Basics of Investing(part 2)

Why invest in the first place?

Well there are two main reasons:

1           a)   To protect the purchasing power of your money  

2            b) To grow your wealth in order to spend more money later, retire earlier or maybe you've always wanted to swim in gold coins.

Although, I should point out that a practically speaking it probably won't work out as you might expect. Anyway, let's take a closer look at reason number one protecting the purchasing power of your money

Imagine it's the beginning of 2018 and you're going grocery shopping.

Let's assume that every time you go grocery shopping you buy the exact same items every week like clockwork.

Now to work with a round number, let's say that this cart of groceries costs exactly $100 this first week of 2018 and for now let's also say that we decide to take another $100 and simply stuff it under a mattress for the time being

We'll revisit this in a moment now we know that over the course of time prices change for the items in our grocery cart and for the most part prices tend to rise over time.

This is known as Inflation which is defined as the general increase in the prices of goods and services over time.

So, if we fast-forward to the first week of the following year 2019, the cart of groceries that we buy every single week without fail might now cost $102 due to inflation.

So, if we go and pull out the $100 that we put under the mattress at the beginning of 2018, we would no longer be able to buy the entire cart of groceries.

If we take our $100 and divide by the new cost of the cart of groceries $102 we find that we would only be able to buy 98.04% of our standard cart of groceries. Our original $100 has lost purchasing power.

If we won our original $100 to keep buying the same standard cart of groceries, we have to invest and earn a Rate of Return equal to the Rate of Inflation.

So, if inflation was 2% per year we would need to earn 2% per year on our money just to maintain our purchasing power. So that's one reason people may want to invest.

The second main reason people may want to invest is to grow their money faster than inflation. In the hopes of increasing their lifestyle or retiring early.

Let's run through a few examples but this time with a time period of 20 years and this time let's say inflation is one percent per year and in all cases, we are starting with $100.    

In scenario 1 we just put the money under the mattress where it earns nothing. 

In scenario 2 we put the money into a savings account that earns 1% per year and

In scenario 3 we put the money into an aggressive set of investments that earn 6 % per year.

And again later in this series we'll explain what is meant by aggressive, so don't worry too much about this for now.

In Scenario one our $100 doesn't grow so we still have $100 at the end of 20 years. But with inflation running 1% per year for 20 years our standard cart of groceries would now be priced at $122.2

$100/$122.2 = 0.82

That means we could only buy 0.82 standard carts of groceries after 20 years in scenario one.

In scenario two our $100 grows at 1% per year and ends up being $122.2 which means we can buy exactly one standard cart worth of groceries. Our purchasing power has been maintained

In scenario three our $100 grows at 6% per year and ends up being $320.71.

If we divide $320.71 by $122.2 we get $2.63.

That means we could buy 2.63 carts worth of groceries. Our purchasing power has been increased and by quite a bit.

Now we have some options we could increase our standard of living by buying fancier groceries or we could keep buying the same groceries and have money left over for other things.

These other things could be anything like vacations, fancier cars or the ability to stop working earlier and any combination of all these things.

Okay we'll stop here because it's easier to work with smaller chunks of information at a time. But I know that at this point many people are thinking well why wouldn't you just take the aggressive investment option and earn 6% all the time.

Hopefully you're already thinking that there must be some kind of catch and you're right. We're going to discuss about the trade-off between Rate of Return and Risk.

To give you a hint, it's imperative for you to understand that the potential of higher returns necessarily comes at the expense of more risk and in the next article or two I'll explain why I use this very specific wording.

If you have not read the first part, click here to read.

Hope you liked this article