Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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Investing is a big scary word that conjures up confusing terms like asset allocation, internal rate of return and volatility. Most people see these words and just give up trying to understand investing, let alone why investing is important.
And yet, we still know that it is important to invest in the future.
But why is that?
To understand the importance of investing we first need to define what it is in the simplest way possible.
What Is Investing?
Investing is a very broader term but we’ll simplify it to mean putting money into something that you believe will produce more money for you.
There are a lot of nuances there. For example, the money invested is usually meant to help a company operate, expand, or buy assets. That is how they can then pay you back with interest (or other pay outs).
Also, investing is different than gambling which technically can have the same definition as the one I gave above. The nuanced difference there is that gambling is a game of odds while investing correctly is more about a company or individual’s performance.
Still, it can be hard to grasp what investing is. So just think of it as you put money in and you get more money out. And someone used it to make more money in the middle of that.
Four Different Types of Investments
There are many different ways to invest your money and each one has different potential results. How you choose to invest is entirely up to you. But you need to understand how you will make your money to decide what to invest in.
1 Interest Investing
Interest investing is the easiest one to understand. You invest $1,000 at a 10% per year interest rate and one year later you have $1,100.
Of course compound interest makes it a bit more complicated than that, and we’re not going to even talk about how your bank calculates the interest they pay you (that’s a nightmare), but the principle is pretty basic.
The most common type of interest investing is investing in bonds. Bonds are basically a note that says if you pay this much money in today you’re guaranteed that much plus a fixed amount of interest back later.
A savings account also pays interest, but the amounts are usually so small they can hardly be called investing. CDs are a bit better, but not by much.
The best paying form of interest investing is private lending. That is where you give money to an individual who promises to repay it, usually at a higher rate.
The reason the rate is higher though is because it is a riskier investment (they’re more likely not to pay you than say a US government bond).
Interest investments are usually best used for maintaining the money you have, but not growing your money long term.
2 Appreciation Investing
Appreciation investing is the second most common form of investing because it is how the bulk of 401(k)s make their money.
The idea here is that you buy something, usually a stock, at a certain price. The price goes up, you sell it at the higher price, and you keep the difference.
This is how stocks work, but it is also how real estate works, as well as commodities like diamonds, gold, or even oil.
You buy something that you believe will go up in a value then you sell it at a higher price.
Appreciation investing is tied to speculation. If you are choosing a single stock to invest in that you think will go up in value, or if you’re buying a house in LA because you believe it will double in price in the next three years, you are speculating.
Speculating is just buying single assets with the hopes of selling them for more money later. If you speculate correctly it can be extremely lucrative. If you don’t then you can lose your shirt.
Speculating is basically the investor version of gambling.
The easiest way to invest for appreciation is to invest in an index fund of stocks. It all but removes the risk of speculation while still giving the steady long term growth of appreciation investing.
Index funds are also a completely passive form of investing, which is a huge bonus.
3 Dividend Investing
Dividend investing goes hand in hand with appreciation investing, though there are situations where they aren’t connected.
Basically, the idea is that if you own part of a company that you deserve part of the profits. When the profits of the company are totaled (usually quarterly) you get a check for owning part of a company.
Most people have at least some dividends being paid to them in their 401(k), but it is not where the bulk of your retirement money comes from.
Most people choose (by default) to reinvest their dividends, so they come out feeling basically the same as appreciation investing.
Dividends are also paid to junior partners in real estate syndications and other large business ventures like that, which most people won’t ever participate in. For that reason, dividends are relatively uncommon.
But, being paid dividends allows the investor to have a little cash coming in while their appreciation investments grow.
So dividends are helpful to sustain investment and provide some cash flow to the investor in the short term.
4 Rental Investing
Rental investments are more than just owning a house and renting it to someone. Any time you own something and let someone else use it for a fee, that is rental investing.
Real estate is the number one (and most tax advantaged) form of rental investing, but there are others. Vending machines are rented out, so are bounce houses, parking spaces, cars, tools, equipment, baby supplies and so much more!
Very few people get into this kind of investing because it isn’t completely passive (you at least have to manage whoever is handling the renting process) and it usually requires a fair amount of money up from.
It is important to note that it is only rental investing if you are renting it out. As soon as you stop renting out an “asset” it becomes a liability.
Rental investing is mostly for cash flow. It starts generating cash that you can use right now. Truly savvy investors, however, usually reinvest that cash flow.
There are other things that people will call investments that are not really investments.
First, your car is not an investment because it costs you money and goes down in value. Cars only become investments when they become collector’s items, but even those are speculative.
Second, your house is not an investment because you are paying a bank to live their and not making money off of it. If you rent a portion of it it becomes an investment.
While some might argue that the appreciation on the house makes it an investment I would say not really because most people sell their house too often to really benefit from that and counting on your house being worth more is not a good retirement strategy (for example, those that retired during the Great Recession).
Third, currencies (like gold or bitcoin) can be considered appreciation investing, but they are really just speculation. At best gold or bitcoins are ways to protect yourself against inflation.
Why Investing Is Important
Now that we understand what investing is we can start to break down why it is important to invest. There are many different reasons why investing benefits you, but we’re going to break it down into five reasons investing is important.
1 Beat Inflation
Money has a certain value, but that value is always changing. The way that this value is measured is by how much you can buy with the same amount of money from year to year.
For example, when I was a young kid I remember I could buy two good sized candy bars for a dollar (I lived in Oregon, so there was no sales tax). Now, you can only buy 1 candy bar for a dollar, and maybe have some change left over.
This decrease in value of money OR the increase in costs to buy things is known as inflation.
Inflation in small amounts is pretty normal in a modern economy. Whether you want it or not, it is there so we need to take that into account.
Economists often say that inflation should run at about the 2-3% range from year to year.
That means that if you have $100, and there is 3% inflation over a year, that money will only be worth about $97 compared to last year even though you still have $100 in the bank.
Another way to look at it is candy bars. Let’s say the candy bars cost $1. So you can buy exactly 100 with $100. After 3% inflation they now cost $1.03. So now you can only buy 97 candy bars. ($100 / $1.03 = 97.087)
In effect your $100 today is only as valuable as $97 was last year because you could buy $97 candy bars with it.
If you park your $100 in a bank for 30 years (getting basically nothing in interest) you can expect that $100 to be really only worth about $47 (assuming 2.5% inflation on average).
So how do you stop inflation from destroying your wealth? You invest!
In order to grow your wealth you have to get more money back each year than inflation takes in value.
If you invest $100 and get a 6% return you now have $106. But you lost about $3 to inflation, so really you have $103. You’re better off than where you started and you’ve beaten inflation.
Without investing your money will become worthless over time.
Use this inflation calculator to test other assumptions. But please note that you need to put in a negative number to show the drop in value of the dollar, since that is the effect of inflation.
2 Preparing For Retirement
Preparing for retirement goes hand in hand with beating inflation.
While you are working a small amount of inflation doesn’t really make a difference because you’ll probably get a cost of living adjustment each year to make up for the inflation.
But if you’re saving money in a savings account to use for retirement then you’re losing 3% of that amount each year which means the money you put in at the beginning will feel almost worthless.
That’s where investing comes in. Investing in stocks, for example, can grow the money you put in at a faster rate than inflation. This means that you’ll have much more money that you put in 30 years ago by the end rather than less.
To put it in perspective, if you invest that same $100 that became valued at $47 due to inflation by sitting in the bank it would become $574.35 at the end of 30 years (at a 6% return). And if you minus 3% for inflation, the real value is $242.73. I’d much rather have my money grow 142% over the course of 30 years than drop 53%.
So if you want to be able to retire you’ll need to invest your money.
For example, to save $1,000,000 over 30 years you’d need to save $2,777.78 per month (not including inflation decreases). But if you invest to get $1,000,000 you only need about $1,000 a month (at a pretty low 6% interest rate).
Play with the investor.gov compound interest calculator can help you understand the power of investing.
3 Tax Advantages
Politicians give lip service to the working class people that grind day in and day out, because that is who their voter base is.
But if you look at the way taxes are, politicians understand that investors are what keep the economy afloat. The government keeps investors happy by offering tax advantages to them.
Now, the working class can be investors and get those tax advantages, primarily through vehicles like the 401(k), but the more you understand investing the more you’ll discover that investing is a way to shield yourself from taxes.
The two primary vehicles for tax advantage I’ll mention though are the 401(k) and the ROTH 401(k) because they apply to the most people.
Please note that an IRA, Roth IRA, 403(b), ROTH 403(b) and others are essentially the same as a 401(k) in this context.
When you invest you make money. And when you make money, naturally the government wants their piece of the pie. But when you’re investing for retirement they give you some options to reduce the amount of money you owe them.
My favorite is the ROTH. Any retirement investment vehicle that has the word ROTH in front will follow this format. You put after tax money in and then you pull out your money, even money that grew from investments, tax free.
For example, let’s say that you make $100. You owe 15% in taxes, so you take home $85. You invest that $85 in a ROTH for 30 years and now you can pull out $488.20 tax free. That’s over 500% of growth tax free!
The other option is the traditional 401(k). In this scenario you put that money in before it is taxed, so it reduces the amount of money you owe in taxes right now. But, when you pull that money out it will then be taxed.
Now if we invest $100 and let it grow for the same amount of time then pull that all out in 30 years at a 15% tax rate we will end up with $488.20 just like the ROTH account. That’s how multiplication works. You can do it in any order.
However, the reason I don’t like the traditional as much is that you don’t know what the tax rates will be in the future. And if history has shown us anything, they are more likely to go up than down.
Also, any money you put into a ROTH account can be pulled out (since it is after tax money), if you absolutely need it, without penalty. Now there are rules about doing that and you should talk to a CPA first, but it is an added bonus.
If, however, you make too much money now, the traditional 401(k) is a great way to reduce your taxes upfront because you’ll likely end up with a lower tax bracket in retirement.
Either way, if you invest for retirement you’ll be better off on your taxes which is a great reason to invest.
4 Leavings Money For Future Generations
Okay, now let’s say you’ve really got this investing thing down. You’re putting money away, beating inflation, getting great tax benefits and you’re on track to have plenty of money in retirement.
So you’re mind turns to your kids, and their kids. What can you do for them?
Let’s say you’re average and you have two kids. And they also have two kids. So you want to leave money to a total of 6 people.
Now let’ say you’ve accumulated 6 MILLION dollars! Wow, you’ve really made it.
When you die you give each of them a big, fat check for $1,000,000 each.
Ignoring taxes, you might think they’re set for life.
But even if they don’t go blow it on a yacht, that is only 20 years of spending at $50,000 a year. That’s only 1/4 of current expected life time!
The other option is to have the 6 million dollars perpetually invested through a trust. I’m not going to get into the legal stuff there (I’m not qualified), but basically the heirs (your kids and grandkids) can’t actually access the $6 million dollars, they can only access what you give them which would be the growth on that money each year.
The 4% rule of thumb states that they should be able to take about 4% of the earnings from the $1,000,000 given to each of them each year without ever running out of money.
The 4% rule is more nuanced than that, but we’ll roll with that for now.
That means that you’ve now gifted them $40,000 a year FOR LIFE, which they can then gift to the next generation. If they don’t take the full allowance out each year it only grows. And that, very simply, is how wealthy families can stay wealthy.
Investing gives you that option.
5 Sustaining Growth
The last reason to invest is that it is good for the economy in general. I know this doesn’t seem like a big deal, but the importance of investing is that it keeps businesses growing.
Recessions happen when capital, the money used to grow businesses, dries up. That capital comes from investors, even small time investors like us.
Without us our economy falls apart and that isn’t good for anyone.
So if you want to keep things chugging along, invest your money.
And when things stop and fall into a recession, just keep investing because it will bounce back, and when it does you’ll be all the better for it.
Disadvantages of Investing
Now there are downsides to investing. If there weren’t then it would be too good to be true and everyone would be doing it.
1 Risk Losses
Investments, especially in the stock market, don’t just go up constantly. It isn’t an interest account like a savings account. So pretty often you can expect to see your investments drop in value.
There are ways to protect against that, but if you are investing in speculations then you could lose all of your money.
We should only invest money that we don’t need for the long term because that is where the money is made, over decades, not weeks.
Remember, when a stock that you own drops in value you haven’t officially lost money until you sell it. Wait it out, diversify what you invest in, and this disadvantage really won’t matter.
2 Being Duped
People often wonder why it is important to learn about investing. It is important to learn about investing because if you don’t understand it you’re likely to lose your money or be duped in some way.
The number one “dupe” is the latest stock tip. People will always tell those that are willing to hear that they know the latest and greatest company to invest in. If you haven’t taken the time to learn about that company then don’t!
Blind speculation is the best way to lose your money or give it to someone who doesn’t have your best interests at heart.
But, with just a little bit of education, this disadvantage can be mostly ignored.
Most investments come with some sort of fee that you have to pay. If you aren’t careful, fees can take all of your hard earned money and pour it down the drain.
Here is where it is important to talk with your HR team and also to educate yourself on your investment options.
Usually, when you sign up for a 401(k) your company will have a mutual fund of some kind that your money is automatically invested in. That doesn’t mean it is the best option. It is just the option that your bosses happened to get sold on.
Review your options careful and find whichever you think will get you the largest growth for the least fees.
Some funds have as much as 2% in fees! Between that and inflation you’d have to make a 5% return on investment before ANY money goes into your pocket.
Other options, such as most index funds, have fees as low at 0.5% or even 0.05%! That is a huge difference which could make or break your retirement.
Know the fees you’re paying, and do what you can do reduce them. Once you have you won’t have to worry about this disadvantage anymore either.
How Do Beginners Invest?
If you’re a beginner who wants to start investing then it is important to start learning. You can’t make good investments without good knowledge.
Fortunately, there is a perfect place for a beginner to start. That’s with index funds.
The reason this is the place to start is because I can teach you everything you need to know about index funds in just a few sentences.
First, when you invest in an index fund you own a broad range of stocks so it is diversified, meaning the risk of losing all your money is basically 0.
Second, an index fund closely mirrors the average performance of the stock market, so historically you’ll make about a 10% return over the long term.
Third, fees for most index funds are under 1%, with some as low as 0.05%, so you keep most of your money.
Fourth, you can set it and forget it, making it easy for a beginner who doesn’t have time to think about investing.
This is the easiest way for beginners to invest, and honestly, some investing experts choose to just invest this way because it is almost fool proof. If you didn’t learn about a single other type of investing you’d probably be okay.
Is Now a Good Time To Invest?
People are always asking, but is now a good time to invest? This usually comes from a place of fear.
If I invest now and then the market drops I’ll lose all of my money!
That might sound like it makes sense, but it is completely bogus.
Let’s say you invested $10,000 in an index fund before the crash in 2008. After such a huge crash that everyone is so scared of you would still have had over $8,000.
Now if you panicked and pulled all of your money out then you’ve lost $2,000.
But your losses in the stock market don’t become real until you actually sell.
So let’s say you held on and kept your money in the index fund because that’s what some blog post told you to do.
By the end of 2020 you would have over $30,000!
Try it yourself with this historical stock market calculator.
The point I’m making is that if you’re investing for the long term it doesn’t matter if the market crashes tomorrow because you don’t need that money tomorrow.
So don’t concern yourself over a market crash today unless you are retiring today. In the end, it will work out and you’ll be grateful you started investing.
Why do you think it is important to invest? Can you think of any other good investments for beginners? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Investing: Giving an entity (or an individual) money whether in the form of stocks, bonds, or buying any other type of asset in hopes of getting more money back in the form of interest, appreciation or other pay outs.
Compound Interest: When interest builds upon interest over time. So a 10% compound interest rate would start with $1,000 becoming $1,100, like simple interest, but then it continues and $1,100 becomes $1,210 and so on.
Bonds: To raise funds for a project an entity (usually a government) will sell bonds or certificates saying that if you pay X amount now you will get X back with interest later. This gives them the money they need now and gives the investor interest on their original investment later.
Speculation: Buying an investment with the assumption that it will go up in value. It has a high potential reward, but also a very high risk of losses.
Index Funds: A way to invest in stocks that puts a little bit of your money into every company listed in that index or list of companies. For example, the index could invest in all companies in the S&P 500 or all publicly traded companies, etc.
Cash Flow: Money coming into your pocket from investing (either through stocks, real estate, or other assets). This is NOT the same as income because it doesn’t necessarily require you to work for it.
Inflation: Money losing value over time usually due to more money being put into circulation.
4% Rule: A rule of thumb–if you pull out 4% of your total investments each year of retirement then you won’t run out of money over a 30 year long retirement. For example, if you have $1,000,000 invested you can pull out $40,000 in a year.
Return on Investment: How much money you get back, usually measured yearly, on the money you invest in something. For example, if you invest $1,000 and receive $100 back from that in the course of a year then you’ve had a 10% return on investment.