Why is investing important?
In this section, we will go over the 2 main reasons why investing is so important for you.
First Reason: Protecting Your Purchasing Power
We will look at a time frame of 1 year from today to break down the concept. Imagine you want to buy a pie that costs $10 today, and you’re paying with a $20 bill. You put the remaining $10 in your wallet and don’t spend it.
Now, we fast forward 1 year. We see that the price of the same kind of pie has gone up to $10.20 due to inflation, which is the increase in the price of goods over time. In this case, annual inflation is 2%.
Inflation: ( $10.20 Price of the pie today / $10 Price of the pie a year ago ) – 1 x 100 = 2%
However, you take out the money you left in your wallet a year ago, the $10, and you see that you now don’t have enough to buy the same type of pie you bought a year ago. You can only buy 0.98 of the pie. This means that your purchasing power has decreased.
Let’s take a look at how to protect ourselves from inflation.
It is easy! Following the previous example, instead of putting the remaining $10 in your wallet and have it lose value over time; you can invest them in a savings account that will generate 2% interest every year. This way, instead of losing purchasing power with your money sitting around in your wallet or under the mattress, you can protect it by investing it safely into savings accounts or other investment products, which will be discussed later on.
Second Reason: Growing Your Wealth
It is not as hard as it sounds! Remember that today we bought a pie for $10. Now we will fast forward 10 years into the future, we’ll look at what happens to the price of a pie and we’ll discuss three possible scenarios. At the end of the period, assuming a constant annual inflation of 2%, a pie that costs $10 today will cost $13.44.
Scenario 1: Wallet
You put your $10 change in your wallet and let it sit earning 0% and making you lose purchasing power over time. That scenario, after 10 years, won’t even allow you to buy three-quarters of a pie.
Scenario 2: Savings Account
Instead of putting your $10 in your wallet, you invested them into a savings account that generated 2% annual interest, which would allow you to buy exactly one pie for $13.44 at the end of the 10 years.
Scenario 3: Investments Account
Imagine that you put your $10 into a portfolio of aggressive (risky) investments – we will learn to manage risk later in the course. That essentially means that you expect to earn a return of 7% every year and your intention is to beat inflation, which will make your money grow faster than inflation. This scenario generated $19.67, which would allow you to buy almost 1.5 pies. And we end up almost doubling our initial $10.
Let’s graph all the scenarios together and analyze the possible outcomes:
Wallet Scenario: If you put your money in our wallet, you earn 0% and you can lose purchasing sower. Not investing your money is only recommendable if you are about to make an important life purchase (such as a house or a car) in the near future; since you will need to have the highest level of liquidity possible.
Savings Scenario: If you put your money in your in a savings account, which is a riskless investment, you can fight inflation to protect your purchasing power. If you have some savings that won’t be needing anytime soon (more than 1 year) but you can’t tolerate any risk of losing that money, this is your ideal option. There are more ways of protecting your purchasing power without bearing any risks.
Investment Scenario: If you invest your money in risky assets, you may earn extra money and beat inflation. However, a keyword here is risk and a key concept is risk tolerance, which will be discussed in future videos. If you have some savings that won’t be needed for a while (over a year), you want to make some extra money and you like thrills, this is your option. In further sections, we’ll go over how to minimize risk in investing.
In the next session, we will discover the power of compounding and how it can work in your favor.