INVESTING RATHER THAN MERELY SAVING - Beginners Guide

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INVESTING RATHER THAN MERELY SAVING

Saving money is a challenge and an achievement. You save money when you earn more than you spend. For most Australians, accumulating cash means consciously forgoing spending. Amassing a cash reserve is useful for emergencies, projects (such as holidays or renovations) and investing.
Saving money is better than spending it, and a lot better than building a large debt on your credit card. A wealth strategy, even more effective than saving money, is investing money.

There is a clear difference between saving and investing. When you save money, you have usually had to work hard to accumulate the cash; when you invest that money you have saved, it works hard for you.

Real returns matter

Investing can be as straightforward as depositing your cash in a high interest bank account. The aim of investing is to protect the purchasing power of your money over time and to accumulate wealth. You may also want to generate a regular income from assets.

You want to invest your cash in investments with a return that is higher than the inflation rate (the annual rate of price increases). If your investment delivers the same rate of return as the inflation rate, then your real return is zero. You may retain the same purchasing power of your money over time, but your wealth will not increase in real terms.

For example, say you have $1000 and you deposit the amount in a high interest bank account earning 5 per cent. The interest you earn is $50 for the year. If inflation, that is the annual rate of price increases, is 5 per cent, then the real return on your money is zero. You deduct the effect of inflation from the return you receive to work out the real rate of return on your investment. You may have $50 more in your account, but the purchasing power of $1050 is effectively worth the same as $1000 a year ago.

If, however, inflation is running at only 2 per cent, then you deduct only $20 from your interest income to work out your real return of $30 (3 per cent).

If inflation is running at 10 per cent (which hasn’t happened for many years), you need a return of at least 10 per cent to hold your ground.

What matters is your real return.

Compounding returns: an easy way to make money

Compound interest (earning returns on your returns) is the elixir of investing. By re-investing the money that your investments earn, your investment grows a lot quicker. For example, you can double your money in five years if your investment earns 14 per cent a year and all returns are re-invested and earn 14 per cent, too.

If you spend your investment’s returns each year, your investment will never grow and it may well go backwards in real terms.

Rule of 72: working out when you double your money

There is a nifty rule of thumb, known as the rule of 72, which can give you a quick answer to how quickly your investment can grow by re-investing your investment’s earnings (see table below).

The rule of 72 tells you how many years (give or take a month) it will take to double your money at a given rate of return. You need to start with the number ‘72’. You then determine what rate of return you expect to get on your investment. By dividing this return into 72 you will know for how many years you need to invest to double your money.

For example, if you expect to receive a return of 10 per cent a year, then you divide 10 into 72, which gives you 7.2 years. In other words, you can double your money in just over seven years when you re-invest your earnings and your investment earns 10 per cent a year.

When you work out the numbers, keeping most of your money in a no-interest or low-interest bank account just doesn’t make “real” sense.