At the fundamental level, people become investors and buy shares because they want a financial instrument that has a historical track record of outpacing inflation and the available ‘risk-free’ interest rate (which government bonds don’t offer).
Risk-free is in quotes because nothing is truly risk free — you are always risking something — but the standard risk-free rate can be boiled down and is generally accepted as United States Treasury Bonds. Since these bonds are backed by the full faith of the US federal government they are the global benchmark for what is considered to be a risk-free rate.
This impacts investors all over the world as many countries invest in US treasuries because of the perceived stability. So it is not just a US investment, but a global one. China, for instance, is the largest holder of US treasuries in the world.
The US Treasury’s aim with its bonds is not to beat inflation, so if you choose this ‘risk-free’ money you risk losing out to the inflation rate, which is historically around 3 per cent per year. This all means that you need to find an investment that is growing faster than that historical inflation rate.
Beating inflation is your primary case for investing, but that doesn’t answer the question of why you should buy a specific share, Exchange Traded Fund or managed fund. At a more personal level, most people invest to secure a financial nest egg so they can either retire or, at the very least, live life on their own terms (LOOT) — that is, be able to do side gigs, work part-time or not work at all.
Let’s look at why you need to start investing early and often.
The magic of compound investing
Albert Einstein called compound interest the eighth wonder of the world saying, ‘He who understands it, earns it; he who doesn’t, pays it’.
While some people question whether the quote was in fact from Einstein, the power of compound interest is unquestionable. And if the man who came up with E=Mc2 is impressed by compounding interest, I think we should be too.
Let me pose to you a scenario, dear reader: In 30 days you can have one of the two options below. Which do you choose?
1. A lump sum of $1 million after 30 days or …
2. A magical penny given to you now; its amount will double every day for the coming 30 days — that is, it will become $0.02 tomorrow, $0.04 the day after tomorrow, $0.08 two days after tomorrow, and so on …
Which did you choose? One million dollars is a lot of coin and many people would go for the $1 million after 30 days option, but that would be the wrong choice if you were trying to maximise your return. Because after 30 days that magical daily compounding/ doubling penny would have become $10.7 million dollars!
The power of compounding returns
This is the power of compounding returns: your principal would accumulate with interest reinvested during the investment period, yielding more returns. The longer the investment period, the more you will benefit from compounding.
The deal with compounding, however, is that it takes time —more than 30 days. So the earlier you get your investments compounding, the better it will be for you in the long run. Let’s look at another example to see what Einstein was talking about.
Craig is a bricklayer. Bricklaying is hard work. Craig saw how hard bricklaying was on his dad once he got into his 50s and decided he didn’t want the aches and pains that his father has. So he started investing in low-cost index funds very early in his career. When he started investing, the balance of his account was mainly from his $500-a-month contributions.
After 10 years, his total contributions had amounted to $60,000 but his portfolio was worth over $135,000 — more than twice as much as he had contributed! At this point Craig was able to see the compounding really kick in! Another 30 years passed — it was now 40 years since his first investment contribution as an 18-year-old bricklayer. His total account was now worth 13 times his contributions.
After 40 years he had invested $240,000, but his retirement account was worth over $3,184,000 (assumed approximate return of 6.5 per cent and inflation of 3 per cent, not including fees or taxes).
Do you want to retire with a $1 million portfolio?
Time is on your side when you are young and against you as you get older. Here’s how to invest if you want to retire at 60 with a $1 million portfolio.
Let’s assume you want to retire at 60 with a 10-per-cent annual return.
• From the age of 20, you should invest $178 a month.
• From the age of 30, you should invest $477 a month.
• From the age of 40, you should invest $1,370 a month.
• From the age of 50, you should invest $4,900 a month.
The power of compound investing should motivate you to get started as soon as possible. Looking at these numbers strikes fear in me to get a time machine, go back to 2001 and buy as many Amazon NASDAQ:AMZN shares as humanly possible. But since I can’t figure out the quantum realm like they did on Ant-Man, I think the next best thing is to have a broad understanding of share markets and make wise investment decisions with the time I have left.
For those of you who are not quite ready to invest — perhaps you might be retraining, down to one income with a young family, or studying to join the workforce for the first time — stay focused on building the best income you can. But once you have your hands on that sweet, sweet income, I encourage you to invest as soon as you can.
This is an edited extract from The Quick-Start Guide to Investing: Learn How to Invest Simpler, Smarter and Sooner, by Glen James and Nick Bradley (published by Wiley, 2024).
About the authors
Glen James is a former financial adviser, the bestselling author of Sort Your Money Out and creator of the money money money (formerly my millennial money) and Retire Right podcasts and platforms.
Nick Bradley is a lifelong investor, self-made millionaire and the host of the this is investing podcast.
