Why to invest?

Why to invest?

In 2020, only 33% of Italians actively participated in the financial markets. The remainder, whether due to a lack of investment planning, a lack of confidence and a low level of financial knowledge, were content to keep their savings in current accounts, deposit accounts and monetary investments.

Italians tend to invest little. They prefer not to invest to avoid any risk. Translated: “I don’t invest my savings, so I’ll give up the return but at least I’ll zero the risk”.

However, their reasoning is flawed for the following reasons:

  • it does not take into account inflation.
  • it does not consider the effect of compounding.
  • investments have always rewarded risk over the long term.

Purchasing Power Erosion

Purchasing Power Erosion

Inflation possesses the ability to erode savings parked “under the mattress” or in the checking account, thwarting any effort of your savings. Looking only at Italy, the erosive power of inflation from 1900 to 2020 has had devastating effects on the purchasing power of savers. In the period from 1960 to 2020 alone, if we had not invested, our 100,000 euros saved would have progressively lost purchasing power, until they were worth less than 5,000 euros. That is, a loss of purchasing power of 96%. Table 1 further illustrates the dramatic effect of inflation on the purchasing power of savers in Italy from 1960-2020. It should be noted that in the same short period of time, 20 years, purchasing power decreased by 25%.

Tabel 1

wdt_ID Periodo 1960-2020 Erosione Potere di Acquisto
1 Variazione ultimi 20 anni -25%
2 Variazione ultimi 30 anni -48%
3 Variazione ultimi 40 anni -79%
4 Variazione ultimi 50 anni -94%
5 Variazione ultimi 60 anni -96%

Fonte: ISTAT, 2020

Figure 1: Purchasing Power Erosion for a capital of 100.000€.

Interest Compound Capitalization

Interest Compound Capitalization

Most Italians do not know or underestimate compounding of interest. Einstein called it the greatest mathematical discovery of all time and the eighth wonder of the world.

Under compounding, the saver reinvests the interest received. In this way, the interest earned in each individual period is in turn considered interest-bearing in subsequent periods. In other words, the interest accrued in each period is added to the initial capital and is subsequently reinvested.

Obviously, the higher the interest and the longer the time period, the more visible the effect of compounding is.

Below, we will see a simulation of the return of a 100,000€ asset invested for 30 years with an average return of 5% in the 2 regimes. This simulation is useful to understand the potential of compounding capitalization.

Figure 2: Evolution of Simple and Compound Interest

wdt_ID Anni Interesse Semplice Intresse Composto
1 0 0 0
2 1 5.000 5.000
3 2 10.000 10.250
4 3 15.000 15.763
5 4 20.000 21.551
6 5 25.000 27.628
7 6 30.000 34.010
8 7 35.000 40.710
9 8 40.000 47.746
10 9 45.000 55.133

As we can see, with simple capitalization, i.e. without reinvesting the profits, we obtain a total value of interest of 150,00€ in 30 years against the 332,194€ we obtain with compound capitalization, i.e. reinvesting the profits. In the first case the capital became 250,000€, in the second 432,194€. A difference of 182,194€, or 73%. (Figure 3)

Figure 3: Simple and Compound Capitalization

Investing Rewards Risk

Investing Rewards Risk

Over the past 50 years, financial markets have rewarded investors.

The nominal return on world equities over the last 50 years has been 8.5% while the nominal return on bonds has been 7.8%.

For the saver it is fundamental to protect his purchasing power, for this reason it is advisable to reason on the real yield, given by the nominal yield minus inflation.

Well, even if we remove the erosive effect of inflation from the returns, over the last 50 years, world equities have, on average, returned 5.5% per year, while a basket of world bonds has returned 4.8% per year (Figure 4).

Figure 4: World, Real Annualized Yield

Fonte: Credit Suisse Global Investment return Yearbook, 2020

We can therefore affirm that, to date, the financial markets over medium to long term time horizons have amply rewarded the risk of investment.

Those who have invested in the financial markets have not only protected their purchasing power but have also constantly increased it.

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