We are often told to save a significant percentage of our income. However, while saving is not entirely a bad idea, many people are yet to understand what actually happens to their money when they simply leave it in a savings box for a prolonged period. For example, if you save $1,000 today, you would be surprised to notice that the value of your cash would reduce over time, thanks to inflation.
Inflation refers to the reduction in money’s purchasing power or value due to the general increase in the prices of goods and services in an economy. The implication is that to purchase the same goods and services in the future, you will have to pay more. This could reduce the value of your savings greatly.
Investing as an alternative to keeping money in the bank is simply buying assets that you think you can sell at a higher price in the future. When you invest, you shield your money from the effects of inflation in the future. Investing is the best bet to cushion the effect of inflation. Thankfully, there are several investment options available to anyone regardless of your income level — we will be discussing a number of them in this series.
This post is essentially a guide to "investing for beginners". So we will be discussing some of the most important reasons to invest and the various factors to consider when investing:
Why you should invest
Investing offers a plethora of benefits, and they include the following:
It helps to combat inflation
Investing is arguably the best way to keep your head above water in the face of inflation. If you invest your cash in some profitable assets like stocks and bonds, you can be assured that the value of your money is liable to outgrow the inflation rate. But when you save your money in a traditional bank, it can only earn you a negligible return. And when inflation hits, the value of your cash is significantly reduced as the cost of living rises.
It is an easy way to reach your big financial goals
Attaining long term financial goals can become extremely hard when you do not have a good investment plan in place. This is because the purchasing power of money often gets reduced in the long run due to the rising cost of living. But with investments, you can generate a healthy stream of income to create more wealth and earn returns that would help you achieve your financial goals faster.
To achieve your long-term financial goals with investing, you can start by making some little short-term investments like investing in mutual funds. This would help you to accumulate money easily to pursue your bigger financial goals, such as buying a car or making a down payment for a house.
It aids retirement plans
Investing is a good way to ensure that you lead a comfortable life even after retirement when your regular income stops. If you make sound investments now, you would easily have enough funds to attain financial freedom when you retire. Generally, it is better to invest for your retirement than to save for retirement. The former is not affected by inflation, while the latter often receives the harsh blows of inflation in the long run.
You can build wealth by investing
If you keep $100,000 in a savings account for a year with a bank that offers 2.5% interest rate per annum you would earn $2,500 after a year but $100,000 invested in an index fund with an average ROI of 10% per year can earn you $10,000 yearly. While investing can be riskier, returns are usually higher than keeping money in the bank. Interest rates on bank savings rarely go up but returns on investments are not fixed and can often increase depending on the asset.
More about "Index Funds" in a future blog post.
Factors to Consider When Investing
Your risk appetite
While investing is a good way to combat the adverse effects of inflation and make your money work for you, it comes with its fair share of risks. Of course, there is no guarantee that you would make money from all your investments; you also stand a chance to lose some or all of your money.
Therefore, you should consider your risk appetite when making any investment decision. It's highly recommended to invest in assets with minimal risk.
Risk / Reward Ratio
Admittedly, all investments come with a certain level of risks, but some investments promise more rewards than others. This can be evaluated by calculating your intended investment’s risk/reward ratio.
A risk/reward ratio compares the expected returns of an investment to the amount of risk undertaken to invest in that asset. To do this, you should divide the amount you stand to lose if things go south (the risk) by the amount of profit you expect to make if the investment moves in your direction.
Return on Investment (ROI)
The main aim of investments is to make profits. If that is true, you should pay attention to how much you stand to gain after deducting the investment cost. This is known as the return on investment or ROI. The return on investment comes in various forms, ranging from interests to dividends and capital appreciation. It is often expressed as the net after-tax income.
Investment Period / Investment Term
The investment term is the expected duration of the investment. It can affect the return on the investment. Generally, an investment can be short, medium, or long-term. Long-term investment can last for more than a year, while short-term investments are usually ripe within months. However, long-term investments often have a higher return on investment (ROI) than short-term investments. This also depends on the investment capital.
Before investing, you should consider the term of your investment depending on your personal needs.
Investment capital refers to the amount you want to invest. It is often a determinant of the choice of investment: there is a significant difference between what you can invest in with $5,000 compared to $50,000. This does not mean that you cannot invest with little amounts. But some investments require a higher investment starting capital than others.
- Investing is simply buying an asset that you think you will be able to sell at a higher price in the future.
- Inflation is the reduction in the purchasing power of money.
- Inflation results in a massive reduction in the value of your savings.
- Investing is an excellent way to combat the adverse effects of inflation.
- Investing is an easy way to reach your big financial goals.
- Investing can greatly aid your retirement plans.
Overall, while saving is good, investing is a better way to combat the effects of inflation in the long run. However, when investing, you should carefully consider some essential factors — risk appetite, risk/reward ratio, return on investment, and more. In our next post in this category, we will discuss some of the best investment ideas to try as a beginner.