Why does investment work?

Last Updated on 5 July 2021 by Dan

Hello! Today we look at the underlying reasoning of exactly why investing works and has a proven track recent, and the long term benefits that can come from investment.

Please note – this article is aimed at those who’ve managed to clear any significant debts and are in a stable financial position as (usually) 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.

What does investment mean?

The world investment is thrown around a lot and used to mean very different things, so I thought it worth clarifying the site’s philosophy.

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 of investing at The Financial Wilderness is always to be aware and understand what you’re investing in.

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 too, but our counter-argument today is that investing done early and done well reaps significant long term benefits.

A picture of a money growing demonstrating why investment works

Why is investing early important?

The benefits of investing early are 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 also re-investing the proceeds of what you’ve made through investing – this it keeps growing and growing. It’s sometimes referred to as money-on-money.

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…….

Do you remember the film Mary Poppins? There’s a song called Fidelity Fiduciary bank about the benefits of interest – it’s actually perfect:

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…..!)

How much could a stock market investment gain over time?

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.

Now an initial challenge is if that is realistic – the number is based on the average yearly return of the S&P 500 (the main stock market index in the US of the 500 largest companies) which averages out a return of 8.86% a year. (Note – the fact it averages out is important as there are years of greater gains and years of greater losses within that).

There’s also been a consistent upward trend in all major stockmarkets since they started, meaning investment over the long term pays off.

Working that example though:

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.

Scrabble tiles spelling out why investment works

Is investment in the stock market guaranteed?

The quick answer is no, any investment in the stock market is subject to price movements both up and down, but we can help choose how much that happens with our investment strategy.

These assumptions assume you stay invested and think long term. You should be aware that markets fluctuate, and I’ll state again that the 8% interest example I’ve used would not be 8% every year but ups and downs averaging out to that.

One of the challenges to investing well is understanding how much volatility you can tolerate – you can reduce or increase it depending what you invest in – shifting out of equity into bonds for example reduces that volatility at a trade off to return (we discuss equity vs. bonds here).

Working out what investments are right for you where a financial advisor can really help, and we also have a guide to understanding your own investment risk profile on this website as an initial guide.

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

Why inflation makes investment important

One other aspect that means we should be doing something to make our money work for us is the constant threat of inflation.

Inflation in a nutshell is a general increases in prices across the economy. If the price of food is increasing by 2%, and our money is in a bank account earning 0.4% interest then the value of our held money is actually decreasing on a relative basis.

Now don’t get me wrong – you always need to keep some cash back for an emergency fund – but if we find ourselves with quite a lot, it doesn’t make sense to let it constantly erode.

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, and if you have a short term cash need you might want to avoid the volality.

However investing in something like well-rated bonds 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.

A summary of why Investment works

There are four core things I’d like you to take away from this article:

  1. Stock market returns have been consistently positive over time, but may be subject to short term volatility.
  2. By staying invested long term, the effect of the volatility can be smoothed out.
  3. Compound interest means the benefits of investment multiply over time.
  4. Money gets eroded if we don’t put it to work in the form of inflation.

Any questions?

The world of investing can be a confusing place to start off so if you’re just getting going and have any questions for us, please do let us know in the comments below – we’d love to hear from you!

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

And that’s it!

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