Inflation is your money’s worst enemy.
In 1913 for the low price of 9 cents, you could buy a whole quart of milk. In 1963, for the same 9 cents you could purchase a small glass of milk. In 2013, 9 cents would buy you the equivalent of 6 tablespoons of milk. The cash in your pocket is worth less and less as time goes on.
At some point, you will likely want to purchase a home, a car, a vacation or something you cannot afford immediately. It would be stupid to toss your dream out the window, so instead you start saving. The challenge is that, over time, the purchasing power of your dollar tends to decline.
Let’s say you are saving for a downpayment of $100,000 for your dream home. You plan on saving $10,000 a year for 10 years. However, inflation may cause the price of your dream home to rise over those 10 years. Inflation has traditionally hovered around 3% over long periods of time. This means your downpayment of $100,000 will need to be around $135,000 in 10 years. Herein lies your challenge: you could either save more each year for the 10 years, wait longer to purchase your home, or invest.
Wait a second, how does investing help?
The capital markets, aka stock markets and bond markets, have rewarded long-term investors for decades. All investors should consider “long-term” as 15 years or more.
A dollar invested into US Large Cap stocks, the S&P500, in 1926 grew to $4,673 by the end of 2013. If the same investor had invested that same dollar into US Small Cap Stocks, as measured by the the CRSP 6-10 index, in 1928, it grew into $17,474 by the end of 2013. That’s a single dollar, just add zeros to the end of those numbers if you invested $100 or $1000 dollars.
Not bad for doing absolutely nothing. Of course, past performance is no guarantee of future results.
How do I make a worthwhile investment?
In order to combat inflation, your money must grow faster than inflation. Investing in stocks is one of the best ways to grow your money and combat inflation.
To use some math, the S&P500 has returned around 10% since 1928. That is roughly 7% higher than inflation. If you were able to return 10% on the savings for your downpayment, you would have around $160,000 at the end of 10 years. More than the $135,000 you will need. This is how investing can help you combat inflation, and possiblely save you time and money.
Unfortunately, investing is not that simple. You are not guaranteed a return, and the only thing you can count on is for your investment to do something you don’t expect. The largest challenge with investing is that you will have to take some risks. Risk and return are always linked. There is no such thing as a no-risk high-return scenario. When investing, you risk losing every single dollar invested. However, by not investing you are also taking a risk, the risk that inflation will force you to save more or wait longer in order to accomplish your goals. Whether you invest or not, you’ve made a decision and taken risk.
So, why invest now?
Since you are in your 20s or 30s, you have a long time to save for large purchases like retirement. By starting to invest today, you not only reduce the impact of inflation, you also increase the chance of having a positive and successful investing experience. If you recall, history has shown us that even though markets fluctuate up and down in short time periods, over long time periods they consistently rise.
Let’s say you are saving for retirement. You want to retire at age 65 with $2 Million in the bank. At age 25, you only need to save $7,148 a year (if you are getting an 8% return). At age 35, you need to save $16,347 a year with the same 8% return. Your yearly saving more than doubles if you wait 10 years. If you wait until you are 45 to start saving for retirement, you will need to save $40,467 a year at the same 8%. That’s going to hurt the kids’ college accounts.
The earlier you start investing, the less you have to save and the more likely you are to make money in your investments.