investing is important

Why is investing important: the only reason

Investing is important because it preserves the time value of money. It may not necessarily make you rich but it has better potential than saving.

The main purpose of investing is to have an equal or greater amount of today’s money in a future period.

The time value of money

You probably already know that a pound today is worth more than a pound tomorrow because inflation chips away a small bit of your savings as each day goes by.

The average inflation in the UK has been around 2.6% in the past decades. It can be lower or higher each year but if you spread it out you’ll get a similar number.

This means that you lose approximately 7.1p per day on every £1,000 you have. I know it’s not that much but if you add it up over 10 years you’ll lose £226.38.

You noticed that the result is not 10 years x 2.6% x £1,000 = £260. When my wealth reaches 0 I will no longer be subjected to inflation but I won’t have anything either. Therefore, there is an element of censorship when we lose money to inflation because we can’t go negative.

Investing is important because it helps you keep up with the cost of living

Inflation is a poor way to determine the amount of money I will need in the future. Most of the products I buy are sold by profit seeking firms.

These companies want to increase prices at a rate higher than inflation. Therefore, I will pay more for products and services in the future.

Even government services like council tax become more expensive because the salaries of the staff increase from time to time. Maintenance costs go up too.

The tarmac required to repair a road will be more expensive in 10 years.

In conclusion, the cost of living increases at a rate higher than inflation. You can use the Consumer Price index (CPI) which reflects the increase in the price of a basket of goods. The takeaway is that investing is important if we want to preserve the time value of money.

Future value and Compound interest

How much money am I going to need in 10 years to purchase the same amount of goods and services that £1,000 can buy today?

We can assume that the cost will increase by an arbitrary value of 5% for example so we only need to plug the inputs in a formula:

Future value = £1000 x (1 + 0.05)^10 = £1628.89 (note that the percentage is in decimal, e.g. 0.05 not 5%)

I think that I will not be able to get that by saving alone. The interest on a savings accounts sits at 0.5-1.5% so I’m short 3.5-4.5%. And that’s only to preserve the time value of money, I won’t be earning anything.

Compound loss of value

You noticed that the percentages are multiplied not added or subtracted.

I’ll lose 5% of the time value of the money during the 1st year. Therefore, the next year I’ll have £950 of last year’s buying power. My cash will drop down to £902.50 the year after and so on until it gets close to 0.

This is compounding. The formula in the previous section allows us to work it out for a set period by using a single calculation.

When we’re losing money we only need to divide the percentages. I want to know how much of today’s money will be equal to £1000 in 10 years.

All I have to do is to calculate the present value of the future money:

Present value = £1000 x 1 / (1 + 0.05)^10 = £613.91

If I want to preserve the time value of money I will have to figure out a way how to turn £600 into £1,000 or more over 10 years.

Compound interest is an important part of investing

The simplest way to explain compound interest is by using a savings account.

I can put my money in a cash ISA to earn 1% over 3 years. Some may think that I’ll get £10 per year for 3 years = £30. However, this is not true because we multiply the 1% by using the future value formula:

FV = £1,000 x (1 + 0.01)^3 = £1,030.30

It’s 30p more. You may think that it is not a lot but if we find a way to beat the cost of living and get 6% annual return over 10 years we may get a bit more than £600:

FV = £1000 x (1 + 0.06)^10 = £1,790.85

You can see that we actually get 31.8% more due to the compound interest!

This happened because the first year we got £60 and we grew our pot to £1,060. Then the second year we’ll get £63.6 adding up to £1,123.60. The third year we’ll get £67.41 and a total of £1,191.16.

It’s almost like magic, right? This is one of the reasons why investing is important. We’ll talk more about it in the dividends section.

What is the result

We figured out that because of the compounding effect we got an overall increase of £790.85 instead of £600. This sounds great but let’s dig in the numbers a bit more to find out what does it mean.

The overall profit is 79% return on investment or the gain divided by £1,000. We can average that out to get a non-compounded growth rate of 7.9% per year.

This means that if you want to withdraw the gains each year you’ll need a higher percentage (7.9%) to match the effect of compounding (6%).

Compound annual growth rate

What if your parents invested £1,000 4 years ago and got some obscure sum like £1,073.53. What is the interest on that?

It’s not 7.353% / 4 = 1.84%. We’ll have to use the compound annual growth rate (CAGR) formula to get it:

CAGR = (£1,073.53/1000)^(1/4) – 1 = 1.79%

This is how you get the CAGR of your existing investments if you never really thought about compounding before.

Final thoughts on percentages

We start our journey in math with subtraction an addition. Then we continue with multiplication, division, fractions, etc.

However, sometimes we miss the practical applications. At the end of the day math is as much of a tool as a hammer. One can pin a nail in the wall, the other can tell you if a 1.5% salary uplift is sufficient enough.

Percentages can be less straightforward but when you use the formulas a few times you figure out how they work. You always need to decide what you want to know and then pick the right formula to calculate it.

Saving doesn’t preserve the time value of money anymore

Investing is import because saving makes you poorer. But first you need to know why so we’ll start with the interest on savings.

If you’re reading this you probably know that the interest on savings accounts is very low: 0.5% or something. That’s what, £5 on every £1,000, an absolute joke.

The base rate and inflation

This is because the Bank of England’s base rate is 0.1%, therefore, the banks see it like they are still giving you a premium of 0.4%. The base rate is the determining factor for all interest rates on savings accounts, loans, mortgages and any other interest bearing assets and liabilities.

You may have heard from your parents or grandparents how they got 5% or 10% interest back in the day and preserved the time value of money. I think we need to look into this.

Let’s see how the base rate and the Consumer Price index (CPI) compare over the last 25 years. CPI reflects the cost of living better than inflation because it includes the increase in the prices of consumer goods. Here’s the graph:

Sources: Office of National Statistics and Bank of England

Your family were not wrong! We can see that up until the Financial Crisis of 2007-2008 a savings account could have preserved the time value of money.

In 2006 we’d make 5% on the savings and lose 2.5% to inflation, therefore, we net a 2.44% gain. You can track the chart and see that the net gain was about 2-3% per year before the crisis.

However, the reverse is true in the post-crisis period. We can no longer preserve the time value of money by saving.

The base rate affects credit too

You may be thinking that you were born at the wrong time. Don’t worry each period has its good and bad sides.

The base rate determines the cost of credit too. Therefore, your parents may have yielded 2-3% on their savings account but they also paid in excess of 5% interest on their mortgage.

We may fail to preserve the time value of money but loans are cheaper now so we have better access to credit.

Why did this happen

Because the Financial Crisis damaged aggregate demand. This just means that you and I started to spend less money.

Growth stalled and the government has been trying to reboot the economy by lowering interest rates. The effect of this is two fold.

First, loans are cheaper and companies can borrow money which allows them to buy machinery and increase their output.

Second, it stimulates us to spend more money on goods and services.

This increases the turnover and profits of the firms, they hire more staff, produce more, salaries increase and we are all happy. Sadly that part is yet to come.

Investing is important because it can preserve the time value of money

If we are to find out why investing is important we have to compare it to saving. We already know that the premium we could ever get out of saving was around 3%.

We want to get the same return as past generations so we have to beat 3% and the average CPI for the past 25 years (2.1%) which adds up to a total of 5.16%.

Benefits from investing in stock

You can invest in anything but the most common assets are property and stock. The former is very capital intensive and some people may be priced out.

Stock on the other hand is easily accessible on your phone and you can start from £1. Even if you are saving up for a property you don’t want your deposit to keep shrinking because of inflation.

Investing in shares doesn’t have any set timeline, it could be retirement, a few years or a few months. The purpose is to make your money work for you.

Capital appreciation

I already mentioned that the low interest rates are meant to stimulate the economy. Therefore, if this works successful companies will become more profitable and their share price will increase.

Instead of saving we can buy shares and benefit from a future expansion of the economy. All firms invest in profit making projects and we expect that the returns will beat inflation.

A project is only viable if it delivers a high return so I’ll have the expectation that the profits will beat savings account interest rates too.

Some companies go bankrupt, therefore, it is important to spread the risk. If I’m brand new to investing I’ll invest in broad market funds to ensure that I eliminate the risk of bankruptcy.

The FTSE 100 index, which consists of the 100 biggest UK companies, is a popular benchmark for the performance of the stock market. Each country has it’s own index if you want to compare geographies.

UK stock market return

We need to know how the index compared to the interest rate. The graph below shows a comparison of the yearly FTSE 100 percentage return and the base rate:

I know, it looks a bit scary, it can go down as much as 20-30%.

This doesn’t mean that you’ll lose any money. Losses occur only when you sell the investments you own so we’ll have to average the return over the 25 year period.

It’s 4.41% per year. You may remember that the average we got for the savings was 2-3% and the banks will give you a bit of a premium on that. Don’t forget that we’ll be getting some dividends from the FTSE 100 so the return adds up to about 7-8%. If we discount that for inflation we get 4.8-5.8%. We just beat saving!

2008 – 2019

However, our period of interest is 2008 – 2019 because this is the time when saving stopped working. I’ll have to recalculate the values to reflect this:

2008 – 2019 average
Base rateFTSE 100 returnCPI
0.645%3.075%2.2%

Note that the chosen period assumes that the FTSE 100 lost 30% of it’s value the year you bought it. This is meant to give you a more realistic scenario because it includes the financial crisis.

Gain

Despite all the fluctuation the FTSE 100 preserved the time value of money and gave us a 0.86% premium or £8.6 per £1,000.

You may think that this is a bit underwhelming but it adds up over time. Let’s use the compounding formula to see what we’ll gain over 10 years:

NPV = £1,000 x [1.03075 / 1.022)]^10 = £1,089

And this is after we’ve accounted for inflation so £1,089 is the net present value (NPV) of our investment.

Net present value is the anticipated future value of the investment discounted for inflation to give us an amount in today’s money. We need to compare like for like sums.

Overall, the investment is viable because we’ll have more of today’s money in 10 years time.

You need to know that capital appreciation is not compounding because it is not realised until the asset is sold. We still use present value as the best method to gauge the performance of the investment.

But that’s not all, I deliberately haven’t talked about dividends yet.

Dividends

As a shareholder you have a call on some of the company’s profits. This is why a lot of companies distribute dividends.

You won’t get rich from dividends but little sums add up over time. The index we are looking at contains 100 companies and a lot of them pay dividends.

Dividend yield

So we can’t really say how much we can make before we look at the dividend yield. This is the dividend divided by the share price and expressed in percentage.

If you have a share which costs £10 and pays a yearly dividend of 70p your yield is 7%.

The average dividend yield of the FTSE 100 for the past 5 years is 4.8%.

So the premium over inflation is 2.54%. This alone can successfully preserve the time value of money.

However, you also benefit from compounding if you re-invest your dividends. They are paid in cash which allows you to buy more stock and receive more dividends in the future.

Total return

Total return = Capital appreciation + Dividends

You have two separate streams of income to fight inflation. Even if the FTSE 100 remains flat over a period of 20 years, you’ll still get your dividends.

We can say that the total return of the FTSE 100 is around 0.86% inflation adjusted return and 4.8% dividends = 5.70%. Now we have to calculate the net present value of a potential 10 year investment:

NPV = £1,000 x [(1.03075 x 1.048)/1.022]^10 = £1,740.35

I hope that now you can truly appreciate the effect of dividend re-investment. We expect to have £1,740.35 of today’s money in 10 years time.

Tax efficiency

A lot of private pensions are tied up in stocks to preserve the time value of the pot. However, tax efficiency improves the overall return too.

For example, imagine that you have a SIPP and you pay 20% tax. If you contribute £1,000 to it you’d save £200 from the tax shield. Should you invest taxed money you’ll need to make 25% on £800 just to reach the initial £1,000.

Another tax efficient way to invest is an ISA account. This time you don’t pay tax on the capital gains and the dividends. The benefit is that unlike the SIPP you can withdraw money anytime you want.

Stock market risk

Risk deserves a separate section because it is extremely important to understand how it works and how you can protect your interests.

The more risk you take, the higher return. It comes at a cost though because you are more likely to lose money.

You may think well, then I’ll go for a low risk investment and get a bit less. The downside of this method is that you may fail to preserve the time value of money.

Any investment will carry risk. The best way to deal with this is to figure out what level of risk is right for you and pick your investments based on that.

Historical returns

This is the best information we can use to gauge the potential for future profit. However, it is flawed because we are looking at events which have already happened.

It doesn’t mean that history will repeat itself. For example, central banks have always been able to boost the economy by lowering the interest rates until this stopped working in 2008.

Central banks ran out of bullets so they came up with a new weapon called Quantitative easing. It hasn’t worked yet so we don’t know what the future holds.

You will most likely make money from the stock market if you can hold your investments for 100 years or more. There’s not doubt in my mind but the problem is that most people save for a set period of time to buy a house, for their kids or to retire.

Unfortunately you can just catch a bad period. We looked at the past 5, 10, 25 years and came up with some average values. These are only relevant for the chosen period.

I can pull out different periods where you’ll get anything from a negative return to +25% per year but there’s no guarantee where your investment will end up.

Past performance is not indicative of future returns is very real. However, if you just do nothing you set yourself for failure because your savings will keep shrinking.

The question is what do you prefer: the risk of a loss or a sure loss? I hope that now you agree that investing should have some importance when you make plans for the future.

Diversification

Buying different assets, like stocks, bonds, paintings, gold, etc., is one way to spread your risk. If one of these underperforms another one may outperform.

The only problem is that you reduce your return and you can over-diversify and end up losing to inflation. You can tweak the risk to something like 70% chance of a 10% gain or loss.

One of the good things about investing is that you still get your dividends. They fluctuate depending on economic conditions but you’ll get something.

For example if you bought a £10 stock which pays a consistent dividend of 50p you’ll repay your stock in 20 years. If the stock is down to £6 at that time (40% loss) you would have still made a profit of (£6 – £10) + £10 = £6. We can say an average of 3% per year, take away the 2.2% CPI and it’s still a positive 0.78%.

This doesn’t mean that you have to rely on dividends alone. Some stocks don’t pay dividends but you get massive capital gains. Think of technology stocks: Amazon, Google, Facebook, Apple, Microsoft, even AMD and Snapchat most recently.

Another form of diversification is to have some dividend stocks and some growth stocks. There are a few different ways to diversify so you need to figure out your risk tolerance first.

Can investing make you rich

Not if you use the methods described in this article. It will make you richer than you were before but you can’t get rich by investing £10k in a diversified portfolio. Even if you could you’ll need to wait something like 100 years.

There are methods which you can use to get rich by buying and selling stock. However, these are high risk so you need to be prepared that you may lose all of your money.

Conclusion

We figured out that investing is important because it preserves the time value of money.

It can beat inflation with ease and is expected to outperform any savings account currently available.

Another benefit is that it provides you with two ways to make money: capital appreciation and dividends.

There is always a risk that you can lose something but keeping cash under the mattress is a sure loss anyway.

It’s never a bad thing to set expectations by using future value, present value, average return and CAGR. An investment is only worthwhile if the present value is positive.