inflation and compounding as reasons to invest

Written by 11:04 am Investing

Why should you invest?

About 6 minutes to read

You may be wondering why on earth anyone would want to invest their hard-earned cash? After all, the investment realm is often littered with jargon (rest assured, you’ll see none of that from us) oozing with complexity not to mention being a rather chancy prospect. 

Alas, perhaps you’re better off stashing all that dosh in a humble no-nonsense savings account? Now while this may sound like a rather tempting option (at least on the surface), your money is exposed to the forces of inflation (rising prices) which over time will sadly melt it away. Thankfully compounding’s in town! (More of that glitter later). 

We’re living through a period of ultra-low low-interest rates which means that if you leave money in a savings account, you’ll earn an interest rate that is well below the level of inflation. In other words, you’ll be losing money. I like to think of inflation as the sun to your ice cream or the water to your snowman. Take your pick. 

Say you had £100 in a savings account while the rate of inflation was 3% and the interest rate was at 1.5%. While your £100 will grow (at the end of year 1) to £101.50 inflation will mean your money will be worth less (£98.46) than you started with! 

So how can we beat this inflation beast and set ourselves up for financial freedom? The answer is (you guessed it) by investing; not saving. Interest rates as they stand are at a piddly 0.1% – not much in the way of compensation. 

Before we dive in, a caveat if I may: It is important to hold 3-6 months’ worth of your salary as a cash buffer (here’s where savings accounts come in handy) in case you need urgent access to money. The last thing you’d want is to be forced to sell investments when markets have taken a tumble.

So, before we embark on this (exciting, I hope) investment journey together let’s first work on that rainy-day fund. You’ll thank me later. 


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Your ticket to freedom   

What makes investing so special is that it is accessible to most people. It is easier now more than ever to set up an investment account and get going. Not to mention the wealth of information that is available to you all through the wonders of the internet and henceforth the democratisation of investing.

Investing requires two resources only: time and money. And it is the time bit that you want to truly maximise. Yet on the surface this almost sounds too simple that many fall into the trap of fiddling around with their investments (especially during downturns) and engage in endless buying and selling. During the crash of March 2020, a whopping 24% of investors sold all their investment holdings. Ouch.

Instead, define your own set of rules and stick to your game plan while trying not to obsess over short-term market moves however difficult that may be.   

Remember this: markets (over the long-term) will always go up. Some (the FTSE 100) may take longer than others but they (will) all get there in the end. Take the S&P 500 – a plain, unglamorous US index but had you stashed your money in there for just five years you would have (almost) doubled your money, with the index returning a whopping 99.8%

The worst time is tomorrow; the best time is today

The trouble is that not enough of us are invested. Recent surveys carried out during the pandemic indicate that only 3% of the UK population have a Stocks & Shares ISA (tax-free wrappers*) but perhaps more encouragingly is that 33% of Brits own shares. Hooray! 

We should all be taking full advantage of the capitalism that surrounds us. After all, what better way to earn a return on your capital than by riding on others’ success? When Jeff Bezos founded his empire (what started out as a simple bookshop in Seattle) we all had the chance to invest and be a part of his journey.

Don’t let opportunities like this pass you by. 

*When investing your capital is at risk. Tax treatment depends on individual circumstances and may be subject to change in the future.


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Compounding: The eighth wonder of the world 

It is thought to have been Albert Einstein (though not actually proven) who said that “compounding interest is the eighth wonder of the world. He who understands it earns it, he who doesn’t, pays it”.

Small but consistent gains over a stretch of time grow to great amounts. It’s almost like magic. 

Let’s take an example to bring this spell crafting to life. Say you’re a rather savvy investor and have managed to bag a 7% annual return on a £15,000 investment, here’s what you’d have made over the next 30 years: 

Past performance is not a guarantee of future results.

While the gains between years 0-10 are not terribly exciting (in % terms), the following 20 years is where the bulk of returns come from – thanks to compounding doing its thing. It can be awfully tempting to want to take out your money early on but look at what you’d have missed out on. In the stock market time really is your dearest companion. 

Here’s a handy trick (Rule of 72) to calculate the number of years it will take for you to double your investment: 72/Rate of return = Years to double.  

Back to our £15,000 example. The rate is 7% which means it will take 10.3 years for you to double your money. So, over a 50-year horizon, the £15,000 will double 4.8 times. That’s pretty slick. 

Here are a couple of visuals to bring it home.

The below chart shows what happens when you invest £10,000 with and without reinvestment (assuming a 9% return).

Past performance is not a guarantee of future success. Source: The Good Fi

The green bars show your £10,000 without reinvestment which means that you are only earning interest on your initial investment. Your investments will grow at an anaemic and rather sloppy pace by not reinvesting earnings.

Take a look at the huge gap between the two – it’s massive! A whopping £268,000 to be precise. That’s a lot of lost cash.  

Compounding is like watching grass grow. It’s that slow. But you have to trust in the process and remain invested. Had you taken your money out at year 36 (only 4 years earlier), this would have cost you (and your portfolio) close to 100k.

When it comes to investing, time really is your dearest companion. The earlier you start, the better.

Let’s take a look at what happens when someone invests a lump sum of £10,000 at the age of 20 vs 30 (Assuming an average interest rate of 7%).

Past performance is not a guarantee of future results.

A modest decade between the two doesn’t sound like much, at first. But, for every 10 years that you wait to start investing you lose half of what you could have earned. Ouch. 

The best time is today; the worst time is tomorrow.

I like to think of compounding as growth on top of growth or, growth squared! If you have £100 in a bank account, earning a hefty 2% interest (which is no longer the case), after one year, this would grow to £102. After the second year, you’ll still be earning your 2% but on top of the £102, meaning your cash is now worth £104.04.

While this seems like a small amount it will build up over time. And that, my friends, is the beauty of compounding!

By putting your money to work in the stock market you stand a far greater chance of growing your capital than if it were to idly sit in a bank account. (Sorry folks). To not only protect but to (hopefully) grow your money it needs to return a rate that is at or above the current rate of inflation. As such, the equity market (buying shares in listed companies) is your best bet. 

While this investment talk is great it is important to establish that you should only invest what you can afford to lose. This sounds obvious but you will be amazed at how many people (including those I personally know) invest more than they can afford to lose. Make sure that you have enough money to pay those bills and then invest what’s left over and set those £££’s to work. 


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And now, to bring it home (literally)

Many of you will be saving for a deposit to (finally) hop onto that proverbial property ladder but as we know all too well, property prices have gone through the roof (pun intended). The average house price in the UK has eclipsed £242,832 this year. This means that deposits will have to grow in line with house price growth which can only mean one thing for all you homebuyers – that deposit of yours will have to stretch that bit farther.

But investing can lend a helping hand. 

So, house prices are on the rise (they’ve doubled in price since the ‘90s) inflation is rearing its ugly head (eroding your savings) and interest rates are still on the low. Not to mention the fact that we’re all living longer; our pensions will need to last us well beyond retirement. 

There is no better time like the present to begin your investment journey. Grab it with both hands. And it’s that easy: show up every month, top up your investment account (be it your ISA, LISA or Sipp), broaden your knowledge and let markets do their thing.  

Happy investing!  


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Maurizio & Edgar, Co-Founders, ikigai

When investing, your capital is at risk.

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Tags: , Last modified: 27 August 2021
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