Sounds like a very basic question – why invest your money after all?
- Inflation And How it Impacts Your Money
- How Can I Grow My Money?
- If There is No Guarantee, Why Should I Invest?
- What Happens If I Do Not Invest My Money?
- Tips to Invest Money
Let’s take the case of onion.
In Jan 2017, the price of Onion was Rs 14.84 per KG. By Jan 2018, it shot up to Rs 42.69. In Jan 2019, the prices stabilized to Rs 18.03/KG.
The price of onions went up. It decreased in Jan 2019, but it is still more expensive compared to 2017.
What about Petrol?
Take a look at the chart below to see how Petrol prices have gone up.
In general, the price of all items tend to move up. This phenomenon is called inflation.
Inflation And How it Impacts Your Money
Inflation is the single biggest reason why you should save as much money as possible.
If you have Rs 100 today and inflation this year is 10%, the Rs 100 note you hold today will be worth only Rs 90, next year. 10% of Rs 100 (Rs 10) value got eroded in a year due to inflation.
If inflation is 10%, that means on an average, the cost of items would go up by 10%. What used to cost Rs 100, would now cost Rs 110.
So the value of Rs 100 you have is reduced by 10%. The Rs 100, while on paper is worth Rs 100, can only effectively buy items worth Rs 90 last year.
The concept is called time-value of money.
This is how inflation works. The money you have today is worthless in the future due to inflation. In other words, the money you have now is more valuable than the same amount in the future.
Note: The opposite of inflation is deflation. While you might think that lower prices are good, it’s generally not good for the growth of the economy. We’ll talk about deflation in a later article.
How Can We Counter Inflation?
If the Rs 100 note that I have today, can only buy items worth Rs 90 in the future (in today’s value), the way to protect my buying power is if Rs 100 becomes Rs 110 or more.
Next year if I have Rs 110, I can buy items that would have cost Rs 100 this year, assuming a 10% inflation.
You see – the money needs to grow. It needs to grow equal to inflation just to hold the purchasing power.
Is it Enough to Retain The Purchasing Power?
Inflation at 10% and money growth at 10% means that the money value is retained. But there is real growth.
However, if inflation is 10% and money growth is 20%, not only did I retain the value of money, I actually increased my purchasing power.
Rs 100 had grown to Rs 120. The purchasing power I have next year is equal to the purchasing power of Rs 110 this year.
The key here is – money needs to keep growing year-on-year.
How Can I Grow My Money?
When you invest your money in any of the asset classes, you are putting aside money with the expectation that it will be worth a lot more in the future.
Depending on the asset class and product you invest in, the growth might be guaranteed. E.g. a Bank FD might guarantee you a 5% return.
In some cases, investments do not guarantee any returns. E.g. investing in a stock or an equity mutual fund. You will need to rely on historical return data to assess whether investing in a particular asset class or product suits you.
The Magic of Compounding
When you invest and grow your money, the magic of compounding can sweeten the deal.
The return/interest on your investment will generate even more money.
Here is an illustration.
Imagine you invest Rs 1 lakh every year for 10 years (2021 to 2030). By the end of 2015 (30 years from now), you can potentially have:
- Rs 36.79 lakhs if your annual return is 5%
- Rs 1.29 Crores if your annual return is 10%
- Rs 4.39 Crores if your annual return is Rs 15%
The amount of money Rs 10 lakhs can grow into, given enough time is mind-blowing.
Notice the divergence for the 3 returns. Initially, the divergence is small. As time goes by, the divergence becomes extremely large.
An FD could potentially grow your Rs 10 lakhs into Rs 30 lakhs in 30 years (3X). However, a solid equity portfolio can grow your Rs 10 lakh into 4 crore + (40X) in 30 years.
If There is No Guarantee, Why Should I Invest?
Because, you cannot afford not to.
Think about this. A Bank FD gives you pre-tax return of around 5% in 2021. After-tax, it might be around 4%.
The official inflation rate in India for 2020 is about 5%. The actual inflation for a lot of items like education etc. might have been in double figures.
Essentially, you are losing money by investing in a guaranteed product like a bank FD. Sure, you do not lose money on paper.
But a 4% return and 5% inflation guarantees that your money loses 1% value every year. You are not growing your wealth – you are destroying it!
Investment in non-guaranteed products often might give you higher returns. Take equity mutual funds. The average return for an equity mutual fund is 10% or more over a 5 year period.
With 10% returns on average and 5% inflation, you are effectively growing your wealth by 5%.
The Risk-Reward Conundrum
As a rule of thumb, the riskier an investment, the higher the reward.
Guaranteed products have extremely low risk – hence they fetch you low returns. Stocks, bonds etc. are comparatively riskier – hence they fetch you higher returns.
The key to investing your money is to understand the risk-rewards of your investments.
You need to ensure that your investment portfolio has the right amount of risk – too much risk and you can end up losing your money. Too low-risk and you might not have enough money to survive
What Happens If I Do Not Invest My Money?
If you do not invest your money, you could end up with less money for your goals. You could also reach a point where you run out of money to meet your needs. Imagine if this happens after you retire.
Investing to grow your wealth also gives you additional flexibility like retiring early, foreign trips, etc.
Tips to Invest Money
Tip: Need an investment plan? Refer to this guide.
Whenever young people speak with me, they ask for tips.
You don’t need any secret tips; just use common sense. Here are some simple guidelines to follow:
- Invest your money. Save as much as you can – as early as you can.
- Sounds preachy – but live within your means. It’s easy to buy a phone you cannot afford on EMI. Debt traps drastically impact your savings
- Take investment risks. Do it in moderation
- Do not fall for get-rich-quick schemes. If something sounds too good to be true, it’s probably not genuine
- Keep realistic return expectations
- Real Estate ~ 4% annual return
- Gold ~ 5% annual return
- Bonds/Guaranteed Products ~ 4% annual return
- Equity ~10% annual return
- Do not mix investment and insurance. Insurance is an expense. Do not consider it as an investment. Buy term insurance – not endowment or money back policies
- Sometimes, investing in yourself is the best return on investment. Take care of yourself
- Compounding does work like magic. Give it enough time, your money will grow dramatically. Your interest/returns will generate even more returns
Over To You
Why do you invest money? Let me know via the comments below.