Alec Renehan and Bryce Leske, authors and founders of finance podcast network Equity Mates, share this extract from their book, Get Started Investing, to explain why investing in the stock market could be the best decision you ever made.
The No. 1 reason people don’t start investing is because they worry the stock market is ‘too risky’. But when you start to understand the awesome wealth-creating power of the stock market, the biggest risk may be missing out.
Many people have heard stories of the major market crashes throughout history – the 1929 Great Depression, the 2000 Tech Wreck, the 2008 Global Financial Crisis. We’ve also heard the stories of individual companies collapsing and investors losing all their money – Enron and Lehman Brothers in America, Ansett Australia and Dick Smith Electronics in Australia. In 2020, many notable companies collapsed during the COVID-19 pandemic, including Australian airline Virgin Australia and global car rental giant Hertz.
These stories make us concerned that we’ll lose our hard-earned money. We don’t want to be working long hours at our 9-5 job, only to see savings lost by a risky stock market investment.
Instead, we choose to save our money in the bank. Saving and saving. Focusing on cutting our expenses, and saving our way to a comfortable retirement.
Unfortunately, saving your money in the bank can be a bigger risk. Your money can actually lose value over time.
In Australia, between 1951 and 2020 prices have risen an average of 4.9 per cent every year. This means every year your $1 buys 4.9 per cent less in goods and services. Or in practical terms, if you’re stashing all your cash under your mattress and not earning any interest, $100 could buy you 100 litres of milk when it was $1 a litre. As prices increase and milk goes to $1.10 a litre, that $100 buys only 90 litres of milk. The same amount of money buys less. Think about the stories your grandparents would tell you about buying a meat pie for 10 cents. Now you’ll be lucky to get one for $4. That’s inflation.
At the very least, you want your savings to keep up with inflation. If prices inflate at 1 per cent in a year, you need to earn at least 1 per cent interest just to buy the same amount of stuff. Unfortunately, most bank savings accounts these days pay less than the historical average for inflation.
Forget what you’ve heard – cash is not king.
You may be thinking, ‘So what? As long as I’ve got a job and am earning a salary, I’ll be okay.’ Unfortunately, this becomes a problem in retirement. Most Australians – 60 per cent – run out of money before they die, and the average Australian outlives their retirement savings by five years. Making your money work for you while you’re young is the best way to ensure you’ll have the retirement you want.
While saving your money in a bank or under your mattress may feel like the least risk, it may be the riskiest option for your future self.
Every dollar you earn from your job offers a choice. You can spend it, you can save it or you can invest it. The difference between the choice you made and the choice you didn’t is called ‘opportunity cost’.
If you are choosing to save your money rather than invest it, it may feel safe today but there is a big opportunity cost in your future.
Don’t save to save. Save to invest, and make your money work for you.
Robert G. Allen is an investment adviser and personal finance author. He asks a question that always reminds us of the importance of investing to set ourselves up for retirement: ‘How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.’
The reason investing is the right call is the awesome power of compounding. Compound interest is a term we all learn at school, and a lot of us promptly forget. It is important to remind ourselves what it means.
Interest is the money we earn on our money (your bank pays you interest on your savings account). There are two types of interest: simple interest and compound interest.
Simple interest and compound interest
Simple interest is where you earn money on the money you put in at the start. For example, if you invest $100 and have a 10 per cent interest rate, every year you get paid $10 (10 per cent of $100).
Compound interest is where you earn money on the money you put in at the start and all interest you are paid. For example, if you invest $100 and have a 10 per cent compound interest rate, the first year you get paid $10 (same as simple interest). But you then have $110, so in the second year you earn interest on the $110, so get paid $11 (10 per cent of $110). In year three, you get paid $12.10 (10 per cent of $121) and it would keep growing from there.
With compound interest, you make money on the money you earn. It is a virtuous cycle where a small investment can grow into a very large amount over a long period of time.
Compound interest gets particularly interesting if you can earn a consistent rate of interest over a long period of time. As the returns grow year after year, the numbers start getting exciting.
Take $100 invested at 10 per cent as an example. If you invest $100 at 10 per cent for five years, you will multiply your money by 1.6 times (you will have $161). If you invest that money at that 10 per cent for 10 times as long (50 years rather than five), you will multiply it by more than 117 times (you will have more than $10,000!).
This is because the growth of this money is exponential. By year 50, you are not just earning money on your original investment, you are also earning money on the previous 49 years’ returns. Your money is making money that is making money.
The way you make money in the stock market is through this compound interest principle. Over time, companies invent new products and services, expand to new markets and grow in value. They get more valuable and then grow again and then some more.
How investors’ money has grown over the past 40 years
|If you’d invested $1000 in Australia (Index: All Ordinaries Total Return)||If you’d invested $1000 in the USA (Index: S&P 500 Total Return)|
|Start of 1980 $1000||Start of 1980 $1000|
|1989 $5088||1989 $5037|
|1999 $14,427||1999 $26,836|
|2009 $33,688||2009 $24,389|
|2019 $71,800||2019 $86,984|
The first thing we notice when we look at the numbers in the table is that, between 1999 and 2009 in the US, our investor lost money. In 1999, at the height of the frenzy over the first generation of internet companies, our investor had $27,000. By 2009, the middle of the US housing crisis, our investor had $24,000.
Over 10 years, they had lost $3000. Not ideal. But … this market fall was a minor hiccup in some incredible growth. Our investor’s money was able to compound year after year into a serious amount of money.
This awesome power of compounding is why the stock market has been such an effective creator of wealth for so many investors. It’s not about day trading or finding the perfect stock; it’s just been about earning a consistent return over a long period of time.
Buy and hold. Set and forget. Thanks to the effect of compounding returns, this is all you have to do.
Are or were shares a big part of your retirement plans? Did you understand the power of compounding interest from an early age? Why not share your experience in the comments section below?
This is an edited extract from Get Started Investing: It’s easier than you think to invest in shares by Alec Renehan and Bryce Leske, published by Allen & Unwin. RRP $32.99.
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