As I mentioned in my article on being wealthy and its importance. One of the important ways using which you become wealthy was investing. Investing prudently over long term gives you the most returns for your money. Here are some reasons why you should invest your money.
1. Invest to beat inflation
On an average we have around 2-3% inflation every year. So whatever items, products you bought last year cost 2-3% more this year. Most checking/savings account as of 2018 give you around 1.50%. Even if you put 1000$ in your account to save, it’s only going to be 1015$ next year. But the same 1000$ worth of products from last year is going to cost you 1030$ because of inflation. You are losing money by keeping the extra in your checking account. Most people do not realize this and are often scared of investing and growing money to beat inflation.
2. Save on Taxes
The government usually incentivizes us to be an investor. By contributing to traditional IRA and 401k’s you can reduce the amount of money that is taxable every year. That way you pay no tax on contributions today and way lesser based on your tax bracket after retirement. Similarly using Roth versions of 401K and IRA’s, you pay taxes today let the money grow and never pay any tax after retirement. Even the dividends that you get every year are taxed lower than the income tax. You can even do tax loss harvesting to reduce the amount of tax you pay on capital gains from sale of assets in loss.
3. Retirement Goals
Chances are when most people retire they will see a big dip in their annual earnings. Social security is having a huge amount of problems. The money most people will get from social security is not going to be enough for daily expenses during retirement. One needs an additional source of income and investments usually allow you to just do that. But its important to start saving early to sit back and watch the magic of compounding work.
4. Magic of compounding
Einstein is rumored to have said compound interest is the 8th wonder of the world. If you save small amounts of money over a long period of time. The interest it earns over interest and principal every year keeps increasing every year. Now imagine investing money slowly every year and getting a 10% average historical return. Slowly you realize the snowball effect compound interest creates over long term. Check out the chart below which compares the returns for 3 people who started investing at 3 different times in their life (courtesy BI/JP Morgan )
Notice how Chris invests just 5k every year starting at 25 and comes out way ahead of the other two people who start late or stop later in their life. So being early and consistent over the long term is what matters.
5. Diversify/Reduce Risk
Investing especially in index funds helps you diversify your money across different companies. This allows you to spread out your risk, in case anything goes wrong with one company. Many people during the Enron scandal invested money but only in their company’s stock. When the scandal broke out, they lost all their life savings. It’s important to diversify and make sure to not have all your eggs in one basket.
6. Financial Independence/Retire Early
Investing allows you to grow money over the long term and once your nest egg is big enough it can become your primary source of income. You can technically earn dividends or take out small percentages every year and let rest of the nest egg grow. This can eventually allow you to stop working forever. You can even spend more time in other non money-making hobbies/family stuff you like. There’s a whole sub reddit devoted to people who have either already retired and are living on their investments or aspire to do so.
Having seen some advantages of investing I think its also important to have a look at some disadvantages/ points to remember:
1. High Risks/Volatile
Most investments options usually come with high risks. Most stocks are traded everyday and so go up and down every day. So its important to know if you need any money over the short term (3-5 years), better to not invest that at all. You tend to see better results and more likely to see the 10% per year return over long term.
2. Needs Patience
Segueing from last point, investing usually needs a lot of time. People buy some index funds/stocks and on first sight of volatility they hurry over to sell them. There have been lost of psychological studies which say people feel more loss and pain when they see their investments go down than the joy when they go up.
3. Too complex
For most people investing seems too complex. Most people do not know how to manage risk or what to do or where to begin with. With this fear most, people never even step into investing. However, with my next few articles, I plan to make all this easier, so people realize its not that big of a deal at all.
4. Emergency Fund
Its very important to know that one should always have an emergency fund before investing. Usually it’s a good idea to have 5-6 months of your monthly expenses saved away before you start investing. There could be a stock market crash or any such event which might make it difficult for you to pull out your invested money.
I hope my next few articles in this category will help you choose your own path to investing.