One of my hopes when I created Paul vs The Market was that I could use it as a teaching tool. This article is part of that goal. My intention is to write a three part series where I do my best to explain the basics of investing in the stock market and why I think it’s so important. This is the first entry, “Why investing?”, where I hope to explain why investing is so important. In the following weeks, I will be releasing parts 2 and 3: “What is investing?” and “How to invest”.

This isn’t the first time that I tried to tackle the topic of why I believe everybody should be investing. A year ago, I wrote a very similar article on Rampant Discourse (the sister site to Paul vs the Market) titled Everybody Should Be Investing. Be sure to check that out if you want more information or to see video of me driving a Barbie car.

Anyway, I hope you enjoy this and find it informative. Please don’t hesitate to reach out if you have any questions or concerns. Thanks.

Financial Literacy

I believe the state of financial education in America is poor. I never had any personal finance classes in school, but I was lucky to have parents who taught me the basics about savings accounts and writing a check and paying off my credit card in full every month. I was also incredibly lucky that they encouraged me to open up and to start contributing to a Roth IRA at a young age. Not everybody is so fortunate, and many people are forced to learn the basics of personal finance by trial and error. If this website can convince just one person to start saving for their retirement at a young age, then it will have all been worth it. That’s how important I feel the stakes are.

There’s a well-known financial literacy quiz that asks three fairly basic questions:

1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
   • More than $102
   • Exactly $102
   • Less than $102
2. Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After one year, with the money in this account, would you be able to buy:
   • More than today
   • Exactly the same as today
   • Less than today
3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”
   • True
   • False

I encourage you to take a stab at answering the questions. When you’re ready to see how you did, compare your answers with the correct ones: “More than $102”, “Less than today”, and “False”. How did you do? If you got them all correct, great! Well done. If you didn’t, don’t feel bad, because the majority of Americans couldn’t answer all three correctly either.

There are so many ways that a lack of financial literacy can hurt people. It can lead to taking out loans that they can’t afford. It can lead to taking on more inflationary risk than people realize. It can lead to being over or under insured. For the purposes of this article, though, I wanted to focus on (unsurprisingly) saving for retirement and how important a role investing, specifically in the stock market, can play.

Why Investing?

Why investing in the stock market? I previously wrote about why I thought everybody should be investing, but if you don’t want to read the whole thing and just want the main takeaway, here it is:

That’s why many investors look forward to the annual publication of the Credit Suisse Global Investment Returns Yearbook, which provides a century-long look at 23 national markets, accompanied with a depth of historical data making sense of short-term trends.

The 2018 edition, published last month, confirms what many value investors have long believed, namely that, by and large, there is no better long-term investment than equities. Since 1900 no other investment class has consistently outperformed. In this period US equities yielded an average 6.5 per cent annual return in real terms.

Nothing beats equities; a hundred years of history proves it by Stephen Vines

In short, I believe that investing in equities (another term for investing in the stock market) is the best way to grow savings over the long term. And yet, it seems like many Americans are unaware of this, and fairly consistently rank other things like real estate and gold as better investments.

Compound Interest

The secret at the core of all saving, whether it be in the stock market or a savings account and whether it’s for retirement or for a vacation, is compound interest. Compound interest has been called “the eighth wonder of the world” and “the most powerful force in the universe”. The concept as it relates to investing is fairly simple: When money makes money, then that new money also makes you money, so you keep making more and more money as time goes on.

There are a plethora of stories out there illustrating how powerful compound interest can be, but I wanted to focus on just a few that I thought did a good job of explaining different aspects of compound interest.

The overly simplistic example

Would you rather have $1 million now or start off with a penny and have it double every day for 30 days? The correct answer (at least if you’re interested in maximizing your money after 30 days) might surprise you…. unless you’re the type of person who is on guard when it comes to questions like this with answers that seem too obvious.

Day	Value	Day	Value
1	$0.01	16	$327.68
2	$0.02	17	$655.36
3	$0.04	18	$1,310.72
4	$0.08	19	$2,621.44
5	$0.16	20	$5,242.88
6	$0.32	21	$10,485.76
7	$0.64	22	$20,971.52
8	$1.28	23	$41,953.04
9	$2.56	24	$83,886.08
10	$5.12	25	$167,772.16
11	$10.24	26	$335,544.32
12	$20.48	27	$671,088.64
13	$40.96	28	$1,342,177.28
14	$81.92	29	$2,684,354.56
15	$163.84	30	$5,368,709.12

Yes, it turns out that the measly, insignificant penny that has so little value that many people want to simply get rid of it altogether can beat a million dollars with a heaping helping of compound interest. In fact, it only needs 27 days to do it. The table above is incredible to look at. By the 10th day, or a third of the way through, the penny has only doubled to a few dollars. Look at that acceleration at the end, though. Obviously doubling every day is an exaggerated example, but you can get a really good sense of how even if it starts slow, compound interest snowballs amazingly over time.

Makes you think twice about all those times you tossed your pennies into those Take a Penny, Leave a Penny trays, huh?

Before we go any further, there are some important caveats that I want to address. Although there was a quote above about the stock market returning an average of 6.5% per year, I think that is incredibly misleading. Why? Because it implies a much smoother ride than it actually is. Check out the below chart from Macrotrends:

The chart shows the return of the S&P 500 each year for the past 90 years. As you can see, there have been a few years where the return for the year has been in the mid-single digits, but most years had much more extreme movements. The market isn’t a gradual and steady climb upward. The market is more like a roller coaster with dizzying highs and nauseating drops. This is why I believe in having a long time horizon when it comes to investing. If you invest $1,000 and the market drops 20% and suddenly you’re looking at a slimmer $800 account, that’s (unfortunately) not too abnormal and probably the worst thing you can do is give up and get out.

Investing is all about riding out those dramatic drops so that you can also experience those amazing gains on the up years. If you go into investing in the stock market with the expectation that your money is going to increase by 6.5% every year then you’re likely going to find yourself alternating between abject horror and absolute glee.

If you go into investing in the stock market with the expectation that your money is going to increase by 6.5% every year then you’re likely going to find yourself alternating between abject horror and absolute glee.

Below is another way of looking at it, and is one of my favorite charts. Based on the returns of the market from 1871-2012, it shows the percentage chance that the returns over a certain time period would be positive. So there was a 52% chance of the market being up on any given day, which is basically a coin flip. Extend that holding period out to a year, and you had a 68% chance of the market being up during that time, which is better, but still leaves about a third of the time where you lost money. However, it only gets better the long the time period that you look at, to where if you have a holding period of 15+ years there was a very small chance of losing money in the market.

It’s incredibly important to note that this is all historical data, and as you’ve no doubt heard, past performance is not indicative of future results. Nobody knows what the market might do in the future, and just because there hasn’t been a 20 year period where the market has lost money in the past, it doesn’t mean it won’t happen in the future. The Japanese market peaked right around 1990 and still has yet to return to that level almost 30 years later. The same thing could happen here.

The point of saying all of this isn’t to scare you away from investing in the market. The point is to brace you for the downturns that are normal parts of the market. You have to be prepared for the possibility of your investment losing money over one, two, or even three plus years. You can’t panic and sell if you see your account drop by 20%. The market is volatile. It is not a smooth ride. Look again at the charts above. Even over 3 years, there’s a 25% chance of losing money in the market. That’s the same as flipping a coin twice and getting tails twice.

There’s also a decent chance the market tanks in your first year investing. The financial crisis / great recession hit early in my investing career and I watched my retirement accounts get cut in half. But I stayed the course and my account value is now double what it was before the crisis hit. I started tracking the performance of the Freedom Portfolio right as last year’s market downturn hit and saw 20% of its value wiped out in a matter of months. I didn’t panic. I remained fully invested in the market and now the portfolio is back above where it was at the start. Having a long term mindset is critical for investing in the market because as time goes on the volatility evens out and you have a better chance of making that average 6.5% return per year.

Now that that is out of the way, let me try to sell you some more on how important investing is and why you should start now.

Importance of Time

Time is one of the most powerful variables when it comes to investing. It’s the fuel that allows the powerful engine of compound interest to work. A 10% return on $1,000 is only $100 after a single year. Over 30 years, though, it’s over a $16,000 gain. This is why it is so critical for people to start saving and investing as early as possible and holding for as long as possible. Young people might not have much money to save, but they have arguably a bigger advantage than a lot of money: time.

Don’t believe me that time can be a powerful advantage? Here’s a story shamelessly stolen from Dave Ramsey’s website which illustrates the incredible power of starting early and time in the market:

Ben and Arthur were friends who grew up together. They both knew they needed to start thinking about the future. At age 19, Ben decided to invest $2,000 every year for eight years. He picked investment funds that averaged a 12% interest rate. Then, at age 26, Ben stopped putting money into his investments. So he put a total of $16,000 into his investment funds.

Now Arthur didn’t start investing until age 27. Just like Ben, he put $2,000 into his investment funds every year until he turned 65. He got the same 12% interest rate as Ben, but he invested for 31 more years than Ben did. So Arthur invested a total of $78,000 over 39 years.

When both Ben and Arthur turned 65, they decided to compare their investment accounts. Who do you think had more? Ben, with his total of $16,000 invested over eight years, or Arthur, who invested $78,000 over 39 years?

How Teens Can Become Millionaires

Amazingly, not only does Ben come out on top despite having put in only around 1/5th as much money, but he comes out way ahead and has almost 50% more money than Arthur. Don’t be misled by the comment that Ben “invested over eight years”. He might have only contributed money for eight years, but his money was compounding for 46 years (age 19 to 65) versus the 39 years that Arthur’s money spend compounding.

Want a real world example? 99% of Warren Buffett’s wealth was earned after his 50th birthday.

So I’ve still got some time.

Up Next?

Thanks for reading. Any questions or suggestions? Please don’t hesitate to comment on this post or email me at paulvsthemarket@gmail.com. Check back soon for part 2 of my Investing for Newbs series: What is investing?