Welcome to our first lesson about the stock market! Before we go over the technical details of what it is and how to get started, it is important to know WHY we should be investing in the first place. Hopefully, having this information upfront will motivate you to continue to take this course seriously and make it a priority, even on those tired nights when you just want to watch Tv or your favorite streamer on YouTube.
The question about whether or not to start investing is a straightforward one, in my opinion. Yes, you should! If you do your due diligence (aka research) before investing your money in MOST cases, the benefits will outweigh the risks. If you only put money into a savings account, you are actually LOSING money.
That is because of something called inflation. Inflation simply means one dollar buys less today than it did yesterday. This is also referred to as purchasing power.
If you have ever talked to an elderly person, you have probably heard the “movies were a nickel back in my day” speech. This is a perfect example of inflation. Now you need over 200 nickels just to buy your movie ticket!
This can also be seen in the graph below, which shows the price of a loaf of bread over the last 70 years.
In the United States, the US Bureau of Labor Statistics (BLS) monitors the inflation rate. They calculate it by using something called the Consumer Price Index (CPI).
Experts aim to have a yearly inflation rate of 2%, which is considered “healthy.” The annual inflation rate is currently at 5.4%, at the time of this writing (2021), for All items.
Food and Energy are seen as more “volatile,” meaning their price moves up or down much more frequently. Some experts believe removing them from the calculation provides a more stable and realistic number.
The current rate of inflation is MUCH greater than current interest rates. Interest is the amount of money a bank will pay you for storing your money with them or the amount you will pay if you borrow the money instead of the one lending it (think of a car loan or mortgage).
An interest rate of 0.06% is extremely low. Historically the United States interest rates have been very low since the financial crisis of 2008.
Without going too much into its economics, the federal government will cut interest rates during a financial downturn. This makes it cheaper to borrow money, and in theory, businesses will be more willing to borrow and invest in their companies, which fuels the economy.
Saving your money in a traditional savings account is one of the safest routes. You do not have to worry about fluctuations in the Stock Market or losing your money in a house fire. Your account decreases only if you remove money via a withdrawal or the bank goes out of business. Nowadays, if a bank does go under, the FDIC will cover your losses up to $250,000.
Bank Runs were one of the many factors that led to the Great Depression in the 1930s. There were even instances where a bank run would happen because of false rumors that the bank was going out of business. This led to people running to the bank to get their cash, which ultimately put the bank out of business and turned the rumor into a self-fulling prophecy.
The important point here is that you are losing money if inflation is more than the interest rate. While the actual dollar amount in your account may be increasing, from the interest payments, your money is buying less than it used to.
The table below illustrates how inflation affects your bank account and your purchasing power. However, the example is very simplified for educational purposes and reflects one period, month, quarter, or year; however, you would prefer to think of it
Note: AB = Account Balance
AB with Interest = (Initial AB* Interest Rate) + Initial AB
AB with Interest = ($1,000*0.06%) + $1,000
AB with Interest =$0.60 + $1,000
AB with Interest = $1,000.60
AB Adjusted for Inflation = (AB with Interest) – (Ab with interest*Inflation Rate)
AB Adjusted for Inflation = $1,000.60 – ($1,000.60*2%)
AB Adjusted for Inflation = $1,000.60 – $20.01
AB Adjusted for Inflation = $980.59
Notice how at the end of the period you have LESS money than when you started? In this example, if you had $1,000 to start the period, you would lose about $20 due to inflation at the end of the period. And that is AFTER the bank paid you for storing your money with them. If you had 1 million dollars sitting in the bank, you would lose almost $20,000!
Keep in mind this is a modest 2% inflation rate. Let’s see how that same table looks using the current rate of 5.4%.
If you had $10,000 in the bank, you would lose over $500 with this inflation rate!
Inflation is often referred to as the “Invisible Tax.” This is because, unlike taxes, we tend not to notice how inflation affects our bills. Unless inflation increases quickly, and our bills increase rapidly.
Money Chimp has a useful inflation calculator that shows what inflation rates have been for previous years.
The benefits of investing are that your Return on Investment (ROI) generally outpaces the average annual inflation rate. On average, the market produces 10% returns per SoFi. This is a year-over-year historical average.
Adjusting for inflation, the average yearly ROI is positive even with a high inflation rate of 5.4%. By investing, we can counteract our money from inflation and increase our wealth. A historical chart of the S&P 500 can be seen below.
Investing as early as possible is critical; it gives you more time to ride out the years the market goes down. There are downsides to investing.
Money invested through an investing account requires you to sell your positions before you are able to access the actual cash. If the market is doing poorly, but you need the money ASAP, you will have to sell for a loss and are unable to ride out the poor market.
The previously mentioned situation illustrates why it is imperative to have a separate emergency fund, either a checking or savings account that you can easily withdraw money from.
The amount to have saved depends on your financial situation, but it is generally recommended to have at least 6 months’ worth of expenses. Doing this allows you to leave your money in the investment account for the long term and reap the rewards.
Another reason it is a good idea to start investing as early as possible is because of something Compounding Interest. According to CNBC, 69% of American adults don’t know what compounding interest is.
Don’t worry if you are one of these people. That is exactly why we created this lesson, and we will teach you right now!
Compounding interest means you earn interest on your initial investment + any interest already earned from previous periods. Here is a simple example to illustrate.
Floyd invests $1,000 into the stock market and does not touch it for multiple years; the table below shows his returns from utilizing Compounding Interest.
Note: For simplicity, we assume the return rate is 8% each year
At the end of year one, his account has grown from $1,000 to $1,080. At the end of year two, it has grown to $1,166.40. Let’s look at where these numbers are coming from.
Year 1 Ending Balance = Starting Balance + (Starting Balance*Return %)
Year 1 Ending Balance = $1,000 + ($1,000 x .08)
Year 1 Ending Balance = $1,080
Year 2 Ending Balance = Starting Balance + (Starting Balance*Return %)
Year 2 Ending Balance = $1,080 + ($1,080 x .08)
Year 2 Ending Balance = $1,166.40
It is important to note how the earnings are calculated by using that year’s starting balance. Now, let us take a look at John. He decides instead to place his $1,000 into a savings account that only accrues simple interest. He also does not touch it for multiple years. The table below shows his returns.
Note: For simplicity, we assume the return rate is 8% each year
At the end of year one, his account has grown from $1,000 to $1,080. At the end of year two, it has grown to only $1,160.00, which is less than Floyd’s. Notice how John’s earnings column is the same dollar amount each year, no matter the starting balance? Let’s explore why.
Year 1 Ending Balance = Starting Balance + (Starting Balance*Return %)
Year 1 Ending Balance = $1,000 + ($1,000 x .08)
Year 1 Ending Balance = $1,080
Year 2 Ending Balance = Starting Balance + (Initial Deposit*Return %)
Year 2 Ending Balance = $1,080 + ($1,000 x .08)
Year 2 Ending Balance = $1,160.00
With simple interest, the earnings are calculated by multiplying the return/interest rate by the INITIAL deposit. You do not earn interest on previously earned interest.
Because of compounding interest, your money can grow exponentially. That is why you can contribute $200,000 of your own money to your retirement account, but your account can be over $1,000,000 at retirement age. US News has a great graph illustrating this point.
I invest AND have a savings account. This allows me to have access to cash for an emergency, and I can leave my investments in the stock market. Whether you decide to Invest, Save, or both is up to you, but the most important takeaway from this lesson is that you should start as early as possible!
The YouTube channel “The Plain Bagel” has a great video explaining some of these previously mentioned concepts. Click on the video below to watch it. We do not take any credit for their work or claim the video to be ours. Please like, follow, and share their video to support their channel!
Don’t forget to check out the Materials Tab for helpful extra resources and definitions of Key Terms!
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TD Ameritrade: Online Stock Trading, Investing, Brokerage | TD Ameritrade
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Extra Resources:
Key Terms (Courtesy of Investopedia):