The following article is a guest post from our friends at Nutmeg, the UK’s largest digital wealth manager. Money Dashboard users get 9 months fee free investing when they open a Nutmeg account. More info here. Capital at risk.
Investing money, rather than just leaving it in the bank, gives us the possibility of building a bigger pot for the future. You can invest now for a specific goal, such as retirement, or a more general desire to have some extra money for a rainy day.
There are a number of key reasons why investing could make good sense for you.
1. The ‘miracle’ of compound returns
What are compound returns?
Compound returns are often referred to as the eighth wonder of the world. They are also an investor’s best friend.
The basic concept is simple. In the first year of investing you generate returns on your initial investment. In the second year you invest the capital plus those returns, and you generate further returns on the total. And so it goes on, helping you to build a bigger pot.
Of course, investing is always subject to the ups and downs of the stock market, so returns aren’t guaranteed every year. However, by investing over a long timeframe, you can give your investment a better chance of making up for short-term losses.
Underestimating the power of compounding
There have been many studies into compound returns and why we fail to mentally account for them properly. One such study was conducted by Craig McKenzie and Michael Liersch at the University of California.
They asked groups of undergraduate students to consider how much their money would grow if they deposited $400 per month into an investment which grew at 10% per year.
One group were given calculators and asked for a calculated answer, the other group were given no aid at all and asked for a best guess. The results? Ninety percent of respondents got it wrong. Both groups grossly underestimated the final value of the portfolio, as they failed to take compounding into account. The average guess for the portfolio size after 40 years was $500,000. The correct figure is around $2.5 million.
This ‘miracle’ of compound returns is perhaps most beneficial when looking at investing for retirement – where the earlier you start the better off you could be. The research group CLSA came to a dramatic conclusion about saving for retirement. They found that if you deposit into a pension from the age of 21 to 30, your pension pot will be worth more than if you saved the same amount each month from the age of 30 to 70. This assumes that you stop contributing at 30, but the fund continues to provide returns at the same rate.
Why little things mean a lot
Seeing the full benefit of compound returns is all about time and patience. That means that you don’t have to stash half your income away immediately. If you commit to setting aside as much as you can every month and make regular contributions to either your investments or to a savings account, small amounts can soon add up – in the case of a cash savings account this would be through compounding on the interest earned.
Correspondingly, what seems like a small disparity in rates of return can soon start making a big difference. Interest rates on cash accounts are at historically low levels at the moment, so it pays to shop around for the best rate. It’s also important to remember, a number of cash ISA providers may have generous introductory offers, and then reduce your interest rate after the account has been open for one year. Be vigilant, keep on top of what rate you’re getting, and it may be worth switching providers if you can get a better deal elsewhere.
2. The need to stay in the market
Investing typically takes a long time. There are no magic beans and the adage ‘if something seems too good to be true, it probably is,’ is a good motto. The longer you are invested in a market the more money you are likely to make over time, this is due to compound returns and because you will likely keep topping up your investment during your working life. However, staying invested for a long time also helps smooth out any short-term volatility. Essentially: by staying invested longer you can iron out the blips when the market goes down; therefore, the longer you invest, the less likely you are to lose money.
Most investors are exposed to the equity markets which offer you a share or stock in a publicly listed company. These shares are listed in indexes such as the FTSE 100, the S&P 500 or the NASDAQ.
Looking at historic UK stock market data from 1969 until 2016, you’d have had a 55.2% chance of making gains if you’d invested for 1 day – similar odds to the toss of a coin. But long-term investing dramatically increases your chances of making positive returns. Investing for one month ups your probability of gains to 63.9%, investing for one year boosts your chances to 82.1% and investing for 10 years or more pushes it to 99.4%.
Below is another chart that takes data from 1971 through to 2020, which shows that were you to invest your money in equity for 15 years, the probability of loss would drop to zero.
Past performance is not a reliable indicator of future performance.
It’s never been easier to visualise your potential investment returns. You can see the effect of investment returns on future spending with our pension calculator.
3. The need to beat inflation
Inflation can be described by how much prices rise or, equally, how much your money devalues. That chocolate bar you enjoyed growing up is likely more expensive now: that’s inflation. Pretty much every price and how it has changed over the years is a measure of inflation: from stamps, to bread, to houses.
If you left your money in the bank you used to be able to hope interest rates would keep up with inflation, meaning your purchasing power kept parity with prices over time. However, today’s interest rates are at record lows.
In August 2020 the Bank of England interest rate was 0.1% and the bank has even discussed the possibility of negative interest rates. By contrast, the CPI inflation rate for the 12 months to June 2020 was 2%. This means the cost of living is outstripping your spending power, as the real value of your cash savings decreases.
Investors are often willing to accept market risk in order to achieve returns that beat inflation.In the current interest rate market, leaving your money in cash is not a good idea if you want to beat inflation.
Let’s look at an example:
You’ve just discovered that a distant relative has left you some money in their will, but you might be disappointed when you realise it’s just £100. When your relative first bequeathed you that money, back in 1975, it would have been the equivalent of about a month’s wages. Nowadays, most people make more than that in a day.
Let’s look at the effect that inflation had on the value of £100 cash over time.
This is what inflation does — it decreases the real value of your money. So, while the actual number remains the same, it will be worth far less in years to come. In order to beat inflation, your money has to generate a return better than the prevailing inflation rate — and that’s where investing comes in.
Finally, in the case of negative interest rates, which have been seen in countries such as Denmark, Switzerland and Japan, you are having to pay to keep your money in the bank. So, in the case above, not only would your pounds be worth less due to inflation, you would actually have fewer pounds year-on-year.
So, is now the right time for you to start investing?
While no investment is completely risk free, sensibly investing your money in a diversified portfolio could help you to achieve the financial goals that are important to you.
Once you’re ready, you can start investing with Nutmeg today. It’s simple, straightforward and we’ll be on hand to help you answer questions you might have.
Nutmeg is offering a special offer of no portfolio management fees for 9 months for Money Dashboard users. To take advantage of this offer, start by entering your email address on our partner page. You’ll then be able to see the sorts of returns associated with each type of Nutmeg investment, with a sample portfolio.
As with all investing, your capital is at risk. The value of your Nutmeg portfolio can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance. Tax treatments apply.
