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Why Should You Invest?

At the end of this module, you will play an interactive game, either by yourself or by competing with your friends, to evaluate your understanding of different types of investment opportunities and the consequences of not investing at all.

When considering the question of why one should invest, it's crucial to first understand the consequences of not investing. Imagine you earn $100,000 per year and spend $50,000 on daily expenses like housing, food, transportation, and medical bills, leaving you with a surplus of $50,000 each year.

Let's dive into a scenario without investing, using some simplified assumptions: For the sake of simplicity, let us ignore the tax effect in this discussion.

• Your salary increases by 5% annually.

• The cost of living rises by 3% yearly.

• You plan to retire at 50, with 20 working years ahead.

• Your expenses remain fixed, with no foreseeable changes.

• Your surplus cash of $50,000 per month remains idle.

With these assumptions, let's examine the cash balance over 20 years:

Total Cash retained after 20 years = $1.9mm

Let’s take a closer look at these figures, and you’ll quickly see why this scenario is cause for concern. Here’s what stands out:

After two decades of dedication, you’ve managed to save up $1.9mm.

Given that your expenses have remained constant, your standard of living hasn’t improved over the years. This likely means you’ve had to put off lifelong dreams like upgrading your home, buying a new car, or enjoying well-deserved vacations.

Assuming your costs continue to rise at an annual rate of 3%, your retirement savings of $1.9mm will only last about 8 years after you retire. From the 15th year on, you’ll find yourself in a precarious situation with no financial cushion to fall back on.

What’s your plan once your funds are depleted in 15 years? How will you support yourself? Is there a strategy to ensure you amass a more substantial sum after 20 years?

You might argue that these assumptions are too simplistic and don’t reflect the complexities of real life. I acknowledge that, and it’s not my intention to challenge that perspective. However, it’s important to recognize that in the scenario described, there’s no investment activity, which results in a stagnant cash growth rate.

But what if you invested that surplus cash instead? Let's say you invested it at a 10% annual return over 20 years. Here's how your cash balance would look:

Total Cash retained after 20 years = $5mm

Your wealth has grown substantially by opting to invest your surplus cash. The initial cash balance of $1.9 mm has burgeoned to $5 mm, representing an impressive increase of 2.65 times its original value. Clearly, choosing to invest has placed you in a far more advantageous position to navigate your post-retirement years.

Returning to the fundamental question of why invest, several compelling reasons emerge:

Combat Inflation: Investing allows you to effectively combat the relentless rise in living expenses, commonly referred to as inflation. By generating returns that outpace inflation, your purchasing power is preserved over time.

Wealth Generation: Investing offers the opportunity to accumulate a larger financial portfolio by the end of your targeted timeframe. While the example cited focused on retirement savings, investments can also be tailored to achieve diverse financial goals such as funding children's education, weddings, home purchases, or retirement vacations.

Enhanced Quality of Life: Investing empowers you to realize your financial aspirations and enjoy a better quality of life. Whether it's securing your dream home, traveling the world, or pursuing your passions without financial constraints, investing plays a pivotal role in transforming these aspirations into reality.

Where Should You Invest?

After understanding the importance of investing, the next crucial step is determining where to allocate your funds and what returns to expect from each investment avenue. When making investment decisions, it's essential to align your choices with your risk tolerance and return expectations.

Asset classes serve as investment vehicles characterized by their risk and return profiles. Let's explore some of the popular asset classes:

Fixed Income Instruments

Fixed-income instruments offer a safe haven for investment, with the principal amount perceived to be secure. Examples include:

• Treasury Bonds (T-Bonds)

• Municipal Bonds

• Corporate Bonds (issued by companies like Apple, Microsoft, Coca-Cola)

• Certificates of Deposit (CDs) offered by banks

As of recent data, the typical returns from fixed-income instruments vary between 2% and 4%. Treasury bonds offer returns ranging from 2% to 3%, while corporate bonds may offer yields of around 3% to 5%. Treasury bonds are considered the safest investment due to zero risk of default, while corporate bonds carry higher risks, with potential instances of default.

Equity (Stock Market)

Investing in equities involves purchasing shares of publicly traded companies listed on exchanges like the New York Stock Exchange (NYSE) and NASDAQ. Unlike fixed-income instruments, equities do not guarantee the return of invested capital. However, they offer the potential for higher returns. Historically, US equities have delivered compound annual growth rates (CAGR) exceeding 7% to 10% over the long term.

Investing in well-established companies with strong fundamentals can yield even higher returns, with some investments generating CAGR exceeding 15% in the long term. Successful equity investing requires careful analysis, patience, and a long-term perspective.

Real Estate

Real estate investment entails buying and selling residential, commercial, or industrial properties. Examples include:

• Single-family homes

• Apartment buildings

• Office spaces

• Retail properties

Income from real estate investments comprises rental income and capital appreciation. Rental yields typically range between 4% and 7%, depending on the location and type of property. Capital appreciation can vary significantly based on market conditions and economic factors.

Real estate transactions involve complex legal processes, and the initial capital outlay is usually substantial. However, real estate investments offer potential tax benefits and portfolio diversification.

Commodities (Precious Metals)

Investing in commodities like gold and silver has been a popular choice for investors seeking stability and long-term growth. Examples include:

Gold ETFs (Exchange-Traded Funds)

Silver bullion

Gold mining stocks (companies like Newmont Corporation, Barrick Gold Corporation)

Gold and silver have historically appreciated, offering compound annual growth rates (CAGR) averaging between 5% and 10% over the past few decades.

While contemplating investment choices, it's essential to diversify across multiple asset classes to mitigate risks and optimize returns. Asset allocation plays a crucial role in balancing risk and return based on individual circumstances. For example, a young investor may allocate a higher percentage to equities, while a retiree may prefer a more conservative approach with a larger allocation to fixed-income securities.

Diversifying investments among equities, real estate, fixed-income instruments, and commodities can enhance portfolio resilience and optimize long-term returns. This strategy ensures a balanced approach to wealth accumulation and financial security across various market conditions.

Before embarking on your investment journey, it's crucial to consider the following factors:

Risk and Return Relationship: Risk and return are inherently linked in investing. Generally, higher risk investments offer the potential for higher returns, while lower risk investments tend to yield lower returns. Understanding your risk tolerance is essential in determining your investment strategy.

Fixed Income Investments: Fixed income investments, such as Treasury bonds, municipal bonds, and corporate bonds, are attractive options for investors seeking to protect their principal amount. These investments are perceived as less risky compared to equities but may still carry inflation risk. For example, if a fixed deposit offers a 9% return while the inflation rate is 10%, the investor experiences a net loss of 1% in purchasing power annually.

Equity (Stock) Investments: Equities offer the BEST opportunity to outpace inflation over the long term. Historically, US equities have delivered returns averaging between 14% and 15% annually. However, investing in stocks comes with inherent risks, including market volatility and the potential for capital loss.

Real Estate Investments: Real estate investment involves substantial capital outlay and may not be feasible for investors with smaller amounts to invest. While real estate can provide rental income and potential capital appreciation, it also presents liquidity challenges. Unlike stocks and bonds, real estate cannot be easily bought or sold, making it less liquid.

Precious Metals (Gold and Silver): Precious metals like gold and silver are often considered safe-haven assets during times of economic uncertainty. However, the historical returns on these investments have not been consistently high. While gold and silver may offer stability in a diversified portfolio, they may not provide significant capital growth over the long term.

Understanding the characteristics and risks associated with each investment option is crucial for making informed decisions. By carefully evaluating your investment goals, risk tolerance, and time horizon, you can develop a diversified portfolio that aligns with your financial objectives and enhances your long-term wealth accumulation strategies.

Now, let's play a game. You have 20 years to grow your wealth. How will you invest it across different assets to maximize your return? Wait for Year 1 of the 20-year game to begin

To fully enjoy this game:

Leave your money as cash throughout the 20-year simulation in your first playthrough. (This teaches you the consequences of not investing.)

Invest only in savings accounts and CDs in your second round to get a glimpse of how limited returns can impact your overall net worth. (This shows you how little returns from these low-risk options affect your wealth over time.)

Invest in index funds and stocks in your third round to understand how volatile the stock market can be and how it can make or break you. (This lets you experience the ups and downs of the market and how it can significantly impact your wealth, both positively and negatively.)