Very few people save their way to becoming wealthy. Instead, people who have gained a measurable amount of wealth tend to invest their money into appreciating assets that, over time, are worth more. Appreciating assets such as real estate, stocks, mutual funds, bonds, CDs (certificate of deposits), annuities, and a whole host of other opportunities are purchased with the expectation that their value will grow and increase the buying power of the money invested. With so many different options, it can be quite overwhelming when attempting to grasp all the information available for each investment opportunity to know which is right for you. So how do you know what a “good” investment is?
Any investing advisor worth their salt would advise any investor to consider a few factors such as the risk, volatility, liquidity, and history of the investment to evaluate the quality of an opportunity. But, of all the metrics used, one of the most popular is the interest rate or the “return rate” of the investment.
When it comes to investments and their earnings, interest rates can be simply be defined as the rate of increase of the value of an investment. Basically, it’s a measure of how hard your money is working to make more money! The higher the interest rate, the harder the investment is working, and the more money the investment is making. If an investment has a negative interest rate for a period of time, it actually lost value over that period. Inflation is a great example. Inflation can simply be defined as the rate at which money loses value over time. As time passes, money is worthless and it cost more money to buy the same items. Money loses its buying power. I know nobody likes to lose money! But the reality is all investments are subject to inflation and all investments will have times where they have negative returns. It’s just something that happens.
What is a good interest rate for an investment? It depends on your goals. Consider the following information in an example to demonstrate the power of high investment return rates.
• CDs have averaged 3.73% returns in the last 30 years.
• Bonds have averaged 4.3% returns in the last 30 years.
• Stocks have averaged 11.5% returns in the last 30 years.
• Inflation has averaged 2.6% over the last 30 years.
Assume a $10,000 investment in made in either CDs, bonds, or stocks 30 years ago.
• A $10,000 investment in CDs would grow to almost $28,922 today.
• A $10,000 investment in bonds would grow to almost $33,904 today.
• A $10,000 investment in stocks would grow to almost $234,948 today.
All three investments look fantastic, right? Well, maybe until you consider inflation. Remember, inflation devalues money and reduces buying power. Inflation has averaged -2.6% for the last 30 years. Because of inflation, the $10,000 invested has been devalued. So now, 30 years later, it takes more than $21,111 to have the same buying power as the $10,000 had 30 years ago. So, $21,111 has to be subtracted from the investment returns as an adjustment because of inflation.
• The buying power of the investment in CDs is reduced by $21,111 to $7,811.
• The buying power of the investment in bonds is reduced by $21,111 to $12,793.
• The buying power of the investment in stocks is reduced by $21,111 to $213,837.
By investing in CDs and bonds, money was made, but it was not impressive considering it took 30 years. But if we look at stocks that have a higher return, the story is different. Even considering inflation, the buying power has still increased to almost $214,000! Now we are building some wealth! This is more than 27X better than the investment in CDs and more than 16X better than investing in bonds.
The whole point of this Money Matters article is to demonstrate the effect a high-interest rate has on the growth of an investment. But a high-interest rate is not the only factor that should be considered. You should think about risk. Although stocks offer high return rates, they also are at high risk. And, on the other side, CDs offer the very low returns, their return rate is guaranteed. I’m not saying investments that have low returns are “bad” investments, but you do have to curb your expectations. If you are looking to grow wealth, CDs and bonds are probably not going to get you to want to be.
A good investment portfolio will have a mixture of investments, and subsequently, the investments will have different return rates. Regardless of your investment mixture, it’s important to understand where, and how, your money is invested. There is no need to try this by yourself! It’s just not wise. If you want to invest, I highly, highly recommend getting a trained professional to explain your investment options and the consequences of each. The bible says, “Wisdom is found in a multitude of counsel” (Proverbs 11:14, 15:22, 24:6), so get professional help and become the best steward you can be! God bless!