All you need to know about investing short and simple
© Leonardo Timis
CHAPTER 1
WHY INVESTING?
1.1 Cost opportunity
The first reason why wealth should not be kept in cash but instead invested in assets is the cost opportunity effect. A lost income from a real estate rent or a stock dividend is a cost (i.e., cost opportunity).
Moreover, not reinvesting that income affects your overall wealth in the long term, considering the compound interest return that would be lost over that time. With compound interest return, we mean a return rate that is applied to any periodic income that comes from your initial investment.
In other terms, you are reinvesting whatever you earn from your initial investment.
Let’s say that we invested $50,000 at only 5% per year, and we keep reinvesting the initial capital plus whatever is earned back, every year, at the same rate. The exponential walk of the compound interest return would reward us back with $81,444.73 after 10 years, $132,664.89 after 20 years, or $216,097.12 after 30 years if we kept reinvesting everything. Therefore, not investing $50,000 would make us lose $31,444.73 over 10 years, $82,664.89 over 20 years and $166,097.12 over 30 years. This money lost is due to the cost opportunity effect.
The bottom line is that the more we wait, the more the compound interest return rewards us back, and it does it exponentially.
1.2 Inflation
The second reason why wealth should be invested in assets is inflation, which is defined as the price increase of goods, services, and assets over time.
The best explanation for this constant increase in prices that has been seen over the last century lies in the economic system humanity has built. In our modern economy, the monetary policy is defined by a powerful public player, which is the central bank. The monetary policy is the power to print new fresh money, which is then pumped by the central bank into the economy, usually by buying debt from the government, which is actually the one that spends this money into the economy.
Most modern countries have a central bank, and almost all of them have a goal to keep inflation between 0% and 2% per year because it is good for the country's economy.
But why inflation is good for the economy?
If prices of goods and services were falling (i.e., deflation), people would stop buying because they want to wait until the prices reach the minimum level. But this waiting strategy clogs the economy; waiting for the minimum price level triggers no more exchanges, which triggers no more production. An economy can be simply defined as a group of people (country) that exchanges continuously in order to satisfy their needs, but when these people stop trading, there is no economy. Deflation is the worst nightmare of central bankers.
How does inflation work?
The more money is circulating into an economy, the more prices are high. The new fresh money created by the central bank is distributed by the economy on all goods, services, and assets making their prices increase - not all types of goods, services, and assets suffer the same level of inflation though, some of them become more expensive than others depending on how the economy distributes this new fresh money.
The bottom line here is that the higher the prices, the less you can buy with your same previous amount of cash held in your pockets; this is named ‘loss of purchasing power.’ On the contrary, if you kept your wealth on assets rather than cash, you would benefit from inflation. Over time, cash loses its value while assets increase their value because of inflation.
Last observation. Monetary policy is just one of the multiple variables that impact inflation, but it is the most effective one in the long term. There are other variables that trigger inflation; one of these is the formation of coalitions and cartels at a specific point of the supply chain.
For instance, the formation of a big cartel in the oil industry led during the 70s to a substantial economic decision power held in the hands of a few, and these few oil producers decided to augment the oil price by cutting the global supply. Since the price of oil skyrocketed, the production cost of any good that involved the use of oil skyrocketed (many goods at the time involved the use of oil), triggering high short-term inflation, and with it, a global crisis.
That said, I have to be more precise on my previous statement, I said that inflation is good, actually moderate inflation is good, too much inflation leads to a crash in the economy like the one in the 70s – which went even over 10% at some points. That is due to the fact that people got scared of such price augmentations and became more conservative in spending, cutting their expenses. Again, when people stop exchanging, there is no economy.
Now we understand why central banks’ sweet spot for inflation is between 0% and 2%.
1.3 Conclusions
Investing your wealth in assets gives you the opportunity to exploit the compound interest return (paragraph 1.1) by reinvesting the periodic income that comes from your initial investment.
Furthermore, investing your wealth in assets gives you also the opportunity to exploit the price increase of your initial investment that comes from inflation (paragraph 1.2).
Compound interest and inflation, summed up, make a long-term investment incredibly attractive.
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