The Armchair Trader will be publishing a series of articles this week designed to take you though the why, when, what and how of investing, showing that stock markets aren’t just an arcane art reserved for highly trained professional investors, but are accessible for everyone. Today’s segment will explore whether you should save money or invest it in the financial markets
Investing should be for everyone
There has always been a common misconception amongst the general public that investing in the stock market should be left to industry professionals, with inexperienced investors lacking the necessary knowledge to successfully engage in the trading of shares. This notion could not be further from the truth. Investing in the stock market should be something everyone feels they are able to do.
Although there is always a certain level of risk associated with investing in the stock market, it can be a great place for individuals to place their long-term savings. In periods of high inflation and low interest rates, such as now, those who invest in stocks and shares are likely to yield more attractive returns than those who leave their funds in a standard savings account.
Our ‘Beginner’s Guide to Investing’ aims to build the foundations for inexperienced investors to start investing in the stock market and construct long-term portfolios based on their own unique investment objectives.
Should you save money or invest it?
For those wondering whether to save money or invest it, the choice is pretty straightforward. With interest rates currently sitting at all-time lows and intense inflationary pressures dominating the domestic economy, money kept in a savings account is steadily losing its value. This means that, although the nominal figure of your savings is not decreasing, the real value of this money diminishes each day. For example, if an individual was to place their money in a cash account earning the current UK interest rate of 0.75%, its real value would reduce by 7.25% each year because the domestic inflation rate stands at 8% per annum.
Investing in the equity market, on the other hand, has the potential to generate rates of return that exceed the rate of inflation, thus adding to your wealth both in nominal and real terms. If investing is performed smartly and safely, it is a great way to grow your wealth over the long term and build an income for the future. This gives you greater financial flexibility and provides a degree of long-term financial independence.
When should you start investing?
Over the past few months, stock markets around the world have suffered from extreme volatility. Concerns about soaring inflation, rising interest rates and the general health of the global economy following the Covid-19 crisis have resulted in decreased business confidence and recessionary fears, which in turn has led to many investors selling their stocks.
Although this implies that it is a bad time to start investing, falling markets present extremely good opportunities to acquire undervalued and under-priced assets as others despondently sell. Recent economic struggles are bound to come to an end soon and when they do, equity prices are likely to soar.
Anyone with a long-term investment outlook should strongly consider investing in the stock market as soon as is reasonably possible. The urgency to start investing immediately is due to what is known as the compounding effect. Compounding is the process in which an asset’s earnings, from either capital gains or dividends, are reinvested to generate additional earnings over time. This growth occurs because the investment will generate earnings from both its capital gain and the accumulated earnings (dividends) from preceding periods.
To illustrate how capital gain compounding works, suppose GBP10,000 is invested into Company A. The first year, the shares rise 10% so that your investment is now worth GBP11,000. Based on good performance, you hold the stock. In the second year, the shares appreciate another 10%, so that your GBP11,000 grows to GBP12,100. Rather than your shares appreciating an additional £1,000 (10%) like they did in the first year, they appreciate an additional £1,100, because the £1,000 you gained in the first year grew by 10% too.
When dividends are added into the mix, the compounding effect is even stronger. Over the long term, reinvested dividends can become increasingly powerful. The FTSE All-Share has grown by 214% over the last 25 years, but with dividends reinvested, this figure trebles to 644%.