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Why do people invest?❓

Analysis written by Vinay Soni

Well, people care about the “real” value of money rather than the “nominal” value. The “nominal” value of money is the value of money in currency. For example, £5. The “real” value of money is what you can buy with the nominal amount. For example, if inflation causes a loaf of bread to increase from £1 to £2 during years 1 and 2, before you could buy 5 loaves of bread with £5 however, now you can only buy 2.5 loaves of bread. You always have had £5 but your nominal amount of money becomes less worthwhile as inflation exists.

A way to combat this is by growing your money. Bank’s interest rates sometimes do not offer rates that are higher than inflation, therefore your money typically grows at a slower rate than inflation causing your money to become less worthwhile like in the example above. Relating to the example above, this would be if your £5 grew by 20% from years 1 and 2 so now it's worth £6. In year 1 you could buy 5 loaves of bread but in year 2 you could only buy 3 loaves. Even though the nominal value of money increased by a pound, the real value of money has decreased like in the original example because the bank’s interest rates were not high enough to combat inflation.

Investing essentially involves growing your money’s real value faster than inflation. That is ultimately why people invest. Let’s bring investing into our example. Let’s say now that from year 1 to year 2 your £5 grew by 120% so in year 2 it was worth £11 in year 2 and assuming inflation caused bread prices to rise to £2 again. You could buy 5 loaves of bread in year 1 but now in year 2, you could buy 5.5 loaves of bread. As the return exceeds inflation the “real” value of money increases.

The example above is highly exaggerated as bank interest rates vary but are generally lower than 3%, whereas the average return of the S&P 500 is 10.26%. Inflation over the past few years has been quite irregular, varying from 2% and peaking as high as 11.1% in October 2022, due to various reasons but generally, inflation in the UK is around 2%. However, this example is to ensure you understand that investing allows your money to become more worthwhile, increasing it's nominal and more importantly its real value so you can combat inflation and afford a wider variety of goods.


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