- Personal Finance
Investing in the Future
- Investing will not make you rich quickly. It is different from speculating or gambling.
- Inflation is reducing the value of your cash if you don’t put it to work.
- Because of compounding effect, the sooner you get started, the better you will be in the long run.
- Investments which promise high returns also have high potential for loss.
- Start with the goals of learning and protecting your capital in mind.
- Consider the following low risk options as you learn:
- Risk-free high yield savings accounts.
- Diversified investment mediums- Index or Mutual Funds.
Will You Retire with Enough Money?
I believe that it is always good to ask yourself "what am I trying to accomplish" before you jump head-first into new endeavors. This is especially important in our case because it will define the mentality with which you dive into this new foray.
Over time, your personal experience will slowly temper you to come to terms with the fact that in order to succeed in this arena, you need to be steel your heart and resist your impulses.
My hope is to help you avoid the time and money that you may have to pay for this "personal experience."
What is Investing?
No one can put it as simply or with as much confidence as the most successful investor of our time, Warren Buffett:
"...the process of laying out money now to receive more money in the future"
It might seem like a simple concept, but when you have to do it consistently and over a long period of time, it becomes exponentially more difficult. Always keep in mind that successful investment is a combination prudent judgment, thorough research, and the nerves to sit still as a mountain amidst a raging storm.
Two Reasons to Start Investing Now
If you think your money is safe in the bank, you’re WRONG! Although the face value of your hard-earned money is safe in a bank account, the purchasing power of your money is steadily declining.
From the perspective of the economy as a whole, moderate inflation rates are viewed in positive light by economists as it reflects the overall growth of the economy is growing. However, for your savings sitting idly in the bank, it is bad news. The measly interest that banks pay pales in comparison to inflation rate.
Per data released by the Bureau of Labor Statistics, the average annual inflation rate in the US in the last 20 years is roughly 2.15%. Comparing this ~2% inflation rate to the 0.1% interest rate of a basic savings account, it becomes quickly apparent that banks stand much more to gain than the customers. They entice customers with the promise of “free money” to use your savings to boost their lending powers for a hefty profit. Meanwhile, customers lacking in financial awareness are simply content with this almost negligible interest payment, while simultaneously taking a beating from inflation.
While you may think that 2% is a small price to pay to keep your money safe, allow me to put it in perspective. If you wanted to buy a car for $10,000 in 1997, that very same car will cost you more than $15,000 in 2017. In other words, the money you have in your savings account has lost more than one-third of its value, while sitting “safely” in your bank account!
If you’re wondering why everything seem to cost so much more than the good old days, you may have guessed it by now, one of the key factors is inflation!
Trying to maintain the value of our hard-earned money should be a baseline goal that everyone has. There is nothing worse than having our hard-earned money diluted by the passage of time simply due to inaction. Now that we’re aware of the invisible hand of Inflation constantly in action, we must realize the importance of starting early to combat this.
2. Compound Interest
Compound interest is the greatest tool in our arsenal to grow our money. Compounding interest, in short, is to grow your investments on the foundation of previous growth. The best way to explain the powerful nature of compounding is through an example.
- Take for example you invest $10,000 at an annual growth rate of 10%.
- By the end of the first year, your investment would have grown to $11,000 ($10,000 + 10% * $10,000). This is where it gets exciting…
- By the end of the second year, your investment would have grown to $12,100. The 10% growth in the second year will be compounded upon previous year's results of $11,000.The total actual growth rate of your investment is, then,10.5% over the last 2 years.
- Now you might be thinking that an extra 0.5% is no big deal, but if we assume the same growth rate, and fast forward a few years. By the thirtieth year, $10,000 would have compounded to... a staggering $175,000. This number represents a growth rate of 1750% over 30 years, or an annualized growth rate of roughly 58%!
This is exactly why the concept of compound interest is especially essential in the young investors. Young investors have the advantage of time by their sides. They have the luxury of compounding their investment gains across a broader time horizons. If we assume the young investor started 10 years earlier, and extrapolate the previous example out to 40 years, a mere 10 additional years almost doubles to yield an astonishing 113% annualized growth rate!
The concept of compounding interest is one of the biggest reason that financial awareness should be taught at an early age. Merely through inaction, they’re losing an unbelievable amount of investment growth potential! Therefore, it is of utmost importance that harness the full potential your investment growth by starting NOW!
The Basics About Investing
There are many different types of investing instruments which each have their own advantages and disadvantages. Investors must weigh both their short term and long term goals to choose the best form of investment for their goals.
When the subject of investments come up, stocks are inevitably the first form that comes to mind. Companies issues stocks when they need to raise cash for capital or operational needs. Each share of a stock represents ownership in the company proportional to the total number of shares. For example, if Company XYZ issued a total of 100 shares, owning 1 out of 100 shares means that you have ownership of 1% of the company. There are two main forms of gains you can receive from stocks. The first is through increasing demand and thus increasing prices of the stocks that you're holding. The second form is a type of a passive income in the form of dividends. Some companies reward their shareholders by paying out a cash sum to their shareholders at a set frequency.
Pro: Potential for high returns. Highly liquid.
Con: Stock prices are volatile. Requires time commitment to ensure your investment is not a victim of shifting business conditions.
- Mutual Funds
A mutual fund is an aggregate of investments. A mutual fund is diversified across many different stocks and bonds. A properly diversified mutual fund protects investors from the swings of any single stock. There are different mutual funds which target virtually any investing strategy you can think of- growth, value, dividend, specific sectors etc. Mutual funds are actively managed by professional fund managers in response to market conditions.
Pros: Requires less time and experience in choosing funds. Portfolio is managed by professional fund managers with access to professional research. Diversification offers lower risks than stocks.
Cons: High management fees. Less potential for gains compared to individual stocks. No control over your portfolio.
- Index Funds
An index fund is really a subset of mutual funds. It shares several characteristics as a mutual fund in that it is highly diversified across many stocks and there is a plethora of index funds you can select from to suit your investment goals. However, there are also several unique traits which warrants its separate mention. Index funds removes the subjectivity of a fund manager, by tracking to an index such as the S&P 500. Because of this, index funds also has the advantage of lower fees due to lower turnover in the portfolio.
Pros: Lower fees. Diversification.
Cons: Possible tracking error. Less potential for gains than individual stocks.
When you purchase a bond, you’re giving a loan to the issuer which may be a government or corporation. By selling bonds to raise capital, the issuer can raise capital to fund operational or strategic advances by taking on more debt obligations instead of giving up any ownership in the entity. The basic mechanism of a bond is for a bond holder to receive a specified interest rate during the life of the bonds and for the bond issuer to repay the principle or face-value of the bond in its entirety at maturity. Before you invest in bonds, you must keep in mind that (1) bond prices move inversely to federal interest rates, (2) bond interest rates are proportional to their associated risks.
Pros: Yields periodic interest income. Less volatile than stocks.
Cons: Less potential for gains than stocks. Affected by rising interest rates. Subject to credit risks if you purchase low quality bonds
* The next few investment instruments below may offer very attractive returns, but in return are highly leveraged and more speculative and therefore riskier in nature. Hence, they are not recommended for individual investors unless they have (1) an profound understanding of the market and (2) have a high risk tolerance.
- Commodity Futures
- Stock Futures
If you managed to stay with me thus far, then you've already come a longer way than most. Hopefully, I was able to persuade you of the risks of inaction. The good news is that it's never too late to start learning. The bad news is that the journey ahead is still long and full of obstacles, and I've barely cracked the doors open.
As new investors, there are 2 priorities which I think you must keep in mind at all times:
- Protect your capital. Avoid as much risk as possible.
- Build your knowledge. There are untold numbers of financial products. They each have their unique characteristics. The trade-off will always be higher risk for more reward. To be successful, you must understand the trade-off of your investment of choice to maximize reward, while avoiding risk.
If you're unsure of what you're doing, but can't stand inaction, the temporary action you can take is to investigate higher yield savings accounts. There's been an increase presence in online banks leveraging different business conditions to offer higher interest rate on their savings accounts.
The longer term goal may be more to the tunes of investigating diversified investment products such as mutual funds or index funds to suit your needs. This can be considered a healthy and safe long term investing solution for many. It can lead to moderate, steady gains, which compounded over time, may be more than you think.
As you become more confident and ambitious with your investment knowledge and skills, you may start considering higher risk and reward products such as individual stocks. As you venture into these riskier territories, it becomes increasingly important to not get swept off course by the sweet promises of greed.
Whichever path you take, never forget your priorities to protect your capital. However ambitious you get, always keep in mind that success is built upon a firm foundation of knowledge.