Inflation kills profits
For those looking to invest in stocks for the first time, it’s mandatory to first understand what happens when money stays in a regular savings account. Many people do this for fear of losing all their money. However, due to Inflation, you lose most of the interest you earn and then some.
Inflation sits on an average of 3% per year since 1900. It’s a silent killer that vaporizes your savings over the long term. To make it more concrete, anyone who saves 10.000 EUR sees his buying power diminish to 9200 EUR over 5 years. Fifty years later, only a small smoldering heap of cash remains, you accumulate a whopping minus 75 percent (see table). You don’t just keep that money under your mattress of course, so thanks to the interest you get from your bank it’s less, but insufficient to counter the inflation.
Stocks are the way to go
The past 150 years, bonds could compensate the inflation and even provide a small extra of about 2.3%. If you want to look at bigger returns and are able to invest long term, you must look at stocks. This investment provided an average real return of 6% over the past 150 years (this includes reinvestment of dividend).
6% might not seem like much, but when converted to ‘nominal’ yields, including inflation, this gives you 9 percent per year.
Compounded interest: The 8th wonder of the world
Those who think 6% isn’t much, might change their mind once they realize this return can repeat itself, year after year. Over the long term, this amasses to a massive amount Albert Einstein didn’t call compounded interest the 8th world wonder for nothing.
Thanks to the power of compounded interest it’s possible to make a fortune out of a small starting amount. Only One condition: start early and/or get a big return. Even better is combining both.
An example: If a student would invest all the money he has earned with his vacation jobs in stocks instead of spending it he need not save a lot the rest of his life (see table). With an average real return of 6% / year, he increases his buying power by 14.5.
His 10,000 euro turned int 145.905 euro. If this smart student is able to get a marginal better return of 7,25%, i.e., a 1.25 increase, he turned his buying power into over 300,000 euro.
Basically, small yearly differences accumulate throughout the years, thanks to the wonder that is compounding interest, and turn into ridiculous differences. Hence the big difference you see in the table if he were to invest in bonds alone.
Of course, that 6% is an average over a great period. Many investors haven’t yet forgotten 2008, one of the worst market years ever. Even the largest stock exchanges dropped over 40%. In contrast, at the moment we are in one the longest bull markets, meaning upward trending markets, ever, which started right after the aforementioned drop.
More often than not, after a period of sustained decline, there is a period if continuous rise.
So even if you have the horrible luck of entering the stock market at a really bad time, you can still end up in profit – on the condition that you remain patient.
Who bought stocks in the year 2000, at the peak of the .com-bubble, and then went down again with the financial crisis of 2008, would see his capital get halved twice. However, today even that bad luck Brian would be in profit.
Overall, the world’s main stock exchanges from 23 countries have since yielded an 80% nominal gain. Admittedly, that gives no 6 percent real revenue per year over those 16 years. But even those unlucky ones have seen their purchasing power increase by more than 2 percent per year. No savings account gets close.