Why does investment work?

Last Updated on 5 January 2021 by Dan

Hello! Today we look at the underlying reasoning of exactly why you should invest, and the long term benefits that can come from it.

This article is aimed at those who’ve managed to clear their debts only and are in a stable financial position as debt management should come before investment in the priority list. If you’re not quite in that position yet, this earlier article on managing your debts may be of interest.

As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter for need to be right for you specifically, and we also suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.

Our definition of investment

The Financial Wilderness here is talking about investing in the context of investments in high-grade companies and would never encourage you to invest in the more speculative end of the market like bitcoin or penny stocks.. Rule 1 is always be aware on what you’re getting yourself into.

Mention investing to the vast majority of people under 40 and the vast majority will pull a face and say it’s something for later, or there are other priorities. Those arguments may be valid, but there are two important key counter arguments to that:

Why Investing early provides long term benefit

This is based on the concept of compound interest. This is best described as a snowball effect – as you grow your money, the invested amount becomes not just what you originally put in, but you start to reap further benefits from investing the gains you’ve already made from investment.

Simply put, if I invest £100 and get a return of 8% on it I have £108. However if I leave it invested the 8% gets applied to that £108 and the pile therefore keeps growing exponentially, not just off the initial investment.

I’ve got a challenge here, in that why should I explain further the benefits when Mary Poppins does it so effectively for me! (And if I try to do so in song myself, it may be entertaining but for all the wrong reasons……)

I hate to break it to anyone looking for career advice, but real banking isn’t so fun.

It’s not quite the spirit of the film, but ol’ Mr. Dawes has it right and investing your tuppence rather than feeding the birds is the way to go (sorry birds…..!)

Let’s demonstrate just how big those benefits can be over time with some longer time periods:

We’re going to assume that you get a 8% return each year and invest £150 a month. The below is designed to show that longer time periods of investing can make a real difference.

I invest my first £150 at age 35. By the time I hit 40, the rolling effect of this is that I have £11,318. (I have deposited £9,150 over 5 years and gained £2,168 in interest).

I invest my first £150 at age 30. By the time I hit 40, the rolling effect of this is that I have £27,958. (I have deposited £18,150 over 10 years and gained £9,808 in interest).

I invest my first £150 at age 25. By the time I hit 40, the rolling effect of this is that I have £52,747. (I have deposited £27,150 over 15 years but by this point I’ve gained a whopping £25,598 in interest).

Wow! That feeds a lot of birds. That rolling effect just shows that if you can set aside a little bit early just how beneficial the effects are in the long term.

Be aware that investment is not guaranteed OR FIXED RETURNS.

These assumptions assume you stay invested and think long term. You should be aware that markets fluctuate, and in practice the 8% interest example I’ve used would not be 8% every year but ups and downs averaging out to that. (However the 8% per year average figure is based on a rough average of stock market history).

You need to give careful thought to how you invest to account for market variability and how much you can tolerate. You may also need to pay capital gains tax depending on your circumstances.

If you’re looking to work out what compound interest would do for your own money pot, Jim at the Money Builders has a compound interest calculator.

How Investment can assist other financial goals

So you’re trying to save up for a house or large purchase and know you won’t need the money for some time, you may want to consider other options than leaving it in a current account. Many people simply like to know their “pot” is there and simple but this could be squandering potential gains when we could look at low risk options.

In the (potentially) higher-yielding stock market returns can be variable. However investing in something like well-rated bond can provide a lower risk option whilst allowing flexibility of allowing your money back at set periods (for instance, you can choose to invest for 1 year). This can net you some useful extra towards a savings goal.

You can see more about bonds and what different types of investments mean in our article on investment products.

In summary – making your money work for you (and getting it started early) can really pay off. Worth considering, hmm?

The “Starting to Invest” series has several other posts. You can read about what investment products are out there here, and then how to understand your risk profile here.

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