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Now, let's get into the details of exactly how investing allows your money to grow so you can get a clear view of the big picture. 

The two key factors are inflation and compounding.


First up - Inflation

1. Investing helps your money keep up with and surpass inflation

What is inflation?

Inflation is defined as a general increase in the prices for goods and services and the fall in the purchasing power of money overtime (a.k.a the decline in the value of money) and it is measured annually. The purchasing power of money is basically the value of a dollar today.
 

What causes inflation? 

There are a number of reasons for inflation for instance:

 
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  • Increased demand: An increase in demand from consumers can push up the prices of good and services
  • Increased costs: Costs to produce goods and services can also push up prices 
  • Increased supply of cash: An increased supply of money in the economy can also push up prices (too much money in the economy, reduces it's value)

All of these reasons, in addition to other economic factors are things that cause inflation which in turn reduces the value of money and increases the cost of living.


- Example:

According to the U.S. Bureau of Labor Statistics - "Prices for milk were ~30% higher in 2017 versus 2000. Between 2000 and 2017, milk experienced an average inflation rate of  ~1.5% per year. In other words, milk costing $5 in the year 2000, cost $6.50 in 2017 due to inflation”.


Inflation in the United States

Currently in the United States, the inflation rate is at about 2.5 to 3% a year.

This means that every year the value of the dollar goes down by 2.5 to 3%. So if you are just putting your money into a savings accounts at today’s savings interest rate of ~1 to 2%, over time, you are actually going to be losing money. For instance if you have $10,000 in a savings account, in 5 years, you might still have $10,000 but the value of the money based on an inflation rate of 2.5% would be somewhere around $9,096 dollars.
 

Investing your money on the other hand over the long term will help your money keep up with and even beat inflation because the average return of the stock market long term over the last 100+ years (since it’s inception) and despite short term declines has been at about 8%. So when it comes to investing vs. saving, investing gets the prize.
 

Use the calculator below to see the power of compounding based on your own numbers:


P.S. We will cover what money you should be savings vs. what money you should be investing, in lesson 5.


Next up - Compounding

2. Investing your money allows your money to make more money with the power of compounding

Can I just say that compounding is aH-MAZING!

So amazing that Albert Einstein even described it as the “eighth wonder of the world", “the most powerful force in the universe” and “the greatest mathematical discovery of all time”. Specifically with investing, compounding lets you earn money on your investments via interest, dividends and capital gains (when the price of your investment goes up).
 

So if you make an initial investment and it earns interest, the interest gets added to your original investment and then you wind up earning interest on your interest!

 

- Example:

 
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Let’s say you start investing $5,000 a year at the age of 25 with a goal to retire 40 years later at age 65 and you get an average return of 6% (average meaning inclusive of the stock market’s declines and growth), after 40 years and with the power of compounding, your investment would be worth $871,667 vs. if you just put your money in a savings account at today’s average bank savings interest rate of ~1 to 2% in which your investment would only be worth $254,321.
 

 Let's say you wait a little longer to invest and you start age 35 with a goal to retire 30 years later at age 65 and start investing $5,000 a year and have the same average rate of return of 6%, after 30 years, your investment would be worth $447,726 vs. if you just put your money in a savings account which it would only be worth $182,403.
 

Keep in mind that these numbers will be significantly higher with a higher average rate of return on your investment!

 


 

Based on the above illustration, it’s very clear that the power of compounding is magnified, the more interest your money can earn and the more time your money is given to grow in the stock market!