When it comes to managing your finances, investing your money might seem like a daunting task, especially if you’re new to the world of finance. However, understanding why it is important to invest your money is a crucial step toward achieving your financial goals and securing your future. In this article, we’ll break down the significance of investing in a way that is easy to understand, helping you embark on your journey toward financial growth and stability.
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Your Money Loses Value Over Time
Inflation is the gradual increase in the general price level of goods and services in an economy over time. When inflation occurs, the same amount of money you have today will have reduced purchasing power in the future. In other words, your money’s value decreases over time due to the rising cost of living. Below is a simple example to illustrate how inflation works and how it diminishes the value of money.
EXAMPLE
Imagine you have $100 today, and the inflation rate is 2% per year. This means that, on average, the prices of goods and services increase by 2% each year. If you don’t do anything with that $100 and simply keep it in a safe place, its nominal value remains $100. However, because of inflation, the actual purchasing power of that $100 decreases over time.
After one year of 2% inflation, the cost of goods and services has risen. So, the same items that cost $100 a year ago now costs $102 due to inflation. Since you didn’t invest your money, its purchasing power has effectively decreased to $98 (original $100 – $2 due to inflation). In essence, your money can buy less than it could a year ago.
If you continue this pattern over several years, the impact of inflation compounds, leading to a significant reduction in the real value of your money. This is why merely keeping your money in a jar or a low-interest savings account may not be an effective long-term strategy.
Investing your money offers the potential to counteract the effects of inflation. When you invest, your money has the opportunity to grow at a rate that might outpace or at least keep up with inflation. This means your investments could increase in value over time, helping you preserve your purchasing power and potentially allowing your money to have the same or even greater value in the future.
In essence, by investing, you’re attempting to ensure that your money maintains its ability to buy goods and services despite the ongoing rise in prices caused by inflation.
You Create a Snowball Effect
Imagine you’re rolling a snowball down a hill. As it gathers more snow, it grows larger and gains momentum. Similarly, investing works like a snowball effect. The earlier you start, the more time your investments have to accumulate and expand. Consider investing a small amount regularly as that snowball, with time, becomes bigger and more powerful. The returns on your initial investment combine with the principal amount, creating a compounding effect (snowball effect). This compounding is like rolling the snowball downhill; it gets bigger and faster as it goes, propelling your wealth growth.
EXAMPLE
Imagine you’re a beginner investor and you decide to invest $1,000 in a mutual fund. The mutual fund historically earns an average annual return of 8%. Here’s how the snowball effect plays out over a span of 10 years:
Year 1:
- Initial Investment: $1,000
- Returns (8%): $80
- Total: $1,080
Year 2:
- Initial Investment: $1,080 (initial investment + returns from Year 1)
- Returns (8%): $86.40
- Total: $1,166.40
Year 3:
- Initial Investment: $1,166.40 (initial investment + returns from Year 1 and Year 2)
- Returns (8%): $93.31
- Total: $1,259.71
And so on…
Year 10:
- Initial Investment: $1,979.51 (initial investment + returns from all previous years)
- Returns (8%): $158.36
- Total: $2,137.87
As you can see, the initial investment grows over time due to the compounding effect of earning returns on both the initial investment and the returns from previous years. The snowball effect becomes more evident as the years go by. In this example, the investment more than doubled in value over a span of 10 years, even though the annual returns remained consistent.
The longer you leave your money invested and compounding, the more pronounced the snowball effect becomes. If you were to extend this example to, let’s say, 30 years, the growth would be much more substantial. This illustrates the power of compounding and how it can lead to significant wealth accumulation over time, one of the best reasons why it is important to invest your money. If you’d like to try out different investment situations to see the snowball effect in action, I can highly recommend the investment calculator.
Though the snowball effect is great, remember that real-world investments can experience fluctuations in returns, and the example uses a simplified scenario. It’s thus important to consider diversification, risk tolerance, and market conditions when making investment decisions.
You Diversify Your Income
Investing can provide you with a way to diversify your income. Diversifying your income means creating multiple sources of revenue to reduce your reliance on a single income stream. This strategy enhances your financial security and can better prepare you for unexpected events or changes in your primary income source.
Now, how does investing help you diversify your income? When you invest your money in various assets like stocks, bonds, real estate, or mutual funds, you’re aiming to generate returns beyond your regular paycheck. These returns can come in the form of interest, dividends, or capital appreciation.
Some of these investments generate passive income, meaning income that requires minimal ongoing effort or time. This is different from your salary, which requires you to actively work to earn it.
Investments can also act as financial safety nets during unexpected situations, such as job loss or economic downturns. Having investment income can help bridge the gap if your primary income source is temporarily disrupted.
EXAMPLE
Let’s say you invest in stocks. As the value of the stocks you own increases over time, you earn capital gains. Additionally, some of your stocks pay dividends, which are a portion of the company’s profits distributed to shareholders. These investment returns become an additional (passive) income stream for you.
If you were to lose your job, having these additional income streams helps you keep you on your feet, as these income streams may cover essential expenses while you search for a new job. This reduces financial stress during the transition.
Diversifying your income through investing thus helps you become less reliant on a single paycheck and provides you with greater financial flexibility and resilience. A good reason why it is important to invest your money.
You Achieve Financial Security
Investing can play a significant role in helping you achieve financial security, which is another great reason why it is important to invest your money. Financial security refers to a state where you have enough resources to cover your essential needs, maintain your desired lifestyle, and handle unexpected expenses without feeling any financial stress. But how does investing contribute to achieving financial security?
Investing allows your money to grow over time through compounding. As your investments generate returns, these returns can be reinvested, leading to exponential growth. Over the years, your investment portfolio can become a substantial asset that contributes to your overall net worth and (passive) income, allowing you to live life without financial worries. All in all, investing gives you a great way to accumulate wealth.
You can also invest for retirement, which is one of the most common ways to achieve financial security. Retirement accounts like 401(k)s and IRAs provide a tax-advantaged way to save and invest for your golden years. By consistently contributing to these accounts and investing wisely, you’re creating a source of income for when you’re no longer working.
Investments can also act as an emergency fund. While it’s important to maintain a separate emergency savings fund, having investments that you can liquidate in case of unexpected expenses provides an additional layer of financial security. It can give you peace of mind, knowing that whatever happens, you’ll always be able to pay for unexpected expenses.
So, Why Is It Important To Invest Your Money?
As this article shows, there are a lot of good reasons to invest. It prevents your money losing value because of inflation, you create a profitable snowball effect, your income will be more diversified, and you’re getting closer to financial security.
Yet, it’s also important to approach investing with a well-thought-out plan that aligns with your goals, risk tolerance, and time horizon. While investing offers potential benefits, it also involves risks, and markets can be unpredictable. Seeking guidance from financial professionals and staying informed about your investments can help you navigate the journey toward financial security. If you’d like to read more, we also have a guide on how to improve your financial literacy.
