Investing 101: How to Determine If It’s the Best Use of Your Money

Investing is a long-term commitment, and results aren’t always instant…nor should they. It takes time before compound interest starts to work in your favour, but when it begins to, your wealth accumulation will be on autopilot.

But is investing even for me? And why should I consider investing if it’s a long-term commitment?

Is Investing for Me?

Investing is not just for the professionals; it is for everyone. If you’re on the fence about starting your investing journey, or just genuinely curious about investing, here are five questions that may help you deduce if it is for you.

• Do you need the money now? – generating wealth with investing takes time. If you have debts to pay off (especially high-interest ones), you should prioritise them over investing.
• Do you have financial goals? – retirement savings goals or financial freedom/independence goals
• Do you want to beat inflation? – increase the purchasing power of your money by investing in high-return assets
• Do you want to build generational wealth? – build and pass on wealth to your future family members
• Are you patient? – investing in the stock market is not a get-rich-quick scheme

These are some general questions, but you can always ask additional ones like “What is my risk tolerance?”, “Do I understand any companies well enough to invest?” and “Do I want to invest on my own?”.

Why You Should Consider Investing

If you answered NO to the first question and YES to the following four, investing may be for you. For those who think investing is right for them, here are five reasons you should consider starting your investing journey.

Achieve Your Financial Goals

Investing can help you achieve your financial goals, whether they are buying a new home, taking care of your current and future family or saving for retirement. After all, investing is putting the money you’ve worked for to work for you. 

Investment securities like stocks and exchange-traded funds (ETFs) have higher rates of return than the returns of traditional savings accounts. Investing in these high-return assets can help you buy that home and achieve financial freedom faster than you could if you relied on the returns from your savings account.

High-return assets also protect the value of your money from inflation.

Beat Inflation While Growing Your Money

Inflation is a sustained increase in the general price levels for goods and services and is measured as an annual percentage increase reported in the Consumer Price Index (CPI). 

UK inflation has hovered around 2% since 1993, so goods and services are, on average, 2% more expensive each year. When goods and services become more expensive, how much of them you can buy lessens – your money has lost value, or your purchasing power has decreased.

Investing in the stock market is a great way to beat inflation while growing your money since stock and ETF returns have historically outpaced the average inflation rate. Your money would be growing, even when adjusted for inflation. 

For example, the S&P 500 averages 10% returns since its inception in 1926. Since goods and services get 2% more expensive each year, on average, your real return would be 8% (the 10% annual investment return minus the 2% average inflation rate). The investment return offsets the inflation rate and your money grows.

It is worth mentioning that the S&P 500 doesn’t return 10% each year. It averages out to 10% over long periods.

Compounding Interest

Compound interest is the eighth wonder of the world, he who understands it earns it, he who doesn’t pays it.

Albert Einstein

Compound interest is interest calculated on your initial investment plus all previously accumulated interest. The benefits of compound interest take time to appear. Hence, great investors are always invested. They understand compound interest and, therefore, earn compound interest.

The power of compound interest is often likened to the snowball effect. A snowball starts small, but as it gathers speed going downhill, it becomes bigger and bigger. In the case of investing, your initial investment is the snowball, and time is the snow. The more time you spend in the market, the bigger your initial investment becomes.

If you invest £1,000, at a 10% return, and forget about it, your investment would be worth £1,100 in a year – your £1,000 initial investment plus £100 in interest. In year two, you would gain an additional £110 in interest, of which £10 is the compounded interest (interest earned on the £100 interest from year one). Therefore, in two years, you would have gained £210 in interest (£100 in year one and £110 in year two).

Fast forward 50 years and your £1,000 investment would be worth £117,400. Investing £1,000 at 10% and letting it compound would earn you a total of £116,400 in interest. Talk about money working for you. 

Compound interest awards those who are patient and willing to spend time in the market. Investing early may be one of your best decisions.

Build Generational Wealth

Generational wealth refers to the transfer of assets from one generation of a family to another. 

Investing in quality companies is a good way of creating generational wealth. For example, if you invested $10,000 in Apple 20 years ago, your investment would have doubled, on average, every 1.98 years. That initial investment of $10,000 would now be worth $4.85 million, giving you financial freedom and wealth to pass on.

Focusing on cash-flowing businesses also helps in building generational wealth. Companies that return excess cash to shareholders through dividends and share repurchases are equally influential as compounding machines for building wealth. 

Dividends are cash payments made to shareholders from the company’s profits. These dividend receipts can be reinvested to increase your share count without investing additional personal capital. By reinvesting and accumulating more shares, you’ll receive more in dividends.

Share repurchases increase your ownership stake in the company without buying additional shares. If a company has ten shares in circulation and you own two, you own 20% of the company. If the company buys back two of those shares, your stake in the company increases to 25% without purchasing an additional share. When a dividend-paying company reduces its share count, existing shareholders receive a higher dividend payment per share they own.

If you find a company that is a good compounder and distributes capital wisely (pays dividends and repurchases shares), you should hold that investment for as long as possible.

Passive Income Source

If financial independence is one of your goals, having additional sources of income can help achieve it. 

Passive income refers to income that doesn’t require a significant commitment of time or money. It requires minimal effort to obtain. Investing in dividend stocks, dividend funds, and investment trusts are ways you can get passive income from the stock market.

Dividends are cash payments made by companies, funds, and investment trusts, to reward shareholders for their investment. The dividend yield, expressed in percentages, shows part of what an investor can expect each year from their investment. 

Dividend payments can be calculated by multiplying a company’s share price by the dividend yield. If a company has a dividend yield of 8% and a share price of £50, the dividend payment will be £4.

While dividend income can be an additional source of income, it’s beneficial to be aware of potential drawbacks. 

Firstly, it takes time and money before dividend receipts can supplement your income. You’ll have to accumulate several shares before the associated dividend income is supplementary enough since the dividends you receive are based on the number of shares you own. Secondly, companies may cut or suspend their dividend to have extra cash to reinvest in the company, thereby removing a stream of passive income. 

Summary

Investing is not only for the professionals on Wall Street. It is for everyone. Once you determine that investing is for you, you should consider starting your investing journey for the following reasons: to help achieve financial goals, increase your purchasing power, take advantage of compound interest, build generational wealth and access an additional income source.

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