Interesting in investing? The Motley Fool has a wealth of articles covering all sorts of investing concepts and strategies. But none of this will mean much to you if you don't understand why you should invest in the first place.
So, in this article, we take a big step back and explain the many ways investing can help you achieve your financial goals.
What's so great about investing, anyway?
Here at the Fool, we are incredibly passionate about investing. We could talk about it for hours (and often do!).
There's nothing we love more than getting into lengthy debates about the merits of value investing versus growth investing, whether cryptocurrencies are worth the risk, or the best defensive shares to buy when interest rates are high.
But sometimes, we must remember to start by explaining exactly why investing is so amazing in the first place – and why we think everyone should be doing it!
So, here we'll cover some of the key benefits of investing – like how compound returns can help you grow your long-term wealth (without you having to do anything) or how the passive income you make from dividends can help supplement your income (and might even allow you to work less).
Because we think that once you know about the many benefits investing provides, you'll be just as passionate about it as we are!
The power of compounding
Essentially, compounding means that you earn interest on your interest. While it might not sound all that impressive, it's one of the most powerful concepts in investing. Einstein even called compounding the eighth wonder of the world!
The way compounding works is pretty simple. Let's say you have an investment that pays interest (or a dividend) every six months. When you receive the payment, you can withdraw it as cash or reinvest it into the same investment.
Reinvesting it adds to the principal and, therefore, grows the next interest payment you receive. It means the amount received will be slightly higher each time. If you continually repeat this process over time, a snowball effect is created whereby the interest you receive grows exponentially.
Here's a quick example to illustrate the magic of compounding.
Assume you have two investors, Ralph and Lisa. Each has a $1,000 portfolio that pays roughly 5% annual interest, payable every six months. Each can choose whether to take or reinvest the money when they receive payment.
Ralph uses his portfolio to supplement his income and accepts his payment as cash every six months. On the other hand, Lisa isn't concerned with earning additional income and instead wants to grow her wealth over the long term. So, she decides to reinvest all her payments.
Fast forward ten years. The total value of Ralph's payments over the period was $500, comprising 20 half-yearly payments of $25. However, Lisa's portfolio has increased in value over the same timeframe from $1,000 to $1,638.62. If she cashes out her portfolio now, she would have made $138.62 more than Ralph simply by reinvesting her payments into her portfolio and harnessing the power of compound interest.
Now, imagine if instead of Lisa's $1,000, it's your lifetime's worth of savings; instead of ten years, it was your entire working life. The wealth-generating potential of compounding can quickly become quite astonishing – it might even end up paying for your retirement!
Beating inflation
Inflation occurs when the prices of goods and services increase over time.
Even the healthiest of economies have low inflation levels. It's unavoidable. It just means that the economy's demand for goods and services is strong, and people are spending money.
So long as the central bank keeps inflation within an acceptable band (about 2% to 3% per annum), everything is hunky dory. The economy is growing, but wage increases keep pace with price increases.
Still, even if we begrudgingly accept that a low level of inflation is a healthy thing for an economy, it doesn't provide us with much comfort when we get to the checkout and realise our groceries cost more than they used to.
Economists refer to this as an erosion in our 'purchasing power'. In other words, the same amount doesn't buy as much stuff as it used to.
So, while you might think you're saving for the future by squirrelling away your money in your everyday bank account (likely earning next to nothing in interest), its real value could be declining – especially when inflation is high.
But what if, instead of saving your money, you invested it?
Investing your money in a diversified portfolio of financial assets can be a great way to beat inflation and grow your real wealth over time.
For example, see the below chart of Australia's annual inflation rate over the past 30 years. While inflation has been volatile (and spiked recently), the average rate over the past 30 years (represented by the red dotted line) has only been about 2.6%.
Compare this against the S&P/ASX All Ordinaries Index (ASX: XAO), which has returned, on average, about 9.2% each year over the same period1. This shows that a well-diversified portfolio of Australian shares would likely have delivered a return well above the inflation rate.
Data source: The World Bank
Building wealth over time
A key ingredient in every successful investment portfolio is time.
Here at the Fool, we don't believe in get-rich-quick schemes. We believe the best way to grow your wealth over time is by investing your money in quality shares and other financial assets. But this requires a long-term mindset.
As mentioned, the average annual return of the ASX All Ords has been about 9.2% over the past 30 years. But that's just the average – sprinkled in were some terrible years, too.
For example, there was the dot-com crash in 2000, then the bear market caused by the Global Financial Crisis (GFC) in 2007. And, of course, as recently as 2020, the COVID market crash took its toll.
Short-term investors who panicked and sold their shares in one of those bad years could have suffered massive losses – but longer-term investors who rode out those short-term downturns would have been rewarded with a long-term average return.
Investing requires discipline and patience (and sometimes even nerves of steel!).
Set clear goals and have a firm idea of what you hope to get from your investments – be it a financially secure retirement, savings for a holiday, or your child's education. Whatever your long-term goals are, if you can easily visualise them, it will help you stick to your plans when things get a little rocky.
Additional income streams
As discussed earlier, your investments can provide regular income streams – from interest, dividends, or other cash distributions.
In our earlier example with Ralph and Lisa, we explained how Lisa reinvested her regular distributions to harness the wealth-generating power of compound interest. However, Ralph elected to take his payments as cash to earn a passive income stream.
As illustrated, reinvesting your interest will typically provide better long-term returns, thanks to compounding. But taking these payments as cash can still offer other important advantages.
For example, additional income from your investments might allow you to work less and pursue other passions. This might be just as important to you as long-term wealth.
And, as you get older, these payments will help finance your lifestyle in retirement.
So, depending on your stage in life and your personal investing goals, the ability of your portfolio to earn a steady stream of passive income can be precious.
Diversification for financial security
Diversifying your investments is one of the key ways you can manage your portfolio's risk.
We've all heard the old phrase, 'Don't put all your eggs in one basket'.
If the basket breaks, all your eggs will fall out and crack, leaving you without breakfast. But if you divide your eggs between multiple baskets, even if one basket breaks, you'll still likely come out with at least an omelette.
Well, the same theory applies to investing.
Investing all your money in one stock means you rely entirely on that share performing well. But if you invest in many different shares, you can still grow your wealth, even if a few fail.
But you aren't limited to diversifying by just buying shares. You can add different financial assets to your portfolio, including commodities, bonds and property. Various assets can have unique risk and return profiles, which can help your portfolio perform well regardless of market conditions.
For example, bonds and gold can be good safe-haven assets to own during a recession. Having part of your portfolio invested in assets like these can help offset losses you might suffer on your shares if the economy tanks, as their prices tend to be most negatively impacted by economic downturns.
If you are just starting on your investing journey, a great way to diversify your portfolio cheaply is to invest in exchange-traded funds (ETFs). These are funds you can invest in that trade on the share market, just like ordinary shares. The benefit of ETFs is that they can provide exposure to a whole portfolio of assets in a single trade.
For example, the Ishares Core S&P/ASX 200 ETF (ASX: IOZ) invests in the 200 largest shares listed on the ASX by market capitalisation. The fund's performance should closely mirror the portfolio of the broader ASX200 Index. Investing in the ETF is like buying a small share in all those companies – in just one trade!
Achieving financial goals
As we touched on earlier, having a clear set of financial goals can help you stay motivated right the way through your investing journey. Most importantly, goal setting can give you personal accountability and a clear purpose.
And one of the great things about investing is that it allows you to tailor a portfolio (or group of investments) to meet a particular goal.
For example, for shorter-term goals (like fancy clothes or a weekend away), you may want to stick to lower-risk investments like bonds or high-interest savings accounts. These investments are usually highly liquid, unlikely to suffer significant price declines, and will probably earn you some income.
For longer-term goals (like home ownership or a financially secure retirement), you can afford to invest more of your money in riskier assets like shares. The prices of these assets can be volatile over the short term, but they also tend to deliver the best returns over the longer term.
We encourage you to read our article on setting financial goals before you start out on your investing journey (though it can still help seasoned investors, too!). Setting reasonable goals at the outset is the best way to set yourself up for investing success.
Foolish takeaway
In this article, we've highlighted a few good reasons why everyone should start investing. The list is not exhaustive – you may be able to think of even more advantages to investing.
And if you're inspired to start, we can provide you with plenty of the tools and tricks required to become a successful investor. Happy investing!
Want to learn more about investing?
You've come to the right place!
This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.
Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.
Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.
- To read the previous article, go to What is investing?
- Check out the next article, Investing versus saving
