Everybody wants to be financially secure. Financial security allows you to enjoy a comfortable standard of living or a secure retirement. Or you could achieve something more specific, such as paying for your children’s education, buying your own home or going on that special holiday.
For some, financial security comes in the form of a wealthy inheritance, a successful business or a highly-paid job. However, if you are like most people, financial security can only come through carefully saving your money and investing it wisely.
What is investing?
Savings and investing are terms that some people mistakenly use as the same thing. In principle, they are very similar but there is an important difference. One way to look at it is that Savings is the part of your income that you set aside to spend at a future date. In effect, you are giving up some spending today for more spending in the future. It is usually put into a safe place, such as a savings account or term deposits which you can easily access when you need it.
Investing, on the other hand, refers to the part of your savings that you use to buy assets that earn money for you. These assets are commonly called “investments” and may include things like real estate property, shares (stocks) in a company, bonds and managed funds such as a unit trust.
Making your Money Work Harder for You
When you invest, you put your money to work with the hope that over time, it will generate an income and grow. In simple terms, investment is all about making your money work smarter for you and making your money earn more money for you. This can happen in two ways:
1. An investment may generate income for you. For example, you may receive dividends on your shares, coupon interest income from bonds or rental income from the property that you lease/rent out.
2. An investment may grow in value over time, allowing you to make a profit when you sell. This is often referred to as a “capital gain”. For example, if you may purchase an asset at a certain price and after a number of years you sell at a higher price, then the profit that you make is called “capital gains”.
Overall, the income and capital gains you receive from your investment can be much higher than the interest from bank deposits, which means you accumulate wealth faster. Of course, the faster you accumulate wealth, the sooner you get to achieve your financial goals.
Another important reason why investing is important is to protect your money from the effects of inflation. Inflation is the increase in prices over time and means that the purchasing power of your money diminishes. For example $5,000 today will be worth $2,800 in 20 years assuming that the inflation is constant at 3 percent. This is why it is important that the value of your savings and investment rises at least at the current rate of inflation.
The Amazing Power of Compounding
The key to accumulating wealth lies in the concept of “compounding”. The compounding principle can help your money grow faster over time. This happens when you reinvest income earned from your initial investment rather than spending it. This reinvested income will earn extra income which you will reinvest as well. If this cycle is allowed to continue, it eventually has a “snowball” effect. This is because with each cycle, your total investment grows larger and therefore earns even more income in the next cycle.
To illustrate this concept, let us use an example:
Say you have $2,000 available, which you invest immediately. Thereafter, you invest an additional $100 every fortnight. Any interest income you receive is also invested. Now assume that you are able to get 8 percent interest on your investment per year. How fast does your money grow?
|1. After 5 years, you would have accumulated $18,936. You would have $44,187 after 10 years and $137,960 after 20 years. If you waited patiently for another 10 years, you would have accumulated $346,401.2. However, if you had invested $200 each fortnight instead of $100, you would accumulate a massive $670,836 after 30 years!The accompanying graph illustrates these figures and clearly shows the acceleration in growth. It is no wonder that Albert Einstein once referred to compounding as the most powerful principle he had ever witnessed!Note that in addition to the effects of compounding, you may also benefit from capital gains on your investment.|
Harnessing the Power of Compounding
As the example suggests, the secret to harnessing the power of compounding can be summarised as follows:
1. Invest early – With each day you wait and do nothing, you lose the opportunity to compound your wealth. Importantly, the lost opportunity accelerates over time.
2. Invest a reasonable amount – As the example showed, increasing the amounts that you invest can make a very large difference over a long period of time.
3. Reinvest income – Each time you reinvest income earned from your investment, you increase your total investment which, at a given interest rate, earns even more income the next time around.
4. Invest for a long period of time – Remember that the effect of compounding speeds up over time, so be patient.
5. Invest at a good interest rate – The higher the interest rate (also referred to as “rate of return”) the more income you make, which can also be invested. However, bear in mind that, as a general rule, investments with high returns tend to be more risky.
Therefore, the appropriate return for you will also depend on how much risk you are prepared to take.
Be Aware of the Risks
Bear in mind that different investments have different risks, and be aware that there is no such thing as a “risk free” investment. Be sure to understand the risks of the investments and that you understand some of the fundamentals of the business that you are investing in. Take your time and think about it before you buy and seek advice from a licensed investment adviser if you are unsure about your investment options.
How to Determine Your Risk Profile
• What is your current life stage?
• Is your goal short-term, medium-term or long-term?
• What is your attitude towards money and risk?
• Are you willing to accept short-term movements in the value of your investments?
• Are you prepared to accept higher risks for greater returns?