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TAKEAWAY
Investing can support wealth accumulation more effectively than saving alone
The earlier you invest, the longer you have a chance for your money to grow
Compounding returns – the idea that growth leads to more growth – can help your money grow faster
You probably make small money-related decisions every day: you shop for groceries, shop online, and put money aside to pay bills. But even though short-term spending is usually your main focus, it’s not the only part of your financial life – it’s also important to think about the future.
The choices you make today can lay the foundation for a comfortable (and ideally wealthy) life. Investing is one of the best ways to grow your money.
Investing is like gardening…
If you’ve ever tried to grow your own tomatoes, you know it takes time and patience. There are often a lot of challenges along the way. From pesky insects and creepy crawlies to choosing the right amount of water and fertilizer, there are many factors to consider. Over time, though, once you know what works, the fruits of your labor can really pay off. Even if you don’t have much to begin with, with consistency and care you can reap a bountiful harvest.
Money is Opportunity
When you think about your future, how many of your plans require money? (If you are not Marie Kondo, probably many.) Do you want to buy a house? Send your kids to summer camp or pay for their college education? (Can you even imagine how much college might cost in 20 years?) Maybe you want to travel or start a small business? You probably need money to do these things, or whatever you plan to do. Investing can help you do that.
Investments are also likely to play a big role in providing for retirement. Consider how long you expect to work, where you want to live, what hobbies you want to pursue, and when you will be picking daisies. Investments are how many people build wealth and prepare for goals near and far.
The Secret Behind Investing:
Compounding Returns
Compounding is sometimes called the eighth wonder of the world. So what does this incredible power consist of?
Put on your gardener’s hat for a moment. Let us say you have an orange tree that produces the sweetest fruit you have ever tasted. Well, one tree is great, but you know what’s even better? Two trees, or maybe a whole orange grove.
If your tree produces fruit every year, you can take some of those oranges and plant new trees. That way, you can plant more and more seedlings year after year, and your little grove will get bigger and bigger. The same concept applies to investing (and reinvesting your earnings) to achieve growth with compound interest.
To better understand the compound interest effect, you can try this calculator from Investor.gov.
What It Means to Be an Investor
When you invest, you don’t just put your money in a little box and hope it’ll magically multiply. When you buy a stock or an exchange-traded fund (ETF), you’re actually buying a stake in a company (or companies). Depending on the type of investment, this may also include some bonds or other assets. But in essence, you become a part owner. (As a shareholder, you experience the ups and downs of a company, whether you make a handsome profit when the company grows, or your investment declines when the company weakens.
So, why isn’t everyone investing?
You can probably guess the answer to this question: We’ve been through some tough times, including a pandemic and a major market downturn. Realistically, many people just aren’t ready to start investing, and in many cases, young people are falling behind. While about 55% of Americans own stocks, that number is much lower among young Americans. Of Millennials in the U.S., nearly 60% have no investments in the stock market at all.
Why invest in the markets?
Basically, investing is about risk and return. While a savings account gives you a low interest rate, an investment can give you a higher return in the long run. How does that work? Let’s look at the S&P 500 Index, a set of stocks representing some of the largest companies in America.
Over the past 30 years, the S&P 500 index has had an annual return of about 7.5%. In other words, between January 1990 and August 2020, a $1,000 investment in the S&P 500 would have grown to about $9,300, before expenses and taxes. (Remember, past performance is no guarantee of future results, and any investment involves risk.) That said, the annual performance of the S&P 500 has varied widely – for example, the index rose 37.5% in 1995 and fell 37% in 2008. That’s just one example of the fluctuations you might experience.
Even though the U.S. stock market in general has grown over time, the performance hasn’t been smooth or straightforward. While this context is sobering, it can help you prepare for when the markets get bumpy.
Investing vs. Saving
To understand the possible difference between investment and savings, let’s consider a hypothetical example calculated over a 40-year period.
Suppose you’re 25 years old today and plan to retire at age 65. What might it look like if you invested $100 a month in a fund that tracks the general stock market?
For our example, let’s assume that you start with an initial investment of $1,200 and that the fund you invest in grows by 6% per year for the next 40 years. (Dividends, taxes and inflation aren’t considered).
If you consistently invest $1,200 per year and ride the ups and downs of the market, your money could grow to nearly $200,000. By comparison, if you invest the same amount in a savings account with an average annual interest rate of 2%, your total investment could grow to only about $75,000. (If you adjust your investment amount, rate of return, or savings account interest rate, you can see how the gap can grow or shrink.)
Why this discrepancy? Simply put, stocks are riskier. When you invest in a company, you’re making part of your financial future dependent on the performance of that company – it may succeed, fail, or simply stagnate. Savings are more stable (the bank uses your money to fund other things like mortgages and car loans), but there’s simply less potential for growth.
Another important difference is that deposits at almost all banks are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. Another important consideration is liquidity – that’s, how readily available is your money and how difficult is it to sell your investments at fair market value? You need to decide what mix of saving and investing is right for you.
How can my investment grow?
Your investments can grow in two ways: appreciation and dividends. Appreciation means that the value of something increases (you may remember people talking about the appreciation of their house). The same is true for stocks – they can increase in value, which means their market value can increase. But the opposite, loss of value, is also possible.
Dividends are your share of the profits. If you hold a stock and the company makes a profit, it may decide to return a small portion of that money to you (the shareholder). You’ve no control over whether the company actually makes a profit or whether it pays a dividend. It’s also possible that the company may cut or skip its dividend without notice.
If you’ve ever heard a stock referred to as a “dividend stock,” it usually means that investors consider the company in question to be relatively stable and paying a reasonably reliable dividend to its investors. It may not be the hottest name, but it’s generally a reasonably battle-tested, potentially older company.
Your investment choices
We’ve discussed some types of investments that build wealth in different ways and produce different returns. In general, savings accounts are the least risky, followed by bonds and then stocks.
For this reason, most investors don’t choose just one type of investment. Instead, most put together a mixed basket (also called a diversified portfolio) to manage their risk and, in turn, optimize their return. Your portfolio may include index funds, individual stocks, bonds and perhaps real estate. Remember, your portfolio is about putting together a combination that works for you and your specific goals.
A diversified portfolio is similar to growing a large garden with many different types of fruits and vegetables. If tomatoes don’t work out, hopefully you’ll still have fresh strawberries, lettuce and onions. And to think, when you started out, all you’d was a packet of seeds.
Revelations
The examples shown are hypothetical and are intended to illustrate basic financial concepts. As such, they don’t represent actual returns that can be realized now or in the future.