We've spoken before about investing your money vs saving your money and why the difference between the two is actually pretty major.
We want to take a little bit of a closer look at the superpower that investing your money has, especially when it comes to rising up against interest rates and inflation.
There are two situations in which interest rates play a very important role with regards to money. The first is when you borrow money from an institution like a bank and pay a percentage of this amount to the bank. Think of it as the cost of being able to borrow money.
The second one is a bit more important when it comes to how you manage your money, specifically in the decision to either save or invest. This is the interest that you earn from a bank, in a savings account for example. If your money is kept in a bank account, you will get a percentage of the amount you have saved paid to you, usually monthly.
Interest rates fluctuate and are determined by various factors, such as the state of the economy. When interest rates go up, you get a higher return from money saved in a bank account. But they can also go down, meaning it may get cheaper to borrow money from the bank, but you also won't be earning much from the money you have saved.
Though interest rates change all the time, in the last 10 years the average reference interest rate (the repo rate) has been 5.6%.
Now, returns from investing in stocks on the stock market also go up and down regularly. In fact the value of a stock you are invested in could drop, grow and stay consistent all in the same year – or a matter of months. But the S&P 500, which measures the value of the top 500 US listed companies by market cap and is often used as an indication of the general performance of the market, has gained about 10% on average annually since it was introduced in 1957.
This supports the idea that over the long term, investing (in equities) is the best way to grow your money.
Ever notice how the things you used to buy a few years ago are now priced much higher that you remember? Everything is more expensive now than it was back then – cars, an iPhone or an average grocery shop. This is because of inflation, which represents the how much the cost of living has increased over time. Each year, your money buys you less than what it used to.
According to The Consumer Price Index for All Urban Consumers (CPI-U) for the 12-month period ending June 2022, inflation increased by just over 9%.
Think about what that means. If you had left your money in a savings account, only earning 5.6%, you would essentially have found yourself out of pocket. The price of living would have cost you more than the returns you would have gotten from keeping your money in a bank account.
If you had invested that money, you would have had the potential to beat inflation with any returns above inflation made from your investment. However it goes both ways. The stock market can be volatile and the prices of shares fluctuate all the time. You could also have experienced a loss on your investment over this period, which highlights why investing requires you to have a long-term point of view. Staying invested over a longer period of time allows you to ride out this volatility, and has been shown historically as the best way to grow your wealth.