Saving even a little amount each month is clearly more sensible than squandering the lot. But choosing to save rather than invest is arguably an even bigger mistake if:
a) you’re not planning on using that money for a big purchase anytime soon.
b) you’ve already managed to build up an ’emergency fund’ for when the boiler breaks.
c) you have many years or decades before you really need to see that money again.
Trouble is, the majority of the UK population still rate savings accounts and Cash ISAs in particular.
Money was deposited into 7.8m of the latter with their soul-sapping interest rates in the 2017/18 fiscal year compared to 2.8m of the stocks and shares equivalent.
That’s not a problem if you consider the prospect of beans on toast every day for decades a wonderful thought. Just keep saving.
If you have finer tastes, then I’d ditch the Cash ISA for three very simple reasons.
The lovely feeling you get from knowing there’s surplus cash in your savings account beyond the aforementioned buffer is a high price to pay. Be aware that inflation is out to kill your retirement dreams.
Does that sound a bit dramatic to you? It really isn’t.
For as long as this is at a higher percentage than the interest your bank is paying you, the value of your money is falling. That’s not a nice thought over one year, but its an absolute nightmare for your wealth over the long term.
To illustrate, let’s assume that your savings account offers no interest (which, for some, isn’t far from the truth). Inflation at 2% every year for 20 years, would reduce £10,000 to £6,730 in real value.
The wonderful thing about owning bits of companies is that it entitles you to a share of the profits.
Next time you’re in Tesco or Sainsbury’s or Morrisons, for example, understand that everyone around you paying for their groceries is indirectly helping to fund your eventual retirement, assuming you own the shares and reinvest what you receive back into the business (more on this in a second).
What’s more, the dividend yields on many stocks are higher — and in some cases a lot higher — than the current rate of inflation.
While we’d avoid some of the biggest payers at the current time (a very large yield can suggest a likely cut in the future), that still leaves plenty of great businesses out there to invest in.
So, receiving cash from companies you own is great. Now combine it with the secret sauce in investing and we’re talking a very powerful mix.
That secret sauce is compounding or ‘interest on interest’. Simply put, the bigger this is, the better the end result will be for you.
Imagine that you invested £10,000 today and managed to achieve growth of 7% every year (a combination of stock markets rising in value and reinvested dividends) for those 20 years.
By 2039, that sum would be almost £39,000, based on my calculations. And that’s without any additional contributions on the way.
An extra £100 a month would increase this to almost £88,000. An extra £200 a month would bring this to just over £137,000. That’s the power of compounding.
Pause to consider this when you next go to make a deposit into your Cash ISA.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.