Why you MUST invest
PART I
Consider you open a savings account and deposit $1000. You would obviously expect to have this money available for your use at a later date. Were you to return a year later to an account balance of $1000 you wouldn't likely think any thing of it. But imagine you went to withdraw your $1000 only to find $970. Now imagine the bank informs you (in all seriousness) that this was due to an imaginary tax. (I would love to witness your reactions.) Such a "tax" actually exists, its called inflation.
You're probably thinking that everyone knows about inflation, of course they do. But how much thought have you actually given it? If your answer is, "not much," don't feel bad, neither have most so called, "professionals" on Wall Street. I will try to put it into simple and relevant context.
Of course inflation has to do with rising prices of goods and services, though many people understandably tend to ignore it. Let me suggest two possible explanations: (i) Inflation is not clearly defined and (ii) incomes tend to go up at least slightly over time. Meaning, you might not immediately feel its effects in the same way as you might feel an income tax, but don't fool yourself, inflation is just as real.
To digress momentarily, let's look at the very basic concept of saving. The fundamental purpose to save rather than spend is to have more money in the future. In a simple world your savings grows simply by adding to it. (If you have $100 and add to it an additional $100, you now have $200, & $200 is obviously greater than $100. When most people save their money it is done with the thought that they will need it sometime in the future (e.g. to buy a house, for retirement, etc). The last thing anyone wants is to lose hard earned money, set aside for something specific and important.
You should try to understand that it is your money's ability to purchase goods and services that ultimately counts, and not the actual ("nominal") amount of dollar increases. I'll refer to this as "Purchasing power". If instead of buying a $1 coke today, you put the $1 into a saving account so that you can buy the coke on a later date. At that later date, you take the $1 and interest, if any, and go to the store to buy a coke. If upon purchase, you have change left over, your purchasing power can be said to have increased. If you have no change left over, your purchasing power can be considered maintained. If you can no longer afford the coke, your purchasing power can be said to have decreased.
Getting back to the inflation discussion, consider three savings accounts A, B, & C each with $1000. Where,
A - pays no interest
B - pays a fixed interest rate of 10%
C - pays a variable interest rate that fluctuates with the inflation rate
At the end of one year, account A would still have $1000, B would now have $1100, and if inflation were 3%, account C would have $1030:
A - (no interest) $1000
B - (@10%) $1100
C - (@3%) $1030
Since inflation was 3% for the year, goods and services would have increased also by 3%. Meaning an item that sold for $1000 at the beginning of the year, now sells for $1030.
The purchasing power of account A has decreased since a $1000 good or service last year now costs $1030 and your $1000 is $30 short.
Account B however increased its purchasing power by 10% or $100. The result is that at the end of the year this money could purchase the $1030 good or service, but $70 would be left over for use elsewhere.
The main point is that you are actually being taxed each year at the inflation rate if you hold money in a bank account that earns no interest. While this seems innocent enough let's take it a step further:
If you had $100,000 that earned no interest for 20 years, this is what you would see when you look at your account balance:
At the end of year 1, $100,000
At the end of year 2, $100,000
At the end of year 5, $100,000
At the end of year 10, $100,000
At the end of year 20, $100,000
Which is not so painful, until you go to spend it.
In real terms your purchasing power is reduced by the inflation rate, which we’ll assume is 3% for each year. Your equivalent balance in real terms:
At the end of year 1, $97,000
At the end of year 2, $94,090
At the end of year 5, $86,261
At the end of year 10, $74,409
At the end of year 20, $55,368
The cost of equivalent $100,000 goods due to inflation:
At the end of year 1, $103,030
At the end of year 2, $106,090
At the end of year 5, $115,927
At the end of year 10, $134,391
At the end of year 20, $180,611
You would have the exact same increase were you to earn 3% interest on $100,000:
At the end of year 1, $103,030
At the end of year 2, $106,090
At the end of year 5, $115,927
At the end of year 10, $134,391
At the end of year 20, $180,611
These relationships can be expressed in consistent terms more easily understood by taking the money you have in the bank, and dividing it by the cost of goods. To illustrate, if you have $100,000 and 3% inflation, a good that once cost $100,000 would in 20 years cost, $180,611:
100,000/180.611= .5573
Alternatively, if you think about it as a tax: A good costs $100,000 today & in 20 years, but you are taxed at 3%, then your balance is $55,368, 20 years hence:
55,368/100,000 = .5573
100,000/180,611 = .5573
55,683/100,000 = .5573
Meaning your purchasing power is 55.73% of what it once was.
Alternatively lets compare the situation in account C, the case that is able to earn a reasonable return (10%) above inflation (3%). The $100,000 account balance:
At the end of year 2, $121,000
At the end of year 5, $161,051
At the end of year 10, $259,374
At the end of year 20, $672,750
672,750/180,611 = 3.725
Meaning your purchasing power has substantially increased.
PART II (unfinished)
MAINTAINING PURCHASING POWER
It should be clear that in a world with inflation if your savings does not earn an average annual long-term interest rate that is at least equal to inflation, the value or purchasing power of your money is in decline even if the dollar amount is increasing.
If you are satisfied with simply maintaining your purchasing power, the best option is to put your money in Treasury Inflation-Protected Securities or “TIPS”. Government securities provide the safest means to preserve, but not increase purchasing power.
Since simply saving your money is not sufficient to maintain the initial amount saved, I will regard savings and investments as one in the same. The only way to earn interest on your money is to invest it. (If it is not clear why a thorough discussion is found further below.)
INCREASING PURCHASING POWER:
The most attractive avenue to grow your investments and purchasing power, and to guard against inflation is by investing in good American businesses. (While international businesses are also perfectly fine are not necessary for this conversation.) Most people do not have the means or the desire to invest their future purchasing power in private business and instead turn to public companies. This is arguably the better option anyway since if you don’t like the way things are going, it is easy to take your investment back and for most, there are many more to choose from. American businesses on average have in the last 20-30 years earned between 7-10 percent for investors and about 6-7 percent over a longer time frame, whereas inflation has averaged about 4% over the long term.
If you believe that in 20 years from now that our country’s standard of living will have risen, then the most sensible thing to do with your money is to own small pieces (stocks) of the best American Businesses (at sensible prices). The Standard of living can be measured by looking at income levels, quality of housing and food, medical care, educational opportunities, transportation, communications, etc. When economists talk about standard of living however, most are referring to changes in per capita (per person) Gross Domestic Product (GDP)-calculated by GDP divided by the population. GDP is defined as the total production of goods and services within the United States.
If the standard of living is thought to increase over time, then the GDP must also increase over time, meaning that the total production of goods and services must also increase accordingly and by definition the average business will march similarly upward. If you own a claim on a prosperous business, then by definition you must prosper too.
If your completely confused just think about it this way. Our country over the last century, has experienced two world wars, a great depression with unemployment of about 25%, two (possibly) three serious financial fiascos, the terrorist attacks of 9-11, the cold war, an assassinated president, the civil rights movement, etc. Yet our standard of living increased about seven-fold. Had you owned pieces of American businesses, you would have prospered similarly. There were however times that inflation rates were very high, even higher than most American businesses, and those who held cash or earned an unduly low return suffered significant long-term reductions in their future purchasing power.
Over the next century, it is certain that our country will experience periods of extreme uncertainty, but our country is equally certain to attain continued prosperity-a result of having a functional rule of law, belief in meritocracy, and an economic system that on the whole is market based.
[WILL ADD TO AND COMPLETE THIS SECTION SOON]!!!!!
