Why Is Investing Important?

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If you are not yet investing, you may be wondering why you should. For most people, the most important reason to invest is so you will have enough money to live on after you retire. Once you retire, you’ll stop getting that steady paycheck and will need another source of income to fund your lifestyle.

A comfortable retirement isn’t the only reason to invest, of course. You may also want to build your wealth to pass it on to your children or donate to charitable causes. Investing is important for these reasons as well.

Here’s what you need to know about why investing is important.

Investing For Retirement

No matter how rewarding your life’s work is, at some point, you may decide to stop doing it. When you do, you’ll need to support yourself after the paychecks have stopped. Social security and pensions may be one way, but they’re only part of the picture. Investing during your working years can help you live worry-free in retirement.

Here’s why investing for retirement is so important.

Social Security Alone Won’t Cut It

Social Security is designed to replace about 40% of your pre-retirement income. Granted, you will likely have fewer expenses in retirement — no commuting expense, work lunches, etc. — but a 60% pay cut is untenable for most people. So you’ll need to have some money put aside if you want to even approach your former standard of living.

Pensions Are Becoming a Thing of the Past

A pension is a retirement benefit provided by employers to help their employees after retirement. Years ago, many people working for the same company for their entire career, and, at retirement, were rewarded with a steady stream of income equal to some percentage of their working salary.

Most private sector companies have eliminated pensions because they got too expensive to administer. With people living 20 or 30 years after retirement — instead of 5 or 10 as they did when pensions were conceived — pensions became a financial burden for employers.

Some professions, such as teachers and law enforcement, still offer pensions, and they are often sufficient to allow these workers to enjoy a standard of living in retirement that is similar to what they had while they were working. But if you don’t have a pension, you’ll need to invest.

The Inflation Issue

Putting your money in a savings account or a CD at the bank will actually cause you to lose money in the long run. While your balance will creep up slowly over time, your purchasing power will decrease.

Inflation causes prices to go up, which means you can buy less with the same amount of money. Inflation affects everything we buy — food, housing, energy, etc. And while the inflation rate we’re experiencing right now is unusually high, inflation is always there.

If the amount you are earning on your money is lower than inflation, you’re losing purchasing power. Here’s an example. Suppose you have $1,000 invested at the bank, earning 1% interest. Inflation is 2%. Each year, the money you are saving will buy 1% less — 2% inflation minus 1% interest on your savings. One percent may not seem like a big deal, but add it up over 40 years and you’ve got a problem.

Reasons Why Investing Is Important

Whether you are concerned about retirement or want to build wealth for another reason, there are several arguments for investing. Here are some of them.

Better Returns

Historically, investing provides better returns than guaranteed investments like bank accounts and CDs. Since 1926, the S&P 500 has returned an annual average of 10.05% per year. Savings rates at banks are still hovering in the very low single digits, and are not expected to rise significantly, even with the federal funds rate rising.

Beating Inflation

The annual average return of the S&P 500 adjusted for inflation is 6.89%. The average inflation rate from 1926 to today is 2.98% per year, so any investment that returns less than 2.98% per year is causing the investor to lose purchasing power over time.

Compound Interest

When you invest, you earn money on your money. When you leave these earnings in your investment account, you’re earning money on your earnings, too. When your investment is returning 10% — like the S&P 500 — instead of 2% — like a CD or savings account — the importance of compound interest becomes clear.

Here’s an example. Joe is 26 years old and puts $5,000 per year in his IRA. He invests his $5,000 per year in an S&P index fund that returns an average of 10% per year. He does this for 40 years, until he retires at age 66.

In the 40 years he worked, Joe has saved $200,000 toward his retirement — $5,000 per year for 40 years. Because he invested this money, and his investment earned the average return of the S&P 500, he now has $2,434,259 in his retirement account.

If Joe had put his money in a savings account that earned 2% interest, he would have $441,177.17.

Tax Deferral

This advantage applies to retirement investing specifically. If you invest in an IRA, 401(k) or another qualified retirement account, you get the advantage of tax deferral. You deposit money into your account before paying any taxes on it. As it earns money, those earnings are not taxed. You only pay taxes on the money when you withdraw it.

Presumably, you will be in a lower tax bracket in retirement than you were when you were working, so this should result in you paying less in taxes than you would have if you had not invested in a qualified account.

Note that there are limits on the amount of money you can save in an IRA, 401(k) or another retirement account. If you want to save more, you can put it in a regular investment account, but you won’t get the tax deferral.

Investing to Build Wealth

If you are already saving enough for your retirement — or if you’re already retired — your reason for investing may be to build your wealth to pass on to your children or to do good by donating money. If this is the case, the advantages of investing for retirement still apply, with the exception of tax deferral.

There are ways to minimize taxes when you transfer your invested wealth, however. If you donate appreciated shares to a charity, you get a tax deduction for the present value of the shares, even though you may not have paid tax on the gain. And when you pass on your investments to your heirs at your death, they get a step up in basis. This means that they will only be taxed on any gains that occur after your date of death.

The Importance of Starting Early

You don’t have to start by investing a lot of money, but you do have to start. The earlier you start, the better off you are, even if you start with less and increase your savings as your income increases.

To further the example above, if Joe had waited just five years to start investing his $5,000 a year, his retirement savings would be $1,490,634. Still a tidy sum, but nearly one million dollars less than he would save if he started at age 26 instead of 31.

If you start investing for retirement with your first job, you can increase the amount you save with each pay raise you get. Try this trick: every time you get a raise, split it with yourself. If you get a 4% raise, add 2% of your salary to your retirement savings and “keep” the other 2% for yourself. If you do this as soon as the raise takes effect, you’ll never miss that 2%.

Final Take

What’s the most important thing to remember about investing? It’s not to “buy low and sell high” or to “buy what you know” — although those are both important. It’s simply to start. Take $100, $1,000 or whatever you can and invest it. You may see the value of your investment go up and down week to week, month to month or even year to year, but historically, over time, the general trajectory of the market is always up. So start today.

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