For those new to the world of investing/ dipping toes into their personal finance journey, I’m sure you have been inundated with articles saying
“Dont just save! INVEST!!”,
“Grow your wealth”
and the list goes on.
The question is –What does it even mean ?
Why isn’t saving enough? How is investing different from gambling- after all we’ve all heard ‘Investing in the stock market is risky’ time and time again.
Of course, before you even consider investing, you’ve gotta save first. That is the foundation, no doubt. If you’re keen to up your savings game, here are 5 simple saving tips.
In the world of finance, there are many things that you can actually invest in. However, most of the time when people say invest, they loosely refer to investing in the stock market.
Let’s break it down.
Why saving isn’t enough
When you save, you are likely keeping your hard earned money in
- Fixed Deposits (‘FD’) (with low interest of approx 1-2%)
Which means if you receive a $3000 paycheck, it will remain as $3000 (or grow negligibly after a year to $3060 bucks (at 2% interest).
The reason why that could be problematic is because of Inflation.
Inflation means that generally, price of goods will continue to rise in the future. The key premise is that money today is worth more than money tomorrow.
Eg. Did you know that an average home in America cost only $5000 in 1900? Fast forward to 2021, what can $5000 buy you? Most certainly not a house…and not even the down–payment.
This means that the value of your money is decreasing as time goes by. So while you may have $3000 in hand today, it will not buy you the same amount of goods 50 years from now.
What is a Stock and the Stock Market?
Stock: A share of a business.
When you own a stock, it means you own a certain % of equity of a business, which makes you a shareholder/minority business owner.
Stock market (also known as a Stock Exchange): A market place for investors – both large institutions (ie. banks, EPF, Unit trust funds like Public Mutual etc) and retail investors (ie. small time investors like you and I) to buy and sell stock.
So, whenever you hear the term ‘The Stock Market is up today’ – simply put, means there are more people buying stock, than selling stock (ie. Demand > Supply).
And when Demand > Supply = Stock prices will rise.
Why does Investing in Stocks provide more returns than Saving?
When you invest in a stock, you can get a return in primarily two ways:
a) Dividends – this is when a company distributes a % of its profit to you
The concept is similar to saving:
If you put $3000 into an FD and you get $60 in interest means you get a 2% return (ie. Interest rate %)
If you buy $3000 worth of stocks, and get a $60 dividend means you get 2% return as well – but it’s called Dividend Yield % – which is the % of dividend over what you have invested
b) Capital Gain – when a stock price rises, beyond the price you paid for it due to higher demand for the stock
Eg. If you bought $3000 worth of stock today, and one year later, the stock price is up so your stock is now worth $3300. That means you made a 10% return of capital gain.
The key reason why investing in stocks is more useful to grow wealth than savings is due to the Power of Compounding.
Eg. The $3000 worth of stock you bought in Year 1 is up 10% – giving you a capital gain of $300, making its overall value $3300. You decide to sell all of it, cashing out on your investment of $3300.
You decide to reinvest it, so you go and buy another stock for the same amount ($3300)
1 year later, the value of that stock grows another 10%, giving you a return of $330 – making your investment portfolio worth $3,630.
Essentially what has happened is because you chose to reinvest the returns, those same returns have now made you more money. Look at the comparison below:
You may think, ‘Well that’s what happens to my FD anyways. My 2% interest rate gets reinvested too.’
The key difference is that:
- Generally the stock market grows at a higher rate because all businesses strive to continue growing so generally demand for the stock will be more than the supply (we all want a piece of that growing pie) vs FD rates which remain largely flat
- You can get two sources of return – through both capital gain and dividends.
And that’s how, the magic of compounding is amplified in stock investing.
Why is Investing in Stock riskier than Saving?
High risk, high returns.
If stocks are providing higher returns, then they must be risky, right?
People often think of stocks as risky because of the volatility of a stock price. Volatility is the degree of variation in price.
Compared to saving in an FD, investing in a stock is definitely more volatile. Your FD’s value will remain largely the same throughout vs a stock whose price can easily fall more 10% in a day if there is some really bad news.
The question is – why?
As we established earlier, a stock price rises due to growing demand for a stock. Stocks listed on a stock market are limited, so you want to own a % of that business, you will have to pay a higher price for it. There are various reasons why there could be more demand for a stock:
- The business is doing well – This is based on hard and supportable facts. eg. Look at how much Apple has grown, as its sales continue to rise year on year, it means it is able pay a higher dividend, and more people are likely to be interested to own the stock, because it’s profitable. So you buy the stock because you believe the company is fundamentally good and other investors will recognise that and they too will buy the stock.
- FOMO – ever bought something just because everyone is buying it? Yup, the same thing happens for stocks too. Because a stock price is trending upwards, some investors may just buy in, hoping to ride the wave and make a quick buck.
- The economy is doing well / High investor confidence– If the economy is booming, you are likely more willing to spend and invest because you believe you can continue to earn more money (maybe better business sales, higher bonus etc). All of this feeds into the stock market and makes it grow.
When stock prices are generally on the rise, economies are booming, there is positive investor sentiment – this indicates we are in a bull market. On the flip side, when we are in a recession, people are fearful (hoarding cash), prices are falling – this is a bear market.
The unifying theme in all of the examples above is emotion / sentiment. It’s what investors perceive the value of a business is.
Where there is emotion, there is irrationality.
When investors feel more confident, they often buy. When they feel fearful, they often sell.
Because as humans we are generally risk averse.
Just think of how moody one person can be in a day, now picture that x1000.
That’s why the stock market goes up and down.
To invest or not to invest?
As important as it is to invest to preserve/grow wealth, it’s also important to assess your current financial situation and your personal readiness to invest.
Do you have enough emergency fund stashed away?
Are you willing to keep up with the news and study the business of companies?
Do you need to use any of this cash within the near future?
Investing in something is always risky, if you don’t know enough about it.
That’s why building financial literacy and doing your homework is so important. It helps us understand what we are investing in.
Money is a tool, learn to use it well.
Disclaimer: I’m not a professional financial advisor and this is not financial advice. I’m just sharing based on what I learned in my own journey and I hope it inspires you to learn more too.
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Stay tuned for the next blog post in this Let’s Talk Money series, where I elaborate further on ways to invest!
Check out other articles within the ‘Lets Talk Money’ blog series.