The Only 2 Reasons You Should Consider Investing Your MoneyJun 23, 2021
This #dudewithsign kind of says it all.
I know I talk about the importance of investing early and often to anyone who listens, but here we're going to discover the 2 fundamental reasons WHY you should be investing and dive a little more into the ‘math’ of things.
‘What do you mean by: Investing?’
Great question. Let’s define investing before we dive in. When I say investing, I’m talking about putting your money to work. Yes, this primarily means the stock market. This could be in your 401k, IRA, or in a personal brokerage account- and no, you don’t have to be a genius stock picker to be successful at this. You can find low cost investments that do most of the diversifying for you. In my opinion, the market is the lowest risk investment option that takes the least amount of time and capital to get started. You can also automate these investments, making them easy to stick with long term.
With all that said, investing doesn't have to stop there! You can invest by starting your own business or supporting someone else’s business. You can invest in bonds or gold or the crypto market. You can invest in real estate or land. You can even invest in wine- the options are endless!
For this blog, I’ll be primarily referring to investing in the market, but know there are other options out there too!
Why you should consider investing
- To beat inflation
- To build wealth
This is it folks! The only to reasons why you want to invest. Let’s break it down further.
1. To beat inflation
Inflation is the increase in the prices of goods and services and it's how your parents or grandparents refer to getting drinks for a dime...seriously, how was it that a soda was ever $.10!
Take a look at this great graphic from Investopedia. In the past 30 years the price of a coffee has risen 53%! Are you planning to retire in 30 years?
Although the costs of all items doesn't rise as fast as coffee, what do you think living expenses will be like the year that you want to store working or become work optional?
I'll tell you, whatever they're like they'll be MORE than what they are today. That means our cash is losing value every. single. day.
The Federal Reserve has long held a target of 2% annual inflation and recently was quoted saying
"We do not seek inflation that substantially exceeds 2 percent, nor do we seek inflation above 2 percent for a prolonged period." - Jerome Powell, Federal Reserve Chair March, 2021
Inflation is caused when there is more demand for items than there is supply. This can be caused by a variety of factors. After the pandemic we're seeing supply chains being disrupted due to a lack of manpower and raw materials.
Inflation is measured by the CPI or consumer price index. This index measures the overall increase in price of good and services across the company. Here's a graph of how prices have changed over the last 20 years for a variety of goods. As you can see electricity hasnt changed too much, especially when compared to ground beef. You can break down this information even more by region on the CPI website.
What does inflation have to do with investing?
Now that you know about inflation, the next question I hope your asking is "how do I beat inflation?"
That's where investing comes into play. We want to make sure that the money we'll need in the future will grow faster than 2% each year. Luckily over 20 year periods of time the market has returned an average of 8% returns. Enough to beat inflation, secure your principle investments and build wealth.
2. To build wealth
Did you know that 88% of millionaires are self made-- meaning they didn't just inherit their wealth. In that study approximately 50% of most millionaires income comes from dividends and market appreciation.
How does investments make you money?
There are basically 2 ways in which any investment can make you money. Investments can deliver payments back to you and they can also appreciate in value- so when you sell them they'll return much more than what you bought them for.
If you're investing in stocks or funds that contain stocks you might receive payments back in the form of dividends. Companies may send you dividends if the company is making a profit and feels like sharing some of the profit with all the shareholders (or people who own the stock). You can check out the 'dividend yield' on any stock investment to see what the annual payments might be.
Dividends can be a powerful source of income, especially when reinvested. More about that later, but for now check out the impact of dividends on the growth of the S&P500 (this is an index that follows the 500 largest U.S. publicly traded companies). On average dividends contribute 42% to the fund.
Payments from other types of investments could be interest payments if your invested in bonds or rent if your invested in rental property.
Appreciation is the 2nd way any investment makes you money. Appreciation is the increase in value of your investment. For the stock market, if the underlying business increases in perceived value, the price of the stock goes up from what you originally bought it for.
Appreciation can affect any investment when the value of your asset increases beyond what you originally paid for it. Remember that generally the appreciation of any investment will not go in a straight line, so it's important to develop a long term strategy & mindset for any investment. You can see here, that although the S&P500 didn't deliver returns every single year, over a 46 year time span the index returned 8.4%
Here's where the magic happens.
Compound interest takes into account the combined effects of:
- Your original investment (called the principle). This could be $10 or $1000!
- The interest rate that your investment in returning. As you can see in the above graph, the stock market provides long term investors about 8%.
- Additional payments. Instead of waiting to invest one large lump sum, it's actually easier to slowly add to your investment over time. As discussed before this is another benefits of investing in the market.
- Time. The longer your assets stay invested, the longer all these other forces have to accelerate the growth of your investment. If you're interested- check out the exact equation below.
An example of compound interest
Let's look at a more practical example, using a 401k as an investment vehicle.
LuAnn is 26 and just started a new job at an insurance company making $50,000/ year. She decides to use her 401k as her main investing vehicle and works hard to contribute the maximum of $19,500. Her employer matches 4% of her contributions.
This leaves LuAnn with about $2,000 take home pay each month. She lives in a low cost of living area and as she recieves small pay increases over time, she can upgrade her lifestyle slightly while keeping her investing objectives the same.
In her 401k LuAnn is investing $19,500 each year and her employer will kick in another $2000 (4% of her $50k salary). So each month about $1,971 will go into her 401k. Within her 401k she's invested in low cost index funds.
Magically, without doing too much work, at 56 LuAnn will have over $2.7 million dollars, more than enough to make her work optional, even with inflation.
Types of income
If learning about the dangers of inflation and the magic of dividends, appreciation and compound interest hasn't made you consider investing- let me give you one extra reason.
There are 3 main types of income. Earned income, investment income and passive income. Earned income like from your day job typically trades time for money and is taxed on a sliding scale, you can check out the 2020 tax brackets below.
|Rate||For Single Individuals, Taxable Income Over||For Married Individuals Filing Joint Returns, Taxable Income Over||For Heads of Households, Taxable Income Over|
Source: Internal Revenue Service
Passive income refers mostly to real estate, but could also refer to income you receive from businesses you are a non-active partner in. Most passive income takes time on the front end to set up, but then takes little time afterwards. It may be taxed in a similar way as earned income, but also allows for lots of deductions to take place!
Investment income generally refers to profits you make when you sell an investment for more than what you bought it for. As long as you've held that asset for over a year, this type of income receives preferred treatment. See the below 2020 bracket for long term capital gains for single filers.
Long-term capital gains tax rate
$0 to $40,000
$40,001 to $441,450
$441,451 or more
Take a second look here.
As a single person you can make up to $40,000 of investment income (as long as you've held the investment for over 1 year) and pay ZERO taxes!
Meanwhile, as a single filer, $40,000 of earned income would cost you $7,812. Not to mention you'd be trading about 2,000 hours each year for this!
So that's my final argument. The math just makes sense. If you're able, start investing today- even if it's just $10 or $20 each week. Your future self will thank you!
Not sure if you're ready to start investing?
Take the 2 minute quiz to find out:
- Exactly how ready you are to start investing
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- My secret weapon to getting started- it's probably not what you're thinking!