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Why invest?

Mark LaMonica, CFA  |  02 Jan 2018Text size  Decrease  Increase  |  
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Money consumes a good deal of most people’s days. People spend most of their day trying to earn it, just to spend their limited leisure time trying not to spend all of it. As a society, we look down on those without it and judge those with it. We use it to keep score and to define success and failure. We have even created a term, affluenza, to describe the debilitating effect it can have on people. Interestingly enough, with all the worry it induces and influence it yields, we don’t spend a lot of time thinking about what it is. Any discussion about investing must start with a discussion about money. Without understanding two key principals about money, it is difficult to make good long-term decisions about investing.

In Australia, and around the world, our money is something called a fiat currency. A fiat currency is a currency that derives its value from the fact that the government says it has value. This is a relatively new concept. Before US President Nixon eliminated the link of the US Dollar to the gold standard in 1971 the value of money was underpinned by gold. That means that before 1971 you could literally exchange the US Dollar for gold from the government held reserves. Nixon’s action also made the Australian Dollar a fiat currency since at the time the Australian Dollar maintained a fixed exchange rate to the US Dollar. Since 1971, instead of being able to exchange your money for something like gold you are able to exchange money only for goods and services. This right to exchange money for goods and services is guaranteed and enforced by the government. The key takeaway is that money itself has no value; the only value is the goods and services that we can exchange it for.

Since money has no value other than the ability to exchange it for goods and services it is important to look at the costs of goods and services. With few exceptions, the cost of goods and services go up over time. This concept is known as inflation. In fact, the inflation rate in Australia has gone up an average of 5.07 percent per year between 1951 and 2017. To put that in real terms, if you paid $3.50 for a cup of coffee in 1951, like many people do today, it would cost $91.55 in 2017 if it increased at the rate of inflation. If the goods and services that money can be exchanged for continue to go up in price, the value of money continues to go down. Simply put, money is a depreciating asset.

The fact that money is a depreciating asset means that keeping all your savings in cash may be a bad idea for many long term investors. Once you get around to spending it, you will be able to buy less than the day you earned the cash. You are probably thinking that this doesn’t apply to you because you put your money in a savings account or term deposit. In addition to keeping your money safe the bank is paying you interest so you don’t need to worry about your money losing value. Unfortunately, this may not be the case. In January 2017, the Reserve Bank released data showing the average interest rate paid by online savings accounts was 0.45 percent. At the same time the Reserve Bank announced that the annual inflation rate was 1.30 percent. While you may be doing better than the person who keeps their savings in cash, it is still projected by the RBA to lose purchasing power each day it sits in the bank. Between 1996 and 2016 the interest paid on cash was 2.60 percent a year while the average inflation rate was 2.50 percent a year. The real return of 0.10 percent per year means that if you put $10,000 into the bank between 1996 and 2016 your real purchasing power would have increased by a grand total of $10. For more information, see the RBA statistics.

There are certainly reasons to keep money in the bank. Savings to cover emergencies and for large planned purchases in the near future makes sense. Keeping some cash in an investment account to take advantage of opportunities that may present themselves as markets fluctuate makes sense. However, it is important to remember that the perceived safety from leaving your long-term savings in the bank is fraught with the risk that your purchasing power will slowly be eroded. Always remember that the only value that money holds is the ability to exchange it for good services and that the value of money is slowing depreciating.

The following chart shows two additional places you can put your money that have historically offered better inflation protection. We will discuss these in more detail throughout this Investment Guide.

 

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The impact of inflation on investment returns

chart

 

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Mark Lamonica is a product manager, Individual Investor, Australia.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

 

is a product manager, individual investor, Australia.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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