Why Should You Invest?

Welcome to Investing Basics! If you've found your way here, chances are you've either got some money tucked away or you're planning to do so. But first things first. Why is investing a smart idea?

Simply put, you want to invest in order to create wealth. It's relatively painless, and the rewards are plentiful. By investing in the share market, you'll have a lot more money for things like retirement, education, recreation — or you could pass on your riches to the next generation so that you become your family's Most Cherished Ancestor.

Whether you're starting from scratch or have a few thousand dollars saved, Investing Basics will help get you going on the road to financial (and Foolish!) well-being.

Know your goals

What are you saving for? Retirement? University for the kids? A new speaker system complete with woofers and tweeters? An exotic animal menagerie complete with Chihuahuas (woofers) and canaries (tweeters)? A retirement villa in the sun-baked hills of Tuscany?

Say you take $2,000 of your savings and put it into the share market. If your money returned 10% a year (around the historical average of the Australian share market), two grand would be worth $34,898.80 after 30 years. That might not get you the perfect retirement home, but it'll at least give you a down payment.

Maybe you don't have $2,000 burning a hole in your bank account, but perhaps you can afford to invest your lunch money. Brown-bag your lunch and tuck away just $4 a day, 250 days a year.

It's not a lot, but if you're in your early 20s, you've got the investor's best ally on your side — time. If you invest $1,000 once a year in an investment that averages a 10% annual return, it'll grow to more than $1 million after 46 years, which is right around the time you'll be ready to retire.

Of course, as you get older and more financially stable, you should be able to put away more to invest. Upping the ante to just $166 a month — which is probably less than lunch money plus what you pay for cable TV — would put you at the million-dollar mark in just 39 years.

The power of compounding

The table below shows you how a single investment of $100 will grow at various rates of return. Five percent is about what you might get from a term deposit over time, 10% is about the historical average share market return, and 15% is what you might get if you decide to learn how to pick your own shares and take advantage of some of our lessons in advanced investing techniques.

Growing At

Why is the difference between a few percentage points of return so massive after long periods of time? You are witnessing the miracle of compound returns.

When your investment gains (returns) begin to earn money, and then those returns start to earn money, your investment can mushroom very quickly. Extend the time period or raise the rate of return, and your results increase exponentially. For instance, if you start young, say at 15 years of age, note how quickly a single $100 investment grows, especially in the later years.

Growing At

Looking at it another way, let's compare two teenagers and their lifetime savings habits.

Bianca baby-sits a lot and spends most of her spare time reading. She saves $1,000 a year starting when she's 15 and invests it in the share market for 10 years earning 12% per year on average. After 10 years, she comes out of her shell, stops adding money to her nest egg, and spends every cent she earns club hopping and on trips to the Gold Coast. But she keeps her nest egg in the share market.

Compare her account to that of her friend Patrice, who squandered her early pay cheques on youthful indiscretions. At age 40 Patrice gets a wake-up call when her parents retire on nothing but the age pension. She starts vigorously tucking away $10,000 every year for the next 25 years.

Guess who has more at age 65?

It's Bianca. (You figured it was a setup, didn't you?) Her 10 years of saving $1,000 per year (just $10,000 total — the same amount Patrice put away in just one year) netted her $1.8 million by age 65.

Patrice, on the other hand, scrimped for 25 years to invest a quarter million dollars out of her own pocket and ended up with just under $1.5 million. Neither will be going to the poorhouse, but you see our point: Bianca's baby-sitting money grew for 50 years, twice as long as Patrice's, and Bianca barely missed it.

The power of compounding is the single most important reason for you to start investing right now. Every day you are invested is a day that your money is working for you, helping to ensure a financially secure and stable future.

Common pitfalls to avoid

Before you race off through the rest of Investing Basics, there are some cautionary points to consider before you proceed. These are common mistakes many people make when considering what to do about investing.

1. Doing nothing. There is no guarantee the share market will go up the first day, month, or even year that you invest in it. But there is one guarantee: Doing nothing at all will not provide for a comfortable retirement.

2. Starting late. Postponing your investing career is second only to not investing at all on the list of investment sins. You already know that the earlier you start the better off you are. (Take another look at the compound return example we gave above.) If you're already past those formative twenties (you don't look a day over 32 to us), we'll re-word this first pitfall to read: "Not starting now."

3. Investing before paying down credit card debt. If you have money in your savings account and you have revolving debt on your credit card, dump your debts first. Many credit cards have an annual interest rate of 18% or more. Let's say you have $5,000 to invest, but you also have $5,000 debt on your credit cards with an average annual interest rate of 18%. It doesn't take an astrophysicist to figure out that you're going to have to get an 18% return after you pay taxes just to break even on that $5,000. Pay the debt off first, then think about investing.

4. Investing for the short term. Only invest money for the short term that you're actually going to need in the short term. Invest money in the share market that you won't need for at least three years, and preferably five years or longer. If you'll need your cash next year for a deposit on a house or for the family Caribbean cruise, use one of the shorter term and safer havens for your cash, such as savings accounts and term deposits.

5. Playing it safe. If you're young, most of your investing dollars should be in the share market. You have enough time to weather any dips in the market and to reap the rewards of long-term gains. Although you may want to transition into cash later in life as you depend on your investments for income, shares should make up a large portion of the portfolio of every investor.

6. Playing it scary. Not every investment is for everyone. Even if you're a daredevil, you shouldn't pour all of your money into something that could end up going down the drain.

7. Viewing collectibles or lottery tickets as investments. If old comic books, Barbie dolls, and abandoned exercise equipment could be used to fund retirements, do you think the share market would exist? Probably not. Don't make the mistake of thinking your jewellery or the lottery will provide for you in your latter years.

8. Trading in and out of the share market. We believe the best approach to investing is the long-term one. Pick your investments well and you'll reap greater rewards over the long-term than you had ever dreamed possible. Trade in and out of the share market and you'll be saddled with fees that chip away at your returns, and you'll potentially miss out on gains that long-term investors enjoy with much less effort.

Congratulations! You've made it through the first part of Investing Basics. (Bet you didn't even break a sweat.) You've witnessed the power of compounding and you understand how some common pitfalls can ruin even the healthiest investing plan. Now, let's turn to the various ways you can start investing.