Top 5 Reasons Why Investing is Important

Why Investing is Important

Investing is important, if not critical, to make your money work for you. You work hard for your money and your money should work hard for you. As it happens, the bank is certainly not breaking a sweat paying you to keep your money in their vault. The onus is on you to put your money at work.

Not investing, or not doing it properly, can mean a longer working life. When taking investing seriously, the returns generated from your investments can provide financial stability in the future. Here is what different investment returns in your TFSA mean after 40 years. The debate over RRSP or TFSA first is ongoing but based on your situation.

TFSA Compound Growth - 40 years

As you can see from the graph, the first million takes the longest, after that it goes much faster. That’s why you often hear that the first million is the hardest. The growth is based on the maximum contributions allowable since 2009 with all future contributions post 2019 at $6,000 for simplicity. See the TFSA Contribution Limits for the details on annual contribution amounts. The TFSA alone can generate massive wealth in 40 years.

The returns that you expect from your investment will depend primarily upon your investment objectives, the amount that you invest and the timeline that you are looking at. There is a popular English proverb “you reap what you sow.” – it is essential that you sow, so that you can reap the benefits in the future. You eventually have to face up to the consequences of your actions (or lack of). Same goes with Investing. Investment is required to meet the important milestones in your life, be it sending your kid to college or building your own retirement fund. When it comes to investments, it is always better to start early.

What is investing?

Investing can mean different things to different people. While investing for some people means putting in money to achieve profit, for some other it can also mean investing time or effort for some future benefit such as investing in oneself’s skills or health.

In this context, we will define investing as “putting money into financial product, shares, property, or a commercial venture with the expectation of achieving a profit”. Investing means committing capital or funds to different types of assets with the expectation that you will generate a gain or profit in the future from these investments.

Savings vs Investing

Investing is also sometimes mixed up with saving and speculation. An investment is generally different from savings as an investment is a more active way of deploying your wealth while saving is generally understood as storing a part of your income without worrying about where you are deploying your surplus funds.

Investing vs Speculating

Investing is also different from speculation as speculation is generally considered as targeting high returns from your investments within a short period of time. Speculation may be considered as a form of a very high risk investment within a short time horizon. Investments are generally long term in nature and take care of the risks such that the returns are commensurate with the undertaken risk.

Top 5 Reasons

1. Higher Investment Returns

Investing funds in an asset involves a tradeoff as the investor foregoes the utility of using the funds for his investment in the present for some higher utility in the future.

  • Investment in stock can lead to returns through two ways – one could be through dividends while the other could be from capital gains.
  • Investing in a bond can benefit the investor in the form of regular payouts or coupons which are given during predetermined time periods.
  • Investing in real estate can also benefit an investor through rental income and capital gains.

2. Retirement Plan or FIRE

The majority of people invest for retirement purposes. As most people rely on their salary income for meeting their needs, it becomes difficult to sustain their lifestyles after retirement when one does not have a job. This means that everyone needs to invest a part of his income during working years to ensure a nest egg during his retirement years. While the government and companies used to give a defined benefit pension plan for employees earlier, now one has to mostly rely on defined contribution plans.

A lot of young people also want to retire early so they need to invest a larger portion of their income in order to meet their goals. The “FIRE” movement has become a major movement amongst millennials. “Financial Independence, Retire Early (FIRE)” is a goal that many are striving for these days. Saving a major proportion of income from a young age (as high as 70% of your income) can allow one to retire at the age of 40-45 years, instead of the 60-65 years. The FIRE movement advocates a frugal lifestyle both at the time of investing as well as during early retirement.

3. Tax Efficiency

Investing can also help in saving taxes as there are accounts such as the RRSP, TFSA, 401k, Roth IRA and others where the taxes on your investments is lower or non-existent. As governments reduce their responsibility towards funding their citizens’ retirement years, they have created these types of accounts so that citizens can contribute and fund their own retirement.

4. Beat Inflation

Investing is also important to beat inflation. If you don’t invest your money but just leave it in your checking or savings account, the money will decline in purchasing power as inflation will eat away the value of your money.

While the reported inflation is quite low nowadays, the actual inflation is quite high as education and healthcare expenses are increasing much faster than reported inflation. Banks are not even paying 2% on your savings deposit which means that if you do not invest, your money will lose value over time. Even this 2% return may not sustain for long as other foreign central banks have cut close to 0% or even lower. This means that you could face a day when your bank deposits earn 0% return or even negative returns sometime in the future when inflation is taken into account. To insure yourself against such a situation, it might make sense to start investing in a mix of assets which can beat inflation.

5. Reach Your Financial Goals

Investing is one of the key ways in achieving the financial goals for oneself. As an individual grows through life, there are new financial requirements that come up. It usually starts with buying a house. Even if one funds a house through a loan, there is the requirement of a substantial down payment. By investing through a mix of assets, an individual can build up the corpus required for the down payment.

Another major investment goal can be the college education of children. With the steep college tuitions required these days, a parent can start investing for college tuitions even when the children are still very young. Besides these financial goals, retirement is always an omnipresent financial goal for people during their working lives.

Downside of Investing

While investing has many advantages, there are some disadvantages to investing as well.

1. Losses

There is no such thing as a total risk-free investment and there is always the risk of a loss of your investment. Even government securities which are considered as the safest type of investment are not totally risk-free. Governments can default on their debt and there are numerous instances of such defaults in modern history.

2. Requires Investing Knowledge

Investing requires specialized knowledge about finance and different types of asset classes. Experience is also very important in investing, as an investor who has seen a number of economic cycles can, in general, navigate different types of situations better than a novice investor. Since most individuals do not have training in finance, they may require the help of a financial advisor. Choosing the right financial advisor is a difficult task due to the potential conflict of interest on how they are paid.

Types of Investment Assets

Investing is very closely related to risk which is an indicator of the return that you would expect from investing in a specific asset. Generally, the higher the risk of an asset, the higher the return that is expected by an investor. For example, the risk from investing in a stock is generally higher than that of a bond so the return expectation is also higher from stock than a bond.
There is a wide spectrum of investment assets each of which has a different risk profile. Some of the common types of assets are – stocks, commodities, fixed income, gold, real estate, art, derivatives and alternative investments such as venture and private equity capital.

Risk vs Rate of Return

Types of Investing Styles

There are also different types of investing styles, also known as investment strategies, besides the different types of investment. The mains ones are outlined below in order of knowledge / effort. The investing style approach you choose will depends on your interest in the topic and the amount of time you are willing to invest in. None are better than the other for generating returns. It’s really up to your skills and lady luck since no one can predict the future.

Index Investing

This strategy is based on John C. Bogle’s investing approach where instead of focusing on beating the index and paying high fees, you would mimic the index at very low fees.

There is a huge momentum nowadays with index investing. It allows for any investor to put their money at work with little knowledge and still get good returns. It is also argued that over a really long period of time, no investors can continuously beat the index. Why try to beat the index if professionals can’t do it is their final conclusion.

Dividend Investing

This approach focuses on dividend stocks with the goal to earn an income and / or use the dividend growth as a method to find high quality growth stocks. A dividend income stock will usually have a higher dividend yield where as a dividend growth stock will have a lower dividend yield.

Retirees often seek high yield stocks to fund their retirement in an attempt to avoid depleting their portfolio. This method provides a method to avoid running out of money and have more control over it.

Value Investing

This approach is probably closer to Warren Buffett’s investing method where he looks for strong companies with an economic moat that is undervalued. Identifying an undervalued stock can be very difficult but also profitable when you can spot them.

Valuation is not a simple technique and there are books written on how to do it along with theories from scholars. This approach requires patience.

Technical Trading

This approach looks at trends from the stock price movement and volume. The patterns are mostly based around how the general investors is approaching investing which leads to recognizable patterns.

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