The Importance of Understanding Compounding and Inflation

If there are two things that every investor needs to understand thoroughly it is inflation and the power of compounding.

Many of the excuses people make for not investing are overcome simply by developing a solid understanding of these two concepts and how they stress the importance of investing for the future if you want to be able to keep up with the cost of living.

On the inflation front, it is fairly powerful to realise that if you had $100 in 1970 and had just stuck it is a drawer until now, you would need to add around $1,400 to that amount to purchase the same amount of goods.

Really understanding the corrosive impact of inflation on your purchasing power over time is one thing, but it is even more impactful when you realise that through investing that $100 over the same time period you would have not only have maintained the purchasing power of the original investment but potentially have multiplied it several times over.

Compounding Outperformance

Even a simple high interest savings account is helpful in keeping up with inflation, particularly when you really understand how interest starts to be earned on interest to compound over time.

Of course, a high interest savings account has a lot of limitations being fully taxable and in many ways is safer but inferior to other alternatives such as the share and property markets but even fixed interest can compound quite strongly.

From these simple but profound concepts of inflation and compounding flows a range of other financial planning concepts such as the importance of investing earlier rather than later, the importance of sticking to a budget to put aside money to invest, understanding the correlation between investment risk and reward, the need for diversification, the power of borrowing to invest, using automation to help with reaching financial goals, and the need to develop an understanding of markets and how they function.

No Time Like the Present

However, the greatest advantage of understanding inflation and compounding is to bring home the absolute urgency of getting started on the investment journey quickly.

One of the most common themes reported by financial planners is that people often keep kicking the investment can down the road and make all sorts of excuses such as the need to get a big chunk of money they could afford to lose before getting started.

The problem with stalling is that there may never be a “perfect” time to start investing, which makes right now almost always the perfect time.

The other thing to realise about your investment journey is that you are sure to make many mistakes along the way but these also are essential learning experiences.

Indeed, most of my really important investing lessons have come from mistakes – some of them really big mistakes – and it is important not to let fear of making mistakes become another excuse for not acting at all.

Get the Jargon Explained

Another big excuse for delaying investing is a lack of understanding of all of the language surrounding investment markets.

 Like all professions, financial markets develop a large amount of jargon that is often useful in making insiders feel important and knowledgeable, but unfortunately also functions as a way of keeping outsiders unable to understand what is being discussed.

The key to remember here is that AI is your friend and is a good way to work out what is being explained and secondly, that there is no such thing as a stupid question.

If you don’t understand terms or products, make sure you ask questions until you do and if the people explaining are not capable of explaining something fully, consider not rewarding them with your precious investment funds.

Keep it Simple

Finally, it is worth remembering that simplicity is your friend.

It is absolutely possible to get a good spread of Australian and international shares with just three exchange traded funds (ETFs), or potentially even just one.

The same thing for listed property exposure, which can be reliably bought through just one ETF, while term deposit style exposure with monthly dividends can also be bought through one ETF.

While complex investment strategies might make for great barbecue conversations, there is a lot to be said for keeping a very simple and logical approach.

Finally, remember that once the basics of inflation and compounding have been learned, there is always room to keep reminding yourself of these important insights along the investment journey.