Many would think that religiously socking money away in the bank is the safest way to grow their wealth. That is far from the truth. With banks giving low-interest rates of around 0.05% on our savings, it is hardly enough to beat inflation.
Over the long-term, Singapore’s inflation has averaged 2.6%. Therefore, our money in the bank is getting skimped away by the inflation-monster at a rate of 2.55% each year. Our hard-earned money is far from being “safe” in the bank.
Therefore, all of us need to learn to invest for a more comfortable retirement. The longer you can invest for, the more time your money has on its side for compound interest to work its magic.
The eighth wonder of the world
The world-renowned physicist, Albert Einstein, was believed to have once quipped that compound interest is the eighth wonder of the world.
Compound interest is the interest that accumulates on the initial principal and the accrued interest thereafter. Compound interest allows your principal capital to grow at a much faster rate than simple interest.
The beauty of compound interest is that the longer and earlier you invest, the stronger your money will compound.
Stock market newsletter Dow Theory Letters once published an article titled Rich Man, Poor Man. It talked about the benefits of compounding our money over the long-term with an example.
Rich Man, Poor Man‘s example
Say there are two people of the same age: Investor A and Investor B.
Investor A starts investing at the age of 19. He invests $2,000 every year from 19 till 25 and stops injecting money thereafter. This means he has invested a total of $14,000 into his stock portfolio.
On the other hand, Investor B starts investing only at the age of 26. From 26 till 65, he invests $2,000 annually in the stock market. By the time he turns 65, he has contributed $80,000 to his portfolio.
Assuming both investors can generate an annual return of 10% on their portfolios, whose portfolio would be larger at age 65?
Most would think that Investor B would have the larger portfolio. And yes that’s true – investor B indeed has the larger portfolio at $973,704. Investor A’s portfolio would be worth ‘only’ $944,641.
However, here’s the kicker. Investor A wins overall as he has higher net earnings of $930,641 on his investments versus Investor B’s $893,704. Remember that Investor A had only contributed $14,000 over seven years, while B contributed $80,000 over 40 years.
Rich Man, Poor Man also mentioned the following about compounding (emphases are mine):
“Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road.
And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.”
Time helps to accelerate the growth of our money. The following is the formula for compound interest:
FV = PV × (1+r)n
where FV = Future Value; PV = Present Value; r = annual interest rate; n = number of periods
As seen, the longer the period, n, the more compounding can occur, creating a larger ending amount, FV. This is also why everyone should start investing at a young age for the power of compounding to take effect.
Some investing ideas
So, what can ordinary folks do to grow their money and beat inflation at the same time?
One can invest in the SPDR STI ETF (SGX: ES3). The STI ETF is an exchange-traded fund (ETF) that tracks the fundamentals of the Singapore stock market benchmark, the Straits Times Index (SGX: ^STI). The Straits Times Index contains the 30 largest companies in the Singapore stock market. Since 2002, SPDR STI ETF has produced an annualised return of around 4% excluding dividends. With dividends included, the return goes up to 7%.
For those who wish to earn higher returns, they can choose to invest in individual stocks within a diversified portfolio. Three of the most recognisable companies in the local stock market – the banking trio of DBS Group Holdings Ltd (SGX: D05), United Overseas Bank Ltd (SGX: U11) or Oversea-Chinese Banking Corporation Limited (SGX: O39) – have historically produced returns that are greater than that of the Straits Times Index.
Five common pitfalls to avoid
Here are some common mistakes people make when it comes to investing:
1. Not starting early. Billionaire investor Warren Buffett bought his first stock at age 11, but he regrets not starting earlier. It’s never too early to start investing. Parents can kickstart their children’s investing journey by buying a few stocks of companies the kids are familiar with. (Note: You should first be familiar with the companies’ business fundamentals.)
2. Waiting for the right time to invest. There is never a right time to invest. The best time to invest is now. Time in the market is more important than timing the market.
3. Investing for the short-term. As seen earlier, for compounding to take effect, we need time to do its thing. Businesses take time to grow. Going in and out of the market will only hurt our portfolio returns.
4. Investing money you require in the next few years. We should only invest capital that we know for sure we do not need in the next five years at least. In this way, we will not become forced-sellers when the market has its mood swings.
5. Investing before paying down huge debt. Credit cards charge interest of around 24% per year. Compare that to the average long-term US stock market returns of some 10%, and the Singapore market’s long-term return of around 7%. We are “losing money” by choosing to invest in stocks instead of paying off credit card debt.
The Foolish takeaway
Investing is not just for the privileged few. Everyone of us can and should start investing to prevent inflation from eating our money away. Here at The Motley Fool Singapore, we strongly advocate long-term investing as it allows the effects of compounding to take place. And the best time to invest is: now.
Worried about the overall state of the market? Do you know the 1 thing you should never do in the stock market? The Motley Fool Singapore’s new e-book lays out a plan to handle market crashes, details the greatest advantage you have as an investor, and looks at decades worth of market data to bring you the smartest insights on investing. You can download the full e-book FREE of charge—Simply click here now to claim your copy
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of DBS Group Holdings Ltd and United Overseas Bank Ltd. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.