I initially thought I can cover the topic of investing in one blog post and yet here I am 4000 words and one week later I’m not even close to being done. Therefore I decided to break this topic down into a blog post series and this will be the first post in the series.
Before we start the series let me make one thing clear:
I’m not a financial advisor. I am sharing my personal strategy that I formulated based on my learning, research and experience. The purpose of this post will be to tell you why you should bother investing and to do so we have to cover some basic finance concepts that we need. I promise I’ll try to keep it light and simple.
Basic Finance Concepts:
Inflation & Time value of money:
Let’s say I give you $CAD 100 that you stuff under the mattress and forget about. A year later you find the money while cleaning and head out to buy avocados. What you will notice is that your money will buy you less avocado than it used to last year. This is due to inflation.
Assuming inflation increases annually by 2% (currently around 1% — See inflation rates for Canada) the quantity of avocado you were able to buy a year ago with 100 bucks is 2% more than what you will be able to buy today. To put it in another way you need 102 dollars today to buy the same amount of avocado you bought with 100 dollars last year.
Now let’s say that you are a wise guy or gal so instead of stuffing your money under the mattress you actually put it in a savings account that gives you a 2% annual interest rate. When you remember the money a year later you will be happy because now you have 102 dollars, however keep in mind that avocado now costs 102 dollars instead of 100 due to the 2% inflation so your buying power has remained the same. Now think of what would happen if your bank gave you an amazing 10% annual interest. You now have more money. You have 8 extra dollars that you can use to buy onions, tomatoes, and jalapeno and make some serious guacamole!
Now let’s look at what would happen if I didn’t give you the 100 dollars a year ago and instead gave it to you today. You will have 100 dollars now as opposed to 102 that you can buy avocados with. So a 100 dollars today are worth less than a 100 dollars a year ago. This example highlights the concept Time value of money; the fact that money today is more valuable than money in 1 year due to its earning potential.
This is all fun and good and this is one reason everyone should be saving and investing but there is an even more compelling reason:
The eighth wonder of the world : Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Albert Einstein
Our avocado example above assumed that you saved the money for one year only, now let’s see what would happen if you keep the money in the bank instead of withdrawing that to pay for groceries.
First year : (your principal amount) 100 + (your interest) (100*2%)= 102
Second year: In the bank you now have 102 and not 100, and you earn interest on all of it!
Second year: 102+(102*2%) = 102* (1+2%) = 100 *(1.02)*(1.02) = 104.4
Third year : 104.4*(1.02) = 106.488
You notice that your money is growing, it is slow but it is interesting .. let’s see what happens on year 10 = 121.90 , Year 20 = 148.59 ,Year 30 = 181.14, Year 40 = 220.80.
I know this example may look boring since you waited 40 years to get 200 bucks but notice that you did NOT add any money during the period, and notice that your money has DOUBLED! So assuming we are talking about 1000 dollars,10,000 dollars, or even 100,000. Your money has doubled in 40 years!
Another reason this example is boring is that the interest rate is pretty damn low. There is no reason for you to put your money into any investment that gives you 2% return unless it is very safe and you need this money for your emergency fund (we will talk about this later)
Now if you try to generalize the relationship and the math above you get something that looks like this:
Money after n years = original amount x ((1+ annual interest rate%)^number of years)
Anyways you are now bored and you are saying you are NOT Einstein and don’t care about equations! fine no problem, there are plenty of online compound interest calculators or what in finance is called Future value
Let’s do some quick math on how would things look if your interest rate is 10% instead of 2%. (10% is definitely reasonable for medium-risk investments) .
Year 5: 100 * (1.10)⁵ = 161.05, Year 10: 100 * (1.10)¹⁰ = 259.37
So your money more than doubled in 10 years with a decent interest rate. This my friends is effect of time lapsing and a decent investment strategy and interest rate. This is Compounding on steroids!!
So why are you investing?
Well everyone has his own reasons for investing but a few good reasons include wealth accumulation, your kids education, rainy days, and your retirement. I’m not going to get into your reason but instead focus on the big picture.
The big picture is if you just put money under your mattress you will lose because of inflation. Inflation is your first enemy. Taxes are your second enemy which we will cover at a later post. If you don’t invest TIME is also your enemy due to its relationship to inflation and its compounding. If you invest and play your cards right TIME is your friend. Not only time heals all wounds. It also helps your compounding and because of general civilization trend it will increase your portfolio’s value.
To leave you with a quote from Warren Buffet’s rules on investing:
Rule №1: Never lose money. Rule №2: Never forget rule №1.