Welcome to Part 2 of Investing 101. In Part 1 of this series, I explained what investing is and why you should care. The decision to invest (instead of spend or save) a $1,600 inheritance I received from my grandmother literally changed my life. Sharing that experience of financial empowerment with other women is what I care about. If you haven’t already read Part 1 of this series, I suggest you take a few minutes to do so.
Once you learn how compound interest works, you are going to kick yourself if you aren’t already in the habit of regularly investing some of the money you earn. First, you need to understand how “simple interest” works. Imagine you put $10,000 in a savings account that earned 4% per year. After one year, you would receive $400 in interest and your account would be worth $10,400.
If you earned simple interest for 20 years, you would receive $400 x 20 (or $8,000) in interest. That means that in 20 years your $10,000 would be worth $18,000. But if you earned compound interest, in 20 years your $10,000 investment would be worth $21,991. With compound interest even your interest earns interest!
Here’s where compound interest gets exciting: instead of making just one deposit of $10,000, what if you were able to add another $1,000 to the savings account each year? In 20 years your account would be worth $51,689. What a difference!
The problem you will find is that no savings account currently pays 4% interest. You might be able to find a bank that pays 1% or 1.5% interest on money in a savings account. If you are willing to lock up your money for one or two years you can probably earn north of 2% interest by investing in a certificate of deposit (CD).
You can’t grow wealth by leaving your money in one of these bank products. It’s not much better than leaving your money under a mattress. Interest rates, although rising, are still near historical lows. If you want your money to grow over time, you need to take investment risk. The hope is that your initial investment (principal) might grow, but it also might go down in value. As a new investor, you’ll learn pretty quickly that investments that have the potential to deliver higher rates of return often fluctuate in value from year-to-year or even day-by-day.
In the three-minute video below, I explain the “Rule of 72” which is a quick way to calculate approximately how many years it would take to double your money when invested at a certain annual interest rate or generating a certain annual rate of return. For example, if you were to find an investment that earns a 7.2% annual rate of return, your money would double in approximately 10 years. However, if you were to invest in a savings account that generates only a 1% annual rate of return, it would take 72 years for your money to double.
Most people think real estate is a good investment. It’s one of the rationales people use when deciding to buy a home instead of renting. Real estate can turn out to be a bad investment if you sell it at a price lower than what you paid for it. You might have to sell your home if you (or your spouse) lose a job, get divorced, or cannot make your mortgage payment. Please do not assume real estate is a safe investment. Real estate prices usually go up over time, but not necessarily at the specific time you need to sell.
Real estate also carries liquidity risk which means you can’t liquidate the asset very quickly to obtain cash. When you invest in publicly-traded securities such as stocks and bonds, you usually receive cash within days of selling.
If you want your money to grow over time, you need to take investment risk.
It’s also very expensive to sell real estate. On a $500,000 house, 6% (which is $30,000) might go to brokers’ fees and other closing costs. Compare that with selling $500,000 worth of a diversified stock portfolio. Depending on how many positions are held, the sales commission could be less than 50 bucks.
I prefer investing in stocks and exchange-traded funds (ETFs) over physical real estate. Through ETFs, I can have exposure to many asset classes including U.S. and foreign stocks; bonds; master limited partnerships; commodities such as oil, silver or gold; and even real estate through real estate investment trusts.
The options for investing are endless, but most people stick to the basics: mutual funds, stocks, bonds, and ETFs.
Mutual funds are like the training wheels of investing. If you contribute to a retirement plan offered by your employer such as a 401(k), 403(b), or thrift savings plan (TSP), your money is most likely invested in mutual funds. If you don’t plan to retire for at least ten years, you probably have most of your money invested in a stock mutual fund. If you plan to retire in only a few years, you probably have most of your money in a bond mutual fund. Or you may invest in a combination of several funds. Sometimes employers make it easy to choose by offering target date retirement funds.
When you purchase a share of company stock, you become a shareholder of that company. You might also receive quarterly dividends. Annual returns on stocks can vary widely. But if you are investing for a 20 or 30 year period, for planning purposes you might want to assume a seven to nine percent average annual return. This return might be comprised of both capital appreciation as well as reinvestment of quarterly dividends where dividend income is used to purchase additional shares of stock. There is no guarantee, however, that stocks will continue to generate rates of return as high as experienced in past 20 to 30 year windows.
When you invest in a bond, you are typically loaning money to a corporation or government or quasi-government entity. Bonds have risks too although they are generally seen as less risky than stocks. While they may pay consistent interest, they may also appreciate or depreciate in terms of price if not held to term.
ETFs are like mutual funds but with a whole host of benefits that are too detailed for this article.
There have been real estate market crashes as well as stock market crashes. Even supposed “safe” bonds can go down in value. So if you need cash to pay for critical living expenses in the next two to three years – such as a down payment on a house, tuition, or medical care – this money should not be invested. However, if you are willing to sock money away for ten years or more, then you should be able to handle the ups and downs of stocks and other investments, as long as you learn how to manage your asset allocation or hire a financial advisor to help you.
Read Part 3 of this series in which I explain how to invest for income versus growth, and how to start investing in a 401(k), IRA, or brokerage account.
If you are separated or recently divorced and wish to learn more about investing and steps you can take to ensure you don’t run out of money, I invite you to take my online course. Make sure to enter WORTHY as the coupon code to get $50 off.
Disclaimer: The information contained herein is strictly for educational, informational, and illustrative purposes, and should not be considered personalized investment advice.
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