost non-existent. This happens due to two reasons:
- The concept of retirement didn’t exist 7–8 decades ago: The older generations simply worked all throughout their lives. Perhaps due to shorter lifespans back then. As older generations didn’t actively plan for their retirement (it didn’t exist!), recent generations are not aware that planning for retirement is essential.
- Off-springs take care of older generation: This is an Indian societal aspect. It’s a social obligation to take care of parents/grandparents. So, older generations don’t necessarily plan for their retirement. Personally, I believe this is a lousy reason. Indians spend 2–3 decades working for money. It wouldn’t hurt to plan finances in a better way. To be clear, I am not saying that Indian parents should go fend for themselves. Rather, financial planning should be better so that retirement finances aren’t a nightmare for their off-springs.
*- Note for Math heads: Lifespan of 70 years is an underestimate. Average life expectancy is calculated at birth so it does not include the impact of Infant Mortality, Child Mortality, etc. Thus, 70 years is an underestimate for any Indian who has survived the initial years of high mortality. Mathematically, 70 years is the expectation of life given current age is 0. Taking my example, the correct way to calculate the average life span is: Conditional expectation of Life given my current age is 23. Unfortunately, I haven’t found any datasets for such calculations. Also, Average is not the right metric, when calculating expenses, it is prudent to consider 80%ile-90%ile of life span.
2. Uncertain future expenses
Expenses work in a weird way. Let’s look at my credit card spend as a proxy for my total expenses.
Couple of things stand out from the above graph,
- Monthly expenses: Every month there will be baseline expenses. Many of it would be everyday essentials.
- Sporadic but LARGE expenses: Occasionally, there are some large expenses. These are seemingly random expenses that pop up.
Monthly expenses are obvious. They will occur in perpetuity.
On the other hand, Sporadic but Large expenses are a complex beast. It took me a while to figure out these expenses. These expenses occur consistently & in perpetuity. When will it occur? Can’t be predicted. How much will be the expense? Can’t be predicted. Some of these expenses might be pre-meditated. But, some will come out of the blue. Taking some examples from the top of my mind, replacing a broken phone/laptop/electronic gadget. Home repair. Urgent flight tickets. What not. Every year <atleast> one of these will expense will occur. Which specific one? That’s uncertain.
Without consistently saving a portion of income, these uncertain expenses can’t be covered.
Why Save money?
Save money today to cover for your future expenses.
The fundamental problem of not saving money is that it forces the future self into a vulnerable state. Very vulnerable state. It rips the future self from the potential to spend.
People incorrectly assume that savings should be for a “goal” & money should be saved for a “purpose”. It couldn’t be further from the truth. Personally, I just save because I know it will be required in the future. When will my saving be required? I don't know. How much will be required? I don’t know. Will my savings suffice? I don’t know. And that is OKAY! Let me repeat. It’s absolutely okay to save without a particular goal in mind. If you really need a purpose, you may motivate yourself by saving for your “early” retirement/financial independence. (FIRE/Screw-you money: Ability to stop working by ensuring that all future expenses are covered by your investments.)
Hopefully, ‘Retirement’ & ‘Uncertain future expenses’ rationalize why one must save. There is a third reason why one must save. But, I will admit. It’s a weak argument. Let me quickly cover that before moving to Why we must invest
Path dependent nature of Humans
The reason is a bit psychological. The journey to the outcome matters to humans. Not only the outcome. But the journey as well. It’s a bit vague, I know. So, let’s take an example:
Take a person whose net worth rises from 0 to 50M. On the other hand, take someone else who has seen net worth go from 0 to 50M but, with a stroke of luck, his net worth jumps from 50M to 100M one day & immediately with a stroke of bad luck, loses 50M and goes back to 50M. Both started equally <at 0> Both ended equally <at 50M> Eventually, both are equally rich. But the person who achieved 100M but lost 50M might not feel as great as the other person. He would feel that he ‘lost’ 50M. This happens due to the path-dependent thinking of humans. Despite the same outcome, the journey will make a difference.
The same problem extends to expenses. Once we get used to a set of expenses (i.e. particular lifestyle) it’s very difficult to reverse the change.
Note: I am not against spending money. I am not against lifestyle upgrades. I am against unsustainable & reckless expenses. ‘Just live in moderation man! Don’t fly too high. or as Mumbaikers say “zyada udane ka nahi!” ’
With the end of 2 strong reasons (& 1 weak reason) to save money. Let’s move to Why Invest the saved money?
B. Why invest the saved money?
People give quite fancy reasons to invest. Compounding & what not! But the reason why the saved money must be invested is quite straightforward. INFLATION! INFLATION! INFLATION!
Inflation is the rise in prices of goods & services over the years. Let’s look at official Indian government reported inflation statistics over the years:
But this is a boooooring graph. Doesn’t tell me the true impact of inflation. Doesn’t depict the ravages of inflation. Let’s consider an example for that. Suppose you had 100K INR in 2006 & you stashed it under your bed & forgot about it for a decade. One decade later, in 2015, you suddenly recall that stash. What is the value of 100K? It’s 41,264. YES!!! It’s dropped by 59% over 1 decade!
Sure, I cherry-picked the worst stat to scare the rational reader. Let’s look at what would happen in each of the decades if this practice was followed every year.
Value of 100K consistently drops by <more than> half over a decade.
And the best part of inflation remains. The above graph is merely based on official reported inflation. Reported inflation is much lower than inflation readers would practically come across. Reported inflation is a measure of the increase in prices of a standard basket. It doesn’t take care of any premium service that we use. It doesn’t include inflation of dining out. Health-care & Education. Flight tickets. Uber/Ola. Zomato/Swiggy. A whole host of services that we use. These services command a much higher inflation rate. Thus, the value of money dropping by half over a decade is a gross underestimate.
Why invest money?
Invest money to maintain your purchasing power. Invest to save yourself from ravages of inflation.
C. Why invest early?
This is a tough one. Has to be explained with an example.
Take 3 sisters who have the capacity to save & invest 50K per annum. Further, assume they have the super-power of growing their investment by 12% per annum. So, whatever they invest will theoretically grow at 12% per annum. Let’s take the reference time point as the year 3000.
Let’s consider different approaches that they take:
First one: Invests 50K every year for 9 years, from year 3000 to 3008. That’s it. Doesn't invest any other penny.
Second one: Doesn't invest in the initial years. She gets serious about investing in the year 3008 & invests for 9 straight years. But then slacks off later. Doesn't invest anything more.
Third one: Doesn’t invest in the initial years. She too gets serious about investing in year 3008 & invests every year.
At the end of 3045 years, who has saved more money?
First One: 50K*9 years=450K
Second One: 50K*9 years=450K
Third One: 50K*38 years= 1.9M!!
Clearly, the third one saved a looooot of money. But they invest with a nice 12% interest rate. So, who has the largest final corpus at the year 3045?
Intuitively, it should be the third, obviously, she saved the most. Next, it should be the first one, she saved the same as the second one but invested earlier. So maybe some difference due to that.
Here are the actual stats of their corpus:
Third One: 30.5M. Seems great.
Second One: 19.8M. Reasonable. Lower than the Third One.
Here comes the kicker.
First One: 48.9M!!! That’s right. She beats the third one. She beats the one who saved the most!
Despite saving a much lower amount (450K vs 1.9M) first one was able to generate a much larger corpus. That’s the difference between investing earlier vs not.
Why invest early?
You may do it later. Nothing “wrong” with it. Financial Life happens to be simpler & easier if one invests early.
Disclosure: Everything I write on personal finance is 100% a rip-off from the internet. In fact, there is no “new” information in any of my personal finance blogs. Nothing! While most concepts I mention are ubiquitous, some concepts & blogs are so wonderful they deserve a shoutout. The sub-section about 3 girls is unashamedly picked from Karthik Ragappa’s Blog on Personal Finance in Varsity. You may read it here. His whole series on Mutual Funds is great! He has done an amazing job in collating information about Indian Mutual Funds.
