Learning The Basics of Investing and Compound Interest

Have you noticed how much the cost of a Chipotle burrito has increased over the last few years? In my city, I now pay about $20 to get one (with queso of course)! Inflation has a significant impact on our everyday lives.

Understanding Inflation

Inflation is a powerful counterforce against monetary growth. It is the general rise in prices of goods and services over time, which decreases the purchasing power of money. The U.S historically has an inflation rate of 2%-3% per year. This means that if you kept $100,00 in cash buried under a tree, you would be losing 2k-3k of purchasing power every year. This is why it is essential to use your money in a smart way, ideally making money off money itself.

Understanding Interest

Depositing your money into a savings account often leads to one or two types of interest. Simple interest means you earn a fixed percentage on your initial deposit after every set period. The formula for this is 𝐴=𝑃(1+𝑟𝑡), where 𝐴 is the final amount (total money), 𝑃 is the initial deposit (principal), 𝑟 is the periodical interest rate, and 𝑡 is the time. For example, If you deposit $1,000 at 5% simple interest for 3 years, the calculation is 𝐴=1000(1+0.05∗3), meaning after 3 years you would have $1,150. While this does help counteract inflation and grow your money, it is not the most effective way to grow your money.

Compounding interest yields significantly higher returns overtime than simple interest does, as you earn a fixed percentage both on your initial deposit and previously

earned interest. The formula for compounding interest is 𝐴=𝑃(1+𝑟𝑛)𝑛𝑡, with n being the number of times interest compounds per year. If we deposited the same $1,000 at 5% interest compounded annually for 3 years you would get is 𝐴=1000(1+0.05)3 equaling $1,157.63. Now this might not seem like much more but the more money you put in and the longer period the interest takes place, the more significant the difference between the two types of interest will be as seen in Image 1. Starting the compounding effect earlier will inevitably lead to more money. Even putting smaller amounts of money into an account in the beginning is better than putting larger amounts in late, because compounding has an exponential effect, the earlier you put it in the more your money will make more of itself.

Image 1 (From: www.alamy.com)

Investing

Another effective way to grow your money is through investing. Whether you invest in the stock market, real estate, or other investments, investing is a high-risk, high-reward reward way to grow your money. The stock market is the most common way to invest, offering higher returns than savings accounts. However, you could also lose your entire investment. Experts generally recommend investing with money you have after saving as a reliable practice (CNBC). Historically, the U.S. stock market averages 7–10% annual growth long-term. So, if you invested $1,000 into the market over 3 years, it would look like  (assuming 8% growth), meaning you would have around $1,249.71. The higher risk correlates to potential higher returns, making investing the potentially fastest method of money growth.

In investing, there are many different places to allocate your money including stocks, bonds, index and mutual funds, and ETF’s. But what are the differences between these investments?

Image 2 (from: https://prettyrambling.wordpress.com/)

Stocks are the most common type of investment in the market. Stocks, also known as shares, are simply a small part of the company. When you buy a share you own a fraction of the company, If the company is doing well or is thought to be doing so, the perceived value of the company increases, and people buy more shares, pushing up the price of the stock. Diversifying, or owning shares from a variety of companies across different sectors decreases the impact on your portfolio if one company performs poorly. I’m sure you’ve heard the saying - don’t put all your eggs into one basket!

Another great way to start investing is through funds, which let you own small portions of multiple companies at once instead of trying to pick individual stocks. Exchange-Traded Funds (ETFs) and index funds are two of the most common options because they track then represent the share price of a group of companies. the biggest one is S&P 500, the index fund of the biggest 500 companies in the U.S.A. These give you instant diversification without having to buy each stock yourself. Mutual funds work in a similar way but are managed by professionals who actively decide where to invest, often attempting to outperform the market (this often comes with high fees however). If you are interested in real estate, Real Estate Investment Trusts (REITs) give a way to invest in property markets without owning buildings. Each of these options helps reduce the risk that comes with individual stocks while still allowing your money to grow over time. For new investors especially, funds make it easier to start small and build wealth gradually through steady, diversified growth with low management.

The earlier you start saving and investing your money, the more it will work to grow itself. If you invest just $100 a month starting at age 18, and your money grows at an average of 7% a year (less than the 10% yearly return of the S&P 500), by the time you’re 65 you’ll have over $350,000, compared to $147,000 if you start at age 30. Even if you can't invest a significant amount each month, anything you put in is more you'll get out in the future.