Why Investing Matters: Part 1

Money as a form of value

The world today revolves around the exchange of value, and the effective mechanism to store this value is money. It is money that provides access to goods, services and security. Those who have enough of it eat better, live longer and are considerably more secure than those who do not.

In the past, there has been no such mechanisms to allow for the storage of value in a convenient and universally accepted way. The ancient Egyptians had Pharaohs that possessed incredible power and wealth, but without money this wealth (in the form of man power and excess agricultural resources) had to be spent soon after it was created. This was perfectly adequate for building pyramids, but less so for advancing the wider economic and financial well-being of either the Pharaohs or the population at-large.

Since then we have seen the widespread abolition of bartering as a form of exchange in favour of money and currency. Fundamentally, it is the invention and adoption of money that has allowed both society and the individual to store value for use at the most effective time, not withstanding advantages such as the abolishment of the ‘coincidence of wants’.

Saving Vs Investing

The terms “saving” and “investing” are often used in a way that is interchangeable, and while both terms deal with the same topic, understanding the differences is crucial in securing a stable financial future. Indiscretion here could put at risk both short term and long term financial goals.

Saving is concerned with highly liquid, stable assets such as cash – often to be used for a specific purpose, such as saving for a wedding, house deposit or new car. These are short term goals (generally under 12 months) and so stability is necessary, and this means the risk is very low. The most prominent example of saving is by using a bank account, such as a savings account.

Whereas saving is concerned with short term value stability and easy access, investing is concerned with exchanging liquid assets, such as cash, to less liquid assets such as equities, bonds and property. It usually involves the ownership of an asset other than cash, an asset that is likely to produce two types of returns: income and appreciation (or capital growth).

A simple example would be buying a farm, the income is generated by the day to day operations whereas the appreciation (or depreciation) will occur from the assets the farm owns, such as the land.

Broadly speaking, investing will produce a far higher return compared to savings. This downside is that this comes with higher risk, higher volatility and the potential to invest now and cash out later at a loss.

Savings is best utilised for short-term financial ambitions because it provides price stability, this provides insurance against cashing out at a short-term loss. Investing works best at much longer time-frames, with 3-5 years being the minimum recommendations for it to really work. The longer the time horizon the easier it is for an investment to ride out market cycles and dips.

 

When to Save:

There are plenty of examples where saving is more effective than investing:

  • Time: When you expect to buy a specific good or service within a few years, the risk of loosing money (and increasing the time it would take to save) is not a risk worth taking.
  • Liquidity: Investments take many shapes and forms, and many types of investments are illiquid and expensive to convert back into cash. A bank current account is extremely liquid, whereas property or art is less liquid and has additional costs associated with its sale.
  • Potential Losses: Whereas current accounts at banks are insured from loss by regulatory requirements, investments are not. The value of investments rises and falls.

When to Invest:

  • Higher Returns: There are areas of our financial lives, such as retirement, where there is a long-term time horizon and the ambition to retire with as large an amount of money as possible. As market cycles trend upwards over the course of decades, the risk to capital is very low and the returns are often very high after compounding. Traditionally, this I the #1 use case of investing over saving for the majority of the population.
  • Wealth Management: For those who have inherited wealth, the cost of inflation can erode a fortune over the course of decades, and so investing is then primary driver of value retention and growth.

It is important to apply the right method of saving or investing to the context of your goal, investing when you should be savings means risking the deadline of your goal. Saving when you should be investing could mean you are financially worse off – this is especially true for longer term time frames.

Another consideration is inflation, current accounts only pay around 0.5% interest, and with inflation in the UK at over 2%. This equates to a loss of 1.5% each year, as opposed to a gain of around 5% after inflation from investing in equities.

Investing over time

When investing for the future, it is fair to say that the market will not do all the heavy lifting. The most successful way to build a growing investment fund is by continuously adding money over time, as this new money will also have the opportunity to grow and compound.

Over time the financial markets will undoubtedly suffer crashes and the value of assets will fall, this can sometimes be off-set by adding additional capital to your investments over time, buying while the market is both high and low. This can be encompassed by dollar cost averaging, which has the potential to reduce risk over time.

 

Why investing is important

There is usually only one distinct reason, and that is to make money. Investing ensures financial security, this might be for retirement or to increase the overall standard of living, whatever that might mean for you. According to Princeton, financial security may be the key to happiness.

  1. Income Management: By investing regularly it is possible to develop sound financial habits, such as reducing spending on frivolous purchases. It will also broaden understanding of income, expenditure and tax payments.
  2. Capital: Usually, when there is an increased awareness of current budgets, more cashflow is diverted to investments. This improve the long-term capital growth rate.
  3. Family Security: Protecting your family’s financial position is an important part of investing. Having adequate insurance coverages and policies can provide an additional layer of financial security.
  4. Investment Portfolio: Understanding how to build a suitable portfolio is fundamental in getting the desired outcome, this is a balancing act between risk, reward and time horizon required.
  5. Standard of Living: As mentioned previously, investing now for the future can help maintain or improve the standard of living. A lack of savings in retirement could mean a substantial drop in the standard of living compared to those in full time employment without prior preparation.
  6. Financial Understanding: The first step on the journey to a secure financial future is knowledge. Understanding the various elements of how investing works allows an informed choice to be made on which investments to participate in.

Ways to Start Saving

There is often a lot to consider when trying to build an investment pot. Living expenditures form the bulk of this: needs and wants. The trick here is reducing the spend on wants and focusing on the needs. Rent, food, fuel, clothing and all the needs should be prioritised.

Make a list of the expenditure of all the needs and then what is left can be spent on the wants, one of which in this case is investing.

 

This should form the bulk of your disposable income, and the best piece of advice I can give is to be consistent – decide what you can afford to investment each month and stick to it. The cumulative benefits of doing this will be a catalyst for your investments growth in value, and that can be a real morale booster for new investors. To learn more about the effects of consistency see Compounding: Why it Matters.

 

Automatic Bank Transfers

It is possible to set up an automatic transfer of money from one account into another each month. To do this you will need bank accounts, and to set up a transfer (perhaps the day after your paycheque) to move an amount into what will become your investment capital. This can be as little or as much as you can afford, and the key is consistency. Having it automated and away from your main current account should help keep you on track!

Money Pots

Dividing your expenditures into different pots can give you a comprehensive idea of what and how much money you spend monthly. This visual approach is often very effective and is a good money management technique. It lends itself well to consistency, as once set-up the process is quick and convenient which helps develop the actions into a habit.

Loose change

It might not lend itself towards consistency as well as the other entries on this list but cleaning out all the loose change at the back of sofas can often provide a surprising amount of change for the money pot.

Lifestyle Changes

This entry depends on your own daily life and activities. If you use the gym, could you instead take up jogging and running at local parks? Spending money on Starbucks? Why not make your own coffee in the morning?

The list could go on but reducing frivolous and often expensive luxuries could help you achieve the goal of financial independence and a growing investment pot much sooner than you might think.

Extra Hours

Unlikely to be the favourite option, but working more hours is one sure-fire way to building an investment fund quickly. This might be incorporated as an extra 2 hours a day, which can eventually turn into a significant amount of capital.

 

Time value of money:

One of the cornerstones of investing concepts, the time value of money, known as TVM or sometimes ‘present discounted value’ is the idea that money is worth more today than it would be tomorrow, or next year. The concept behind this is that money can be invested for a return known as earning capacity.

Rational investors prefer money to be paid to them as soon as possible, so that this money can be invested and has the ability to grow over time in addition to the effect of compounding. A simple example of this would be a cash deposit or current account, which pays interest on the capital and then interest on the interest – ultimately leading to an increased net worth.

This can be explained from a rational investors point of view as choosing between £20,000 now or in a one year’s time. Most people would take the money now as opposed to waiting, despite the value remaining the same. A rational investor might use this capital to invest in the financial markets, therefore providing a return on the investment. The cost of not taking the capital in this case would be the opportunity cost.

 

Simple Time Value of Money Equation

The TVM equation can change depending on the use case, such as with annuity or perpetuity payments. In broad terms, the following are covered in most TVM equations:

  • FV – Future Value of Money
  • PV – Present Value of Money
  • i – Interest Rate
  • n – Number of Compounding Years
  • t – Number of Years

Using the above factors, the model would look like:

FV = PV x [ 1 + (i / n) ] (n x t)

 

If £20,000 is invested at 10% capital appreciation per year, the future value of this capital would be:

FV = £20,000 x (1 + (10% / 1) ^ (1 x 1) = £22,000

 

This equation can be expanded on to look at the future sum in current day sterling prices. Lets take the above example of £20,000 at a 4% interest rate over a 1 year period.

PV = £20,000 / (1 + (4% / 1) ^ (1 x 1) = £19,230

 

Compounding Periods via Future Value Equation:

While somewhat more complicated, the # of compounding periods has a significant effect on the TVM output.

When using the above illustrations, the changes to the periods of compounding for quarterly, monthly and daily would be calculated as follows:

Quarterly Compounding:

FV = £20,000 x (1 + (10% / 4)) ^ (4 x 1) = £22,076

 

Monthly Compounding:

FV = £20,000 x (1 + (10% / 12)) ^ (12 x 1) = £22,094

 

Daily Compounding:

FV = £20,000 x (1 + (10% / 365)) ^ (365 x 1) = £22,103

 

The above calculations of the Time Value of Money indicate that the number of times the capital is compounded has a direct effect on the returns received. This is due to interest being paid on interest a greater number of times over the same time horizon which in this case is 1 year.

 

Compounding: Why it Matters

Einstein is once believed to have said “The most powerful force in the world is compound interest”, and without hesitation, Buffet responds “Compound interest” whenever asked for the single largest factor behind his success. Such illustrious minds have rarely been wrong regarding their prospective fields, and thus we should indeed sit up and take note.

It is important to start putting aside some capital as soon as you can, whether this is for upcoming goals, such as weddings, or long term aspirations, such as that yacht, investing matters. The trick is to start small, and more importantly, as soon as you can.

This way, you can take the most advantage out of compound returns, and the almost magical effect on your capital growth. This is long term thinking, and the amount you put in now is less important compared to how long your money has to grow.

The idea of compound interest is that money makes money, you can earn interest on interest earned at, for example, your local bank account.

The chart below shows the staggering differences between starting to invest at 25 and 35 years of age, and the outcomes based on retiring at 65. It shows how one saver, who invests for 10 years, end up with more total capital than Bill, who spent 30 years.

The same principle works when you invest in stocks or mutual funds, where annual returns are, on average, higher than they are at the bank. With compounded returns, the money your investments earn one year will earn money for you in following years — as long as you reinvest it.

 

Here are a few more examples with varying rates of returns:

For example, if you invest 100 pounds a month for 40 years at a modest 5% rate of return, you will have more than 150,000 pounds in total.

At 6%, almost 200 000.

Assuming you make good investments, at 10%, almost 600 000.

On a total investment of 60 000, this is 10 times the initial investment.

 

This often leads to the question of “Why don’t retirement savings work the same way, providing similar returns?”.

The truth is some do, there are some great funds that have performance at around these levels. One example is Horizon Capital, who generated returns of 24% over the last 12 months in its high risk fund.

Otherwise, it is likely that these returns are being made, but that the fees charged by brokers, traders, and wealth managers often leave the investor with very little reward.

To end with a final quote, “The aim of the wise is not to secure pleasure, but to avoid pain.” – Aristotle, and that’s why compound interest matters.