What is investing?
Investing is putting money in assets that are expected to give a decent return in the future.
Investing makes your money work for you.
Returns on investments are mostly either through capital appreciation or regular income.
Investments usually give decent returns only after a period of time, typically many years.
There is always a risk factor associated with investments.
That said, the potential of the investment growing is also very high.
Investing includes stock investing, real estate investing, gold, etc. Investing involves research and mostly investments are illiquid except low risk investments like fixed deposits or savings account in a bank.
Difference between Investing and Saving
Savings are money that we allocate for short term emergencies in a bank account while investing is money that we allocate in assets for long term gains.
Savings requires little to no research involved whereas investing could involve extensive research.
Savings mostly don’t beat the rate of inflation, whereas if the investments perform well they can outperform inflation.
Savings are risk-free while investments can be risky and you could lose all your money, and at the other side of the coin you also have the potential to increase the value of your investment exponentially.
Savings are stress-free because you will be getting the returns at a certain percentage from, say, your savings account with certainty whereas with investments the returns could be high, it could get stressful because of the volatility and uncertain nature of the investment.
Savings are liquid and you can immediately access your cash whereas investments are usually for long term and it takes time to convert an investment into cash.
Power of compounding
Compounding means return on your returns.
Compounding increases the value of investments exponentially after a certain time, usually after several decades.
For this to happen, you need to stay invested for a long period of time.
Compounding is better for people who like to be patient and watch the growth rapidly only after 3-4 decades.
Compounding just takes time, in simple words. Starting early is one major component of compounding.
In short duration, compounding gives little returns, which is insignificant, that’s not worth your time.
I think it’s great for generational wealth because at that point it makes a lot of sense.
Compounding includes rule of 72 which is 72 divided by the annual interest rate gives you the years it takes to double the initial investment.
Inflation
Inflation is the rise in prices of everyday purchases. Inflation also means the reduction in the purchasing power of money.
Inflation occurs due to several reasons like supply, demand, printing more money, employment and a variety of factors influence the inflation rate.
What happens when inflation happens:
When inflation, usually expressed in percentages, say 3% rises per year, what cost $100 last year would now cost $103.
Now what happens when it happens is automatically the purchasing power is lowered.
When this happens across all products and services, there is a great reduction in purchasing power. For example, if you saved $100, after one year, it’s only worth $97.
Causes of inflation
- Cost pull inflation.
- It is when the cost of the production increases, the businesses pass on the costs to the buyers, thus an increase in prices occurs. Now why does the cost of production increase in the first place? Due to many reasons. One is, for example, the demand for raw material is more, so the prices went up.
- Likewise, there are many factors like businessmen’s greed that artificially raise the prices. This is called cost pull inflation.
- Demand-pull inflation.
- This type of inflation occurs when there is too much demand for the same goods and services driving the prices higher. For example, if everyone at the same time needs a certain product for a season, then the cost of that product goes up due to the sudden demand.
- Printing more money
- Inflation occurs when the money supply is more than the goods can be bought for.
- This is a powerful move and should be done cautiously because too much supply can devalue the currency.
- Governments print more money when something unexpected like COVID happens which leads to major unemployment and shaked the economic activity where the government needs to print more money to keep the economy going.
Is it bad? How much is bad? What happens when it goes too high or low?
Small changes every year inflation is actually needed for the economy.
But too much inflation can lead to reduction in spending which could slow down the economy.
Central banks across the world control this by varying interest rates of the borrowed money, by changing the monetary policies and printing more money if needed.
The central government regulates inflation by adjusting the taxation and its spending.
Central banks typically aim for 2% inflation each year to maintain the steady pace of the economy.
No inflation means the prices of goods and services stay the same, which is not practical as there are many factors influencing the supply, demand, cost of the goods/services.
When inflation gets to negative, that is when prices of goods and services cost less, called deflation.
Too much deflation can lead to depression.
When deflation happens, the cost of goods and services get low, then people wait for the prices to get even low and stop spending, thereby reducing economic activity. To combat this, the central governments reduce interest rates for people to borrow money and spend to boost the economy during deflation.
How it affects Savings:
Inflation affects savings because the money saved loses the purchasing power due to the rise in prices of goods and services.
For example, if you save $1000 today, then next year on this day, if we consider 2% inflation, then the savings lost 2% worth of purchasing power, leading to purchase of goods and services of only $980.
This is why people invest their money that outpaces inflation to protect themselves from inflation.