Investing 101: Why invest?
In the first article of the Investing 101 series (Part 1: What is investing?), I explained what investing means. In this article, I will explain why we should invest.
People invest for a variety of different reasons. Some have a specific financial goal they want to meet. Others want to make sure they have enough money for retirement. Institutions invest as well. Companies invest to make more profits. Pension funds invest to grow their assets to pay out future benefits. Schools invest their endowments to grow the endowment and fund future plans. Governments invest to pay for social programs and benefits.
Whatever the reasons, the thinking goes that having more money is preferable to having less money. As Leonardo DiCaprio’s character says in the 2018 film Wolf of Wall Street:
“There is no nobility in poverty. I have been a rich man and I have been a poor man. I choose rich every time”.
As I alluded to in part 1, for the average person (including physicians), the opportunity cost of not investing is staggering. One of the first blogs I ever posted was Why Investing is Important, and much of the information here remains the same. But this topic is always worth revisiting in detail.
The power of compound growth
The power of compound growth over time is simply incredible. If you have $100 and can grow it at 10% per year, it’s obvious that you will make $10 and have $110 next year. But the year after that, you will make $11 instead of $10, and have $121 instead of $120. Compounding causes your money to grow exponentially. The basic formula for compounding is:
A = p (1+r)t
Where A is the final amount, p is the initial amount, r is the annual growth rate or interest rate, and t is the time in years.
Just how extreme can exponential growth get? Fans of the TV show Futurama might remember the 1999 episode A Fishful of Dollars. In this episode, the main character Fry (who was thawed after being frozen for 1,000 years) goes to a bank in the year 3000 to check on his account balance. He had just 93 cents in his bank account in year 2000 with an annual interest of 2.25%. The teller checks his account and informs Fry that his balance, 1,000 years later, is $4.3 billion dollars. Fry immediately faints. A clip of this unforgettable scene is below (note: I do not own this video and this YouTube account is not mine. The video may or may not be in compliance with any appropriate copyrights).
The interesting part about this scene is that the despite how ridiculous it sounds, the math is exactly correct. Starting with 93 cents and compounding 2.25% annually, we get $4,283,508,449.71 after 1000 years. The teller rounded that up to $4.3 billion.
Check for yourself with any calculator, or Microsoft Excel
Obviously, we can’t wait 1,000 years. But if we start investing at a young age, we probably have 30 or 40 years before retirement. For most people, a 35 year career is reasonable. Also, we’re not counting on having only 93 cents to invest! If we can be frugal and throw as much money as we can towards investing, even 35 years is plenty of time for compound growth to do tremendous work.
Hypothetically, let’s pretend that we found an investment which returns 10% annually. Over 35 years, let’s compare four scenarios:
Starting with $10,000 but not investing. End result: $10,000.
Starting with $10,000 and investing at 10%. End result: $281,024.
Starting with $10,000 and saving another $500 per month, but not investing. End result: $220,000.
Starting with $10,000 and saving another $500 per month, and investing at 10%. End result: $1,907,171.
So in our scenario, investing just $500 per month over a 35 year career makes you a millionaire at retirement. And the more you invest, the better. Many people who read my blog are not physicians, but I think $500 per month is doable for most people. And for my physician friends out there, if you can’t spare $500 or even $5000 per month to invest on your salary, then shame on you.
Fantastic, you say, except 10% annual growth doesn’t happen in the real world. Or does it? Over the past 35 years, the US stock market, as measured by the S&P 500, has done better. Let’s compare what actual investment into Vanguard’s simple but popular S&P 500 index fund did over the past 35 years (1986 to 2021). Note that this time period includes the infamous Black Monday (October 19, 1987, a 20.4% drop in the S&P 500 in a single day), the 2000 dot-com crash, the 2008 global financial crisis, and the COVID-related 2020 stock market crash.
Despite 4 severe market crashes in the last 35 years, the S&P 500, and by extension VFINX, still outperformed our hypothetical 10% investment, with or without ongoing contributions.
Of course, the returns of the S&P 500, and by extension, the stock market, can fluctuate wildly in the short term. But over long periods of time, the stock market has never failed to deliver returns to investors. I explore this topic in more detail in my book, but simply put, over the past 100 years or so, the S&P 500 averages about 9 to 10% annualized returns.
At this point, you’re probably asking: what is the S&P 500? The S&P 500 is a stock market index, and a very popular one at that. The companies included in the S&P 500 represent approximately 80% of the entire U.S. stock market in value. Investing in it is easier than ordering pizza. There will be articles later in this series devoted entirely to the S&P 500, market indices, and index funds. But for now, I am just trying to show the power of compound growth.
The ravages of inflation
The other side of the coin is inflation. Oxford dictionary defines inflation as a general increase in prices and fall in the purchasing value of money.
When my family immigrated to the United States in 1997, the price of a Big Mac was about $2.45. In 2021, a Big Mac is $3.99, not quite double (yet). The burger, as far as I can tell, remains the same. It doesn’t actually cost more, as hard as that is to believe. Instead, a dollar in 2021 just isn’t as valuable as a dollar was in 1997. Simply put, the purchasing power of a dollar decreases over time, and goods appear to get more and more expensive. The root causes of inflation are too complex to discuss here, and inflation has both positive and negative consequences. And in rare circumstances, inflation can be negative (also known as deflation). In healthy, modern economies, however, the rate of inflation is positive, rather than negative, and is not arbitrary, but is instead carefully controlled by central banks through monetary policy.
In the United States, the rate of inflation is measured by the Consumer Price Index (CPI-U) which is published by the Bureau of Labor Statistics. Inflation has remained fairly steady in recent decades at between 2 to 5%. The CPI first started tracking consumer prices in 1913. The historical rates of inflation for the past 100+ years from 1914 to 2020 are shown:
In 2020, the most recent year for which we have data, inflation was 1.2%. The annualized rate of inflation from 1914 to 2020 sits at 3.08%.
This means that without investing, the purchasing power of your money will decrease by 3.08% per year on average. The power of compounding is just as powerful when it goes in the opposite direction. Annualized inflation of 3.08% means $10,000 today will only be worth $3,346 in 35 years. You’ll still have $10,000, but that $10,000 will only have the same purchasing power as $3,346 does today.
As you can see, any non-investor will be in serious trouble 35 years from now. Saving is not enough. Investing is the only way to preserve capital and beat back the ravages of inflation.
Money has a time value
Why does money behave this way? In other words, if we have some money today, why is it even possible to use it to earn more money in the future? Why would anyone want to borrow our money? Why would anyone want to exchange assets for our money? Why are there opportunities to capture interest or compound growth? Why is it necessary for a dollar in 2021 to have less value than a dollar in 1997?
As it turns out, money has a time value. If you’ve ever taken any business or finance class at some point, you will probably be familiar with this concept. Simply put, a dollar today does not have the same value as a dollar tomorrow or a dollar next year. If you had the choice of getting paid $10,000 today or $10,000 in 5 years, all else being equal, you would choose $10,000 today. Even if inflation didn’t exist, $10,000 today still has more utility than $10,000 in 5 years, because you can use it right away. Therefore, the promise of a future $10,000 payout has a different value (less than $10,000) in the present. In other words, the present value of any money in the future is subject to a calculation known as a present day discount.
The time value of money is one of the fundamental principles of financial theory. It creates demand for money in the present, empowering us to invest it. It allows us to charge interest on money that we lend. It allows us to purchase valuable assets in the future at a discount today. It allows us to calculate what we should pay for such an asset. And it gives rise to the idea of opportunity cost.
Opportunity cost
Opportunity cost is the loss of potential gain from other alternatives when one action is chosen. On the surface, not doing anything with your money (such as keeping it in a savings account) seems to be safe, free, and also worry-free. It’s very comfortable.
But I hope by now that the answer to “Why invest?” is obvious. Unless you’re beating inflation with your money, you’re losing money every day. People tolerate the risks of investing because not investing is far riskier. Forget about becoming wealthy for a second. At minimum, you have to grow your money by about 3% per year just to preserve its future value. The time value of a dollar that you have today is the highest that it will ever be. Saving but not investing only gives the illusion of safety and wealth preservation. The value of all un-invested money approaches zero over time. The opportunity cost of not investing is too terrible to consider. Investing is the only way to both beat inflation and grow your wealth.
And don’t forget that the U.S. stock market, as measured by the S&P 500 index, beat our hypothetical 10% annual growth investment over the past 35 years, and investing in it is easier than ordering pizza! So the next time you have $5, $50, or $500 to spare, what will you do? Spend it at a store, put it in a bank, or invest?
In the next few articles of the Investing 101 series, we will take a look at stocks and bonds, two of the most common types of investments, starting with Part 3: What are stocks? Happy investing!
