OtOoI Ch. 1: Why You Should Invest

OtOoI Ch. 1: Why You Should Invest

Welcome to the first instalment of On the Origin of Investing, a 5-part series on what I’ve learned about saving for retirement effectively (hint: investing is involved). Yesterday, I told you that I am not promising to make you the next Wolf of Wall Street or our generation’s Warren Buffett. What I’m promising is to give you the tools to start planning for financial success and independence in retirement.

In this series, we’re not really talking about penny stocks, initial public offerings, and Wall Street lunches with Matthew McConaughey, so you may be asking yourself: why should I invest?

We invest to prepare for retirement.

Retirement seems like a long way off for most of you. Many of you are still in school, or are only just getting started in your careers. The idea of preparing for retirement, which may be 30, 40, or even 50 years down the road for you, may seem a little strange, but thinking about retirement, and starting to prepare for it now, is of the utmost importance.

Why?

When you retire, you are no longer working. Shocking, I know, but that also means the amount of money coming in is going to be far less than in your working years.

There is good news. As a Canadian, you will contribute to the Canada Pension Plan (or CPP) throughout your career. The average monthly benefit after age 65 is currently just shy of $630 a month, for a whopping $7,560 a year. Generous, I know, but even with this lavish pension, you might have to cut back on those trips down south you’ve been planning.

Now before we get too doom and gloom, at 65 you will also be eligible for Old Age Security (OAS) which currently has an average monthly benefit of $570, for another $6,840 annually. This certainly helps, but we’re still talking about an annual income well below the poverty line, and this may be a difficult adjustment after what were probably your most lucrative years in employment just prior to retirement.

If you were lucky enough in your career to be able to contribute to a pension plan with your employer, things will look a little more rosy (especially if you work for the government!).

Of course, there is only one real reason for this: you are being forced to start saving for retirement early!

But, what if you don’t have a pension plan at your work? What if your employer doesn’t offer it (which is becoming more and more common in the modern age of contract work)! Or maybe you’re self-employed! What’s an entrepreneur to do?

Start. Saving. Early.

Retirement is not as far away as it seems, and we can’t rely on the government to put a roof over our heads, food on our table, and tickets for flights to Miami in our hands.

Now, I’ve managed to tell you why you need to save, but not why you need to invest. To explain this, I’d like to explore three simple rules to justify investment.

The First Rule

If you’ve ever read Terry Goodkind’s epic fantasy series, The Sword of Truth, you would know that the Wizard’s First Rule is that “people are stupid.” I’m going to challenge you not to be stupid, or rather, not to work stupid. You need to work smart.

wsnh-poster3
Figure 2. Our diplomas mean a lot less these days. Better work REAL smart.

Therefore, the first rule of retirement planning is to make every dollar work for you.

Every dollar you make needs to be earmarked for something. Your dollar works for you by keeping a roof over your head which, in turn, makes it possible to keep working and earning more money. Same goes for the food you buy and the gas in your car.

However, if you budget well (and by God, you need a budget!), there are going to be some dollars left over at the end of the month that you are not making work. Or at least, you are not making them work as hard as they should be.

For example, you may be putting your money in your bank’s savings account where they are accruing interest at a rate of 0.05% (at your major bank, in a no-fee savings account), to a whopping 2.25% (at your discount bank, on a promotion). Your money is working, but it’s not working smart, and it’s not working hard.

It’s your job to whip those dollars into shape, because savings at those rates are not going to cut it, primarily because of the second rule.

The second rule is practically a law of nature, at least in our world, and explains why savings accounts do not work for retirement.

Rule Numéro Duo

Inflation. I don’t want to call it a rule, because it is more of a fact of life. Let’s just say it is not something that you have to follow, but rather something you must always keep in mind. Inflation will dictate how much the money that you save now is worth when you retire.

Inflation is the natural process by which goods increase in price, and therefore, inflation decreases the purchasing power of your dollar. As you can see in the graph below, inflation has been relatively steady for the past two decades, with prices usually rising by approximately 1-2% per year. This is why a loaf of bread cost 5 cents in the 1950s, and costs $2.99 (or more, I see you with your fancy artisan whole wheat round) today.

Screen Shot 2016-08-04 at 5.08.15 PM
Figure 3. The historical rate of inflation in Canada, from 1950-2015.

This is also why using a savings account to accumulate money for your retirement is not going to work. Using an average (and sustainable) paid savings account at a major bank, your money will appreciate approximately 0.1% per year. Meanwhile, the price of that Starbucks latté you buy every Monday (and Tuesday, Wednesday, Thursday, and Friday) is going to rise approximately 1% per year.

Let’s use an example to illustrate how inflation works.

Say in 1990, you stashed $20,000 away in your savings account. In its first year, at 0.5% interest (much higher than what you’ll get today), it is going to appreciate by $100.23, and you’ll be left with $20,100.23. Extrapolating this forward, down a 25 year time to retirement, your initial $20,000 will become $22,662.38. Not bad for doing nothing! You’ve made $2,662.38 in 25 years thanks to the power of time and compound interest (see the third rule). It’s 2015 and you can buy that base model Ford Mustang you’ve had your eye on.

1990-ford-mustang-7
Figure 4. Mmmmmmmm.

But there’s a catch.

Over the same period of time, due to inflation, every one of those dollars in your bank account is now worth a whole lot less. In the period between 1990 and 2015, inflation’s cumulative 25 year rate was 58.8%! This means that something that cost $1 in 1990 now costs nearly $1.59. Your brand new Ford Mustang cost $20,500 in 1990, but a brand new Mustang in 2015 costs $32,554. I guess you won’t be getting that dank whip after all.

You’ve been bested by the effects of time and a crappy interest rate*.

These are the devastating effects of inflation, and are the primary reason why you must invest if you want to maintain your buying power into retirement.

*Interest rates are not always as low as they are now, and there have been times in history when interest on savings accounts have managed to outstrip inflation. It is important to remember that the Bank of Canada sets interest rates, and the banks will typically offer interest on savings well below this, in order to leave room for them to profit. Shitty right? Wrong, because that can be our profit too.

Third Rule

Time is your best friend. I know the idea is a little strange, given that time just kicked your ass back to 1991, and given enough of a leash, time will literally kill you, but trust me, time can be real friendly if we follow rule number one, which was?

Make every dollar work for you!

Come on, keep up.

In order to beat the devastating effects of inflation, you’re going to need a better way of saving, because savings accounts aren’t going to cut it.

When you make every dollar work hard, you CAN achieve a rate of return that beats inflation. All you need to beat inflation is a measly 1-2%, but we can do much better than that if we have the right mindset, and make our money work smart.

If you can, at the very least, match inflation, every dollar you stash away will at least be able to buy you the same things you buy today. If you can do better than inflation, your wealth will grow with the power of compound interest. Compound interest is the reason why time is your best friend.

So, what is compound  interest?

It is the interest you earn on interest. If you are earning a very conservative 4% interest per year, your actual gain becomes much higher than this with time.

Screen Shot 2016-08-04 at 5.13.36 PM
Figure 5. The effect of compound interest, depending on frequency of compounding. Graph created by Jelson25.

4% in your first year becomes 4.16% in your second year (0.16% is interest on the 4% interest you made in your first year), becomes 4.49% in your third, and 8.02% in your tenth. This is because you are earning interest on interest, which makes your actual return relative to your investment, a little bit higher with each compounding period.

A $20,000 investment, with no further contributions, and annual returns of 4.0%, becomes $54,275.30 after 25 years. You have made $34,275.30 in interest alone (more than the value of that 2015 Ford Mustang you wanted). The sooner you start to invest, the sooner you can harness the power of compound interest for yourself.

So, if a savings account isn’t going to cut it, how do we get this kind of return?

We invest.

Keep your eye out for Chapter 2, next Friday, where we will discuss the various financial instruments available for investing.

Happy living,

JRM

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