If you asked the average saver if it's safer to invest $100 in the stock market or to put $100 in a savings account, most would pick the savings account. This makes sense in the short term: Stocks can lose value, but the Federal Deposit Insurance Corporation (FDIC) guarantees savings accounts. However, the long-term answer is the exact opposite – it is much riskier to continue to sock money away into savings than to invest it. It certainly is possible to make money in stocks.
This is one situation where short-term rationality does not equate to long-term rationality. The $100 put into a savings account will earn a very low interest rate, and over time, it will likely lose value to inflation; a real loss in purchasing power is almost inevitable. The $100 invested into the stock market may have up days and down days, but the lesson from history is that stocks outperform virtually everything else over a period of several decades. (Caveat: Needless to say, we are not talking about putting all your money in high-risk penny stocks or similarly risky investment vehicles.)
Monthly contributions really begin to make sense when you understand the concept of compounding. Compound returns act like a snowball rolling downhill: It begins small and slowly at first, but picks up size and momentum as time moves on.
The two key elements of compound returns are re-investment of earnings and time. Stocks generate dividends that can be re-invested, and over time this acts as a self-feeding source of financial growth. At its core, compound investing is all about letting your interest generate more interest, which ends up generating even more interest down the road.
Suppose, for example, that a 30-year-old individual has $5,000 invested in equities earning 8% a year, which is a little below historical averages. At the end of the first year, the investor's portfolio earned $400 in interest ($5,000 x 1.08). If the investor re-invests the interest, the same 8% growth will yield $432 in year two ($5,400 x 1.08). Year three will generate $466.56, year four generates $503.88 and so on. At age 35, the re-invested portfolio is worth $7,346.64, all without any additional non-interest contributions by the investor.
Follow this pattern for another 25 years, and the investment reaches $50,313.28. This represents more than a 10-fold increase, despite a lack of additional contributions.
Now suppose the same 30-year-old investor finds a way to save an additional $100 per month. He contributes the extra $100 to his portfolio and keeps reinvesting his dividends and interest payments. His investment still earns 8% per year. For simplicity's sake, assume compounding takes place once per year in January.
After a 30-year period, thanks to compound returns and a small monthly contribution, his portfolio will grow to $186,253.14 (as compared to $50,313.28 without the monthly contributions). While $186,253.14 is not enough money to retire on, especially after 30 years of inflation, remember that this is just with $100 a month in contributions and returns below historical averages.
Suppose the annual return is 9%, which is closer to historical averages for a 30-year period. With a $5,000 principal investment and $100 monthly contributions, the portfolio grows to $229,907.44. If the investor is able to save $200 a month for contributions, the future value of his portfolio is $393,476.48.
Equities (such as stocks or mutual funds) are the best investment option for those who are decades from retirement. Stocks are more likely to lose value in the short term than bonds, certificates of deposit (CDs) or money market accounts, but they have been proved to be a better long-term value that any common alternative.
This is especially true in low-interest-rate environments. CDs, bonds, money market accounts and savings accounts all yield less when rates are low. This often pushes savers to equities to beat inflation and bids up the price of stocks and other equity assets.
Research by Dr. Jeremy Siegel and John Bogle, the founder of Vanguard, looked back over a period of 196 years and compared the real returns for stocks, bonds and gold. They found that if an investor had started around the year 1810 (the New York Stock Exchange was actually founded in 1817) and put $10,000 in gold, his inflation-adjusted portfolio would be worth just $26,000. The same investment in bonds would have grown to $8 million. However, had the investor picked stocks in 1810, he would have turned his $10,000 in $5.6 billion.
Stocks are still the big winner if you select a more realistic time frame; most investors have a 30- to 40-year horizon, not 200 years. Between January 1980 and January 2010, the average annualized growth rate of the S&P 500 was 8.15%. The Dow Jones averaged 8.81% over the same period, while the NASDAQ jumped 9.51% per year. Bond returns averaged less than 3% between 1980 and 2010. Inflation robbed cash of 62.2% of its purchasing power over those 30 years, meaning that $1,000 in a savings account in 1980 would only have a real value of $378 in 2010.
The 30-year period between 1985 and 2015 was even stronger. The S&P averaged 8.73%, the Dow Jones averaged 9.33% and the NASDAQ averaged an impressive 10.34% per year.
The first step in investing $100 a month is to save $100. There are a number of simple steps the average person could take to cut costs; it doesn't require drastic lifestyle changes.
Shopping at warehouse stores (Costco and Sam's Club are two good options) for bulk items is a good idea. Bulk purchases cost less per item, so maybe make one trip to Costco each month rather than three or four trips to the local grocer. If you eat out a lot or buy your lunch every day, this is probably a better place to start.
If you need a little more discipline in your checking account activity, set up an automatic transfer each month from checking to savings. Savings are more difficult to dip into, and this could end up saving you a lot more than $100 a month by preventing frivolous purchases.
If you pay for utilities, you can save on air conditioning by opening a window or buying a small fan. The opposite is true in the winter, when you can close your blinds or throw on a sweater to help avoid high energy bills.
Younger workers can save by going out on the town one or two fewer nights a month, which could save at least $50 to $150 a month. Homeowners can refinance their mortgage to lower their interest payments. Credit card users can sometimes save by just transferring their balance to a card with a lower interest rate.
If you don't think you can save $100 a month, try tracking all of your purchases for a month. This is a healthy financial habit that can help you find extra savings by limiting impulse spending.
Investing $100 a month adds up over time, especially with compound interest. Making small sacrifices every day to consistently add $100 to your stock investments every month will benefit you in the long run.