Every dollar that you earn must be used in one of two ways:
- Spent on goods or services today
- Saved for use at a later date
Your lifestyle and location play an important role in the decision. If you live somewhere that is comparatively expensive, you will be forced to allocate more income to necessary expenses, including housing, food, insurance, and taxes. If you live somewhere with a lower cost of living, these fixed expenses will be less.
If you are highly paid, you have the ability to save a larger percentage of your income than someone who is paid less (all else equal). But the same framework still applies – you must decide how much to consume and how much to save.
If you choose to spend all of your income, there isn’t a lot of applicable financial advice. You will be forced to continue working indefinitely because you will be unable to support your lifestyle without a consistent paycheck.
If you are able to spend less than you earn, you can use those financial savings to begin investing.
What is Investing?
Saving is the process of spending less than you earn, creating a pool of financial resources.
Investing is the process of committing your savings to a goal, with the expectation of obtaining a future benefit that outweighs the cost.
To illustrate, consider a few investment examples:
Home ownership is often viewed as an investment. Can you guess why?
There is an underlying assumption that the long-term value of a home (economic and emotional) outweighs the total cost (mortgage, insurance, taxes, repairs, etc.).
If that assumption is not true, there is no reason to purchase a home.
Your human capital is the economic value of your knowledge and skills, or in academic speak, the estimated present value of your lifetime earnings.
Human capital can be developed through an educational program that teaches you an employable set of skills. In exchange for your investment in education, you gain knowledge/skills that can be used to earn additional income in the future.
When making the investment, you must expect the future payoff (employment opportunities) to outweigh the cost (time, money, energy, and effort). Otherwise, you shouldn’t waste your time.
Maybe you aren’t interested in obtaining a new skillset or buying a home. Maybe your goal is to accumulate significant financial resources so that you can travel the world, change careers, or live more freely.
Creating financial wealth involves the same cost-benefit analysis. You can choose to restrict your spending today (deferring consumption is the cost) and invest your savings in financial assets that are expected to provide more wealth in the future (the benefit).
If the expected future benefit is large, you will be more willing to defer consumption (save) today. If the expected future benefit is small, you will be less willing to save today.
Why Should You Invest?
Investing in financial assets will allow you to grow your financial resources over time. There are two components to growth that should be considered:
In economics, inflation is a sustained increase in the general price of goods and services over a period of time, resulting in a reduction in the purchasing power of any currency.
In other words, the price of goods and services continues increasing, making each of your dollars less valuable over time.
If your groceries cost an average of $100 this month, and inflation is 3% over the next year (historically, inflation has averaged roughly 3% each year), the same groceries will cost about $103 one year from now.
If you save the necessary $100 today and put that money in a savings account, you won’t earn enough interest to keep pace with inflation. As a result, you won’t be able to afford the $103 grocery bill next year.
If instead, you invest the $100 in a bond that is offering a 4% return on your money, you will have $104 available next year. Even though the groceries will cost $103 after inflation, your purchasing power has increased, allowing you to purchase an extra $1 in groceries.
Investing provides a way to maintain or increase the purchasing power of your savings.
In addition to maintaining purchasing power, investing allows you to create additional wealth through the power of compounding.
Over time, you expect a financial gain in exchange for your investment. If you reinvest your earnings, the growth can be exponential. For example, consider the following graph:
This graph assumes a 7% annual rate of return. Even though Susan invests $50,000 and Bill invests $150,000 over the entire time horizon, Susan accumulates more wealth.
Because she started investing at age 25, Susan had 10 additional years of compounding. Even though Bill invests more money overall, he lost the first decade of investment growth.
Perhaps even more importantly, Chris accumulates twice as much money as both Susan and Bill by continuing to invest over a longer period of time.
How Much Should You Save and Invest?
Suppose you embrace a simple lifestyle in an effort to begin saving more money (your income exceeds your expenses). The next step is figuring out how much to save, and how to invest your savings.
The optimal amount to save and invest will depend on your personal preferences, including:
- Goals: All investing decisions begin with your goals. Saving and investing are the means to achieving each of your specific financial goals. If your goal is to retire early and travel, you need to save and invest a significant amount of your current income to create a portfolio can that support your future lifestyle (so that you don’t have to work).
- Risk Profile: Once you have a specific goal in mind, you must decide how to invest your savings to achieve that goal. There are a wide variety of investment options available to choose from, and each has a different level of risk involved. As a general rule, risk and reward are inseparable when investing. If you want the possibility of a large future reward, you must accept more risk (typically risk is defined as the potential for loss).
- Expectations: Your investment expectations play a massive role in your decision to save and invest. You will be much more willing to invest if you expect a large future benefit. For example, the stock market has provided investors an average return of roughly 10% each year over the past century. However, many experts are predicting lower future returns in our current economic environment. If stocks provide a lower return, perhaps 5-6% each year moving forward, there is less incentive to save and invest.
How to Start Investing
Determine your financial goals, and use those goals to guide your investment decisions.
You can construct your investment portfolio using a wide array of available investments, but most investors stick to traditional asset classes like stocks and bonds. More obscure asset classes are sometimes difficult to evaluate, and often carry higher fees and/or excessive risk.
Available investments include:
- Stocks: Historically, stocks (also called equities) have offered the greatest risk and return of all asset classes. If you are brand new to investing, you can hire a professional robo-advisor to invest your savings for just 0.25% annually. Or, you can purchase stocks for free using M1 Finance.
- Bonds: Bonds have historically provided lower returns than stocks, with less volatility (risk). Bonds represent debt. In exchange for your investment capital, companies will pay you interest for a specified period of time, and then return your capital at some point in the future.
- Real Estate: Real estate has provided excellent investment returns in the past. You can invest in real estate through Real Estate Investment Trusts (REITs) as well as physical real estate.
- Collectibles: Collectibles like art, coins, stamps, and wine can be difficult to value because demand is limited.
- Commodities: This category includes precious metals like gold and silver, agricultural products, oil and gas, etc.
- Cash Equivalents: This includes cash and cash equivalents, including certificates of deposit, savings accounts, and money market accounts. These investments are often insured by the Federal Deposit Insurance Corporation (FDIC), making them extremely safe. However, cash equivalents offer a low return on your investment.