What is it?
A quick browse online will quickly reveal a bevy of news outlets, finance blogs, and other websites discussing investments ad nauseum. Stocks! Bonds! Gold! Real estate! Bitcoin! It can be a bit daunting to wade through for sure. So I thought I’d share a few thoughts on investing and how investing principles can be applied in our everyday lives to help us save those crumbs.
What is Investing?
First, we should establish the definition of investing. I like this one from Investopedia:
The act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.
For the more initiated, here is Warren Buffett’s definition as found in his 2011 Berkshire Hathaway Letter to Shareholders:
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.
More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
The common thread in both of these definitions is that investing involves two distinct things: 1) Initial outlay of means for 2) a later, increased return on what was initially committed.
Buffett’s definition is helpful as it elucidates on the true measure of investment gain. It’s not simply an increase in dollar amount, but rather the increase of actual purchasing power AFTER taxes. So by his definition, a savings account (and most CDs) really can’t be considered true investments because after taxes and inflation, we haven’t gained any purchasing power—we’ve actually LOST it. Yikes!
In case you haven’t read it already, I actually shared a post a while back that illustrates how investing works while never labeling it as such. If you need a refresher, catch it right here: Don’t Kill Your Money!
One of the ways to measure and compare different investments is to look at their rate of return. A rate of return can be figured in different ways, but for our purposes it is a statement of how much money a certain purchase will return to us on an annual basis expressed as a percentage. We deal with rates of return all the time, for instance:
- Your savings account offers you 0.02% interest on your funds. That account has a 0.02% rate of return (often called APY, short for Annual Percentage Yield), meaning it will return to you 0.02% of the amount in your account every year. (These are real numbers pulled from the Bank of America website. If your savings account is earning this little, I seriously recommend you take a look at online banking.)
- You receive a 0.50% interest US Savings Bond as a gift. You have a 0.50% rate of return on the price of the bond every year.
Now I’m assuming that most of you already knew that. But if investing at its most basic is simply giving an initial outlay so that it can produce a return for us in the future, shouldn’t we be able to ascribe a rate of return to many of our day-to-day transactions as well?
- If you pay an extra $1000 into your credit card balance that charges 20% interest, you are getting a 20% rate of return on that $1000.
- Similarly, any extra amount you put toward your 7.8% interest student loan would be yielding you a 7.8% rate of return.
- If you spend $5000 to replace your current gas-guzzling car with an efficient one that saves $800 in gas per year, you are getting a 16% annual rate of return on the $5000 that you spent on the car.
- Assuming that you need a refrigerator anyway, by spending an extra $200 to buy an energy star model that saves you $20 a year in electricity costs, you are earning a 10% annual rate of return on that extra $200 you paid.
- Installing a solar panel system costing $9500 that produces $840 per year results in an 8.8% rate of return. (This is a true story, you can read about our solar panels in this post: How to Get Paid by Your Power Company with Solar Panels.)
- If you upgrade the insulation on your house for $1000 and it results in a savings of $500 in your power bill annually, your $1000 has a 50% rate of return.
- Paying an extra $35,000 for a house that has an apartment that can be rented out for $650 a month results in a 22% rate of return on the extra $35,000 you paid.
These examples are all based on realistic scenarios. Notice how much higher the rates of return are in each of these instances compared to the paltry interest from savings bonds and savings accounts.
Let me pause here to underscore a key take-away that you simply cannot miss:
If you have high-interest consumer debt like credit cards, car notes, student loans, etc. and you have excess money sitting idly in your bank account, pull as much of it out as possible and extinguish your debts ASAP!
Why are you still here? Go now! This is an emergency! Come back and finish reading this post later!
It is also important to notice that a lot of purchasing decisions that we make can be viewed through the prism of investing—especially the large ones that can increase efficiency or reduce overall cost of ownership.
Moreover, I’ve often been asked how it’s possible to get an 8%* rate of return on investments. As we’ve seen, intelligent financial decisions such as these examples are some ways to make that level of returns. Paying off high-interest debt and making carefully evaluated purchases/replacements/upgrades can yield returns far above 8% every single day–the best part is that they are usually much lower risk or even entirely risk-free in some instances!
Investing > Spending
So in the spirit of giving our green soldiers gainful employment, stop thinking in terms of spending and start thinking in terms of investing.
What ways can you think of that you can start putting your money to work for you today? Share with us in the comments below!
*6-8% is a commonly accepted number for the annual rate of return for the overall US stock market over roughly the past 100 years as measured by the S&P 500 index. This is why I typically use 8% as my reference point when discussing investment returns.