It is very important for one to distinguish between investing and merely saving.
Saving involves simply setting money aside for future spending. It is usually put in a safe place, whether under your mattress or in a savings account at a bank, which you can get access to easily.
Investing is when you use your money to buy an asset that you expect to generate an acceptable return, through income or capital growth, making you wealthier over time. People who own businesses invest their personal money into these businesses to increase their wealth.
Investing involves using part of your income to buy investments such as shares in companies, bonds or property. You are putting the money you worked hard to earn to work for you to earn even more money. These investments can be attractive because they can produce two forms of returns –
- income in the form of dividends on shares, interest on bonds or rent from property; and
- capital growth, which is the rise in value of your investments over time so that when you sell them in the future you can get more money for them than you paid.
How is investment different from saving? Savings typically are low risk for the return you receive on the amount of money you saved. From savings you can receive income but no capital growth. Because they are low risk, savings also attract low returns in the form of low interest rates.
Sometimes, the rate you earn on savings can be less than the rate of inflation, so your wealth is actually going backwards. This demonstrates that there is a risk to only relying on saving money to achieve your long term goals.
Investments typically are higher risk for the return you receive on the money you invest. Because they are higher risk, investments tend to attract higher returns in the form of income and capital growth.
Let’s compare examples of savings and investing in shares.
Savings example 1: If you saved 1000 kina in your bank account at an interest rate of 5% a year (let’s call it year 1), you would receive an income of 50 kina for the year. If you leave your 1000 kina in the bank and spend the 50 kina, then in year 2 you will again earn an income of 50 kina. If you again leave your 1000 kina in the bank and spend the 50 kina, then in year 3 you will again earn an income of 50 kina.
At the end of 3 years you will have 1000 kina and will have earned 150 kina.
Savings example 2: If you saved 1000 kina in your bank account at an interest rate of 5% a year you would receive an income of 50 kina for the first year. If, instead of spending the 50 kina, you add it to the 1000 kina, you are now earning income on 1050 kina. You will earn an income of 52.5 kina for year 2. If, instead of spending this 52.5 kina, you again add it to the 1050 kina, you are now earning income on 1102.5 kina. You will earn an income of 55.13 kina for year 3.
At the end of 3 years you will have 1157.63 kina and will have earned 157.63 kina.
Investment example: If you invested 1000 kina in 100 shares (10 kina per share) which paid dividends of 0.5 kina per share a year in year 1, you would receive an income of 50 kina for the year. Assume that the market price of those shares also increased by 5% during the year and at the end of year one are worth 10.5 kina each. If, instead of spending the 50 kina dividend, you use it to buy 4 more shares through a company Dividend Reinvestment Plan, you are now earning income on 104 shares for year 2. Assume that the company again pays a dividend of 0.5 kina per share in years 2 and 3 and the market price of those shares also increased by 5% each year and each time you reinvest the dividends to buy more shares.
At the end of the three years, because of the way dividend reinvestment works, you will have 114 shares worth 1319 kina and 9.68 kina in cash. Over the 3 years, you will have earned 329 kina.
Examples 2 and 3 are examples of compounding, or re-investing your income rather than spending it.
The examples are simplified as they ignore certain costs and they make certain assumptions about returns and risk, but they will give you an indication of potential outcomes. However, you need to remember that, while the examples assume the price of shares increase each year, they may also decrease, which would result in a very different outcome. This is why it’s very important to understand risk and return.
The information in this article is general in nature and you should take care to inform yourself about the specific characteristics of a particular investment before making a decision to invest in it. PNGX recommends discussing your investment objectives and needs with a stockbroker or qualified financial adviser. In PNG, you can either contact JMP Securities Limited (enquiries@jmpmarkets.com) or Kina Securities Limited (wealth@kinabank.com.pg).
By following these articles and reading the information available on the PNGX website (www.pngx.com.pg) or following PNGX on LinkedIn or Facebook you can learn more and build your wealth by investing in PNG.
