Savings and Investing Made Easy; Part IV Invest Today – Enjoy Tomorrow!
The 20 years old you is investing just $100/month in a Roth IRA that is invested in well picked mutual funds. Assuming the funds earn average market returns, how much money will be in your account when you reaches age 67? Any Ideas? How does $2.2 million sound!?
Now if you were to wait just 10 years, and you begin investing at age 30, following the same assumptions as above, what do you think the outcome would be? That $2.2 million is now reduced to $730,000. That means that in waiting just until you are just 30, you would now have to invest more than $300/month just to achieve that same $2.2 million by age 65; that’s more than 3 times the amount!
That is your first lesson on investing, don’t wait!
Welcome to Part IV of the Savings & Investing Made Easy series! If you are at this stage in your financial journey, congratulations! You rock! If you are not quite there yet, don’t be discouraged! Use this information to educate yourself on the topic of investing, to inspire you to dream about your family’s future, and to serve as motivation for your journey to financial greatness!
Interested in this series but haven’t yet read Parts I-III? Click here to check out the Savings & Investing Series!
While the Investment Level sits perched, high above the others, it is important to recognize that it is only able to do so because we expertly laid the foundation for it to rest upon. Without our Management and Savings levels established the entire pyramid would crumble at the slightest hiccup.
What is Investing?
The basic concept of investing is quite simple; it’s the expenditure of time or money with the expectation of that investment bringing you increased value or earnings. While the investment of your time can arguably be more important, in this series we will be referring to investments from a financial standpoint.
What Investing is Not!
We live in a world of instant gratification. With smartphones and tablets we are never further than a few swipes and taps away from every piece of information we as a species have ever collected. I love technology, I embrace it, however it has led many of us to become impatient, unfocused, and stagnant.
Investing is not a get rich quick scheme. While there certainly are cases of overnight millionaires this does not represent the norm. I want you to put the concept of “fast money” out of your brain.
Do you want to know the secret of investing? It’s easy! Pick quality investments and consistently deposit money into it! You can’t earn significant levels of success from inconsistent actions.
I know what you’re saying, “if your investing strategy really works, why are there not more millionaires?” Well that’s simple, it takes dedication, hard work, and commitment; things that many are not willing to do on the long term!
With regards to investing you need to be patient, you need to have focus, and most importantly you need to be consistent. Just like any measurable success, that success did not occur overnight.
Often times we see successful people and we assume that we too can just wake up and be at that same level, not accounting for the fact that there were likely years of small, yet consistent actions that took place that lead to the success you are seeing!
So why do we invest? Well we already learned in Part III that Savings provide us with safety and liquidity. This safety comes at the expense of yield; savings vessels rarely have any!
I hear people tell me that they would like to put all their money in savings accounts because they simply cannot bear to see their money lost in the market. I get it, risk tolerance is something every financial planner should factor into a financial counseling however who would you rather be from these two examples below:
Example 1
You are 20 years old and save $500/month for retirement in a savings account. By age 67 you have saved a respectable $282,000, less than half of the recommended retirement nest egg.
Example 2
You are 20 years old and save $500/month for retirement in a Roth IRA and or 401(k), invested in well researched mutual funds earning the average rate of return of the market for the past 75 years. You retire at age 67 with $11.4 million in the bank!
In both examples you contributed the same $282,000 towards your retirement while in example 1, you only get to take out exactly what you put in over those 47 years. In example two, on the other hand, you reaped the rewards of compounding interest, and your money earned you $11.2 million more than the alternate you in example 1!
But it’s actually even worse for the you in example 1, we forgot to calculate inflation. Inflation simply means that one dollar today will be worth less than a dollar tomorrow. How much you may ask? Consider that an item that cost $100 in 1985 would cost you $229 today. That’s about 129% difference!
The point I’m trying to convey is that the investment plan in Example 1 is even worse than it initially looks because that Mike is not just missing out on the higher balance from interest, but due to inflation his money will actually be worth less upon his retirement than it was when he contributed it.
In all actuality any time your money is not earning at least the rate of inflation, 3.22%, your money is losing value.
That means that you need to earn at least 3.22% just for your money to be worth tomorrow what it is today! That excludes just about everything in the savings world which answers the question as to why we invest!
A good investment is based upon four factors:
Time Horizon
Objective
Risk Tolerance
Age
Time Horizon
Time Horizon is the duration of time between the initial investment and the projected time you will need to withdraw your money. You may recall from Part III that, due to how the market fluctuates, we don’t want to invest our money if we need that money in less than 5 years.
Example - If you plan on making a down payment on a home in three years you would not want to invest that money since you may find that the market has decreased, and your funds are now worth less than when you originally purchased them. In this instance you would either be forced to realize a loss, or you would have to wait until the market picks back up, meaning you would have to push out your time horizon.
Objective
What is the goal of this investment? If your goal is for this fund to produce a reliable source of income, let’s say for a retiree, you likely wouldn’t want to be invested in an ultra-high-risk fund as the “guarantee” of income is ultimately more important than the risk of losing anything.
If your objective is to grow your money in an aggressive manner, those who have prolonged time horizons or those who are not solely dependent on this income, then you would want to be invested in a fund that rewards your increased risk with increased reward.
Age
The role age plays in your investment strategy is that it makes several assumptions. It assumes that the younger you are, the more aggressively you can invest because you have more time to recoup any dips in the market. It also assumes that the older you get, the more likely you are to invest in lower risk vessels as you have less time to recoup said losses and you may be more dependent on that investment as a source of income.
Risk Tolerance
This is what makes finance personal. Risk tolerance is very subjective to the individual. What one-person views as an acceptable risk, another may view as too risky. The general rule of thumb is that the younger you are the more invested you should be in “higher risk” funds while those who are later in their life should exercise more conservative investment strategies.
Types of Investments
There are many different types of investments:
Stocks
Mutual Funds
Bonds
Real Estate
Commodities
Options
Today we will be discussing the three types of investment the average person is likely to come across: Stocks, Mutual Funds, and Bonds.
Although I am a keen believer in real estate investing, I am only a fan of it when you are able to purchase your investment real estate with cold hard cash, no loans! (Just to clarify I am speaking about the purchase of a home with the sole purpose of turning it into a rental or flipping it, not the purchase of a primary home)
Stocks, Mutual Funds, and Bonds, on the other hand, are all investment vessels you can get into with relatively small initial investments.
While Stocks and Mutual Funds have my full endorsement, I also have a place for Bonds; not within 100’ of my portfolio! I will explain in a moment!
Stocks
Stocks are what everyone thinks by default when they think of investing. Each share of stock that you own represents a share in the ownership of a particular company and as such, you benefit from that company’s success as well as feel the burden when times are rough.
Owning stocks in one, or even just a few companies, is risky as you are putting all of your eggs in one basket. To be properly diversified it is advised that you be invested in 20-30 single stocks to broaden your portfolio.
Despite the requirement for 20-30 Stocks in order to maintain diversity, wisely chosen stocks can have an average rate of return of approximately 11% or greater.
Mutual Funds
Mutual Funds are my personal favorite investment vessel! A Mutual Fund is simply multiple single stocks that are pooled up into a fund. They are managed by professional fund managers, and are mutually funded by a group of investors, of which I am one of. If you think of single stocks as sheets of paper, think of a Mutual Fund as a folder. The fund manager simply picks the specific stocks that the fund will be comprised of based upon the goal of that particular fund.
Why are mutual funds so awesome? Well if the nature of the game is diversity, then Mutual Funds are king! The very structure of a mutual fund ensures diversity as they are comprised of numerous, sometimes 100+ individual stocks.
Mutual Funds can be comprised of similar stocks, for example a technology fund may have Apple, Google, Microsoft, Master Card and so on while other funds could be comprised of opposing stocks such as technology and commodities. If technology dips down, commodities will either maintain or go up. This built-in diversity serves as a form of protection from the fluctuating market, all within a single fund.
Remember if you want this type of diversity from single stocks you would need a minimum of 20-30 individual stocks!
I will talk about Mutual Funds in depth in an upcoming post but just know that you should have no difficulty locating a fund that either matches the market or outperforms it completely! How do I know this? Mutual Funds are what I am invested in and I personally do not own one fund that has earned less than 10% as their average over the past 15 years.
Don’t feel comfortable in picking your own funds? You’re not alone! Regardless of whether or not you are going to be choosing investments on your own, or going through a fund broker, I highly suggest that you hop online and gain at least a basic understanding of the concepts of investing, Investopedia.com and MorningStar.com are great places to start! The most important thing to remember is that you never want to put your money into something that you don’t understand!
So how do Stocks and Mutual Funds earn you money? Great questions, in the form of dividends and capital gains.
Capital gains are the stereotypical, buy low sell high technique. The goal being to purchase shares of stock or a fund at one price and sell it when it is worth a higher amount. There can be no capital gain until the stock is sold for a profit.
There are two forms of capital gains:
Short Term – Asset is held for less than one year and upon sale, the gains are taxed as income for the year at your personal income tax bracket.
Long Term – Asset is held for longer than one year and upon sale, the gains are taxed for most at less than 15%.
Dividends on the other hand are assets paid out of the profits of a company to their stockholders. Dividends can be paid out in two ways: As taxable income for that year, or they can be reinvested to purchase more shares of that stock or fund, not to be taxed until its sale…my personal recommendation!
Bonds
For better or for worse, savings bonds are likely the safest investment out there. Like a savings account, the money you put inside is guaranteed to be there, however, unlike a savings account, you actually will earn a little interest along the way; maybe even the rate of inflation…
A savings bond is simply a loan from you to a local municipality or the federal government. In exchange for your money, they give you a savings certificate which serves as an IOU.
You agree to allow them to hold on to your money for a specified period of time, the maturation period, anywhere from six months to 30 years, and at the end of that period you are not only repaid your initial investment, but they thank you for allowing them to make more money off of your money by providing you a small percentage of the growth (.10%-5%).
Why am I so opposed to bonds? The main reason is that at this point in my life I have no need for such conservative investments because I have more than enough time to ride out any market dips with my more aggressive investments.
Who are bonds designed for? Bonds may be a great choice for two categories of people. The first are those who have smaller nest eggs and are later in life. This category of people still should invest their money however they are dependent on that money as a source of livable income and may not be willing to or able to accept any potential “loss.”
The second group of people who may benefit from bonds are those who are unwilling to accept any risk. If the reason you are unwilling to accept increased risk is simply a lack of understanding, I encourage you to learn and become more comfortable so that you may engage in more substantial investments.
If you are just unwilling to accept risk just because… that’s ok too! This is PERSONAL finance!
Some common questions I often hear during financial counselings:
“But Mike, I don’t want to lose money!”
Well that makes two of us! First of all, you need to choose quality investments. When buying a new Mutual Fund, I only consider funds who have maintained an average of 10% return over the past 15 years or longer; yes, they exist! Put in the effort in the front end so that you are not scrambling to make a sale in lieu of a hasty investment.
“If the market goes down don’t I lose my money?”
It’s a solid question. The answer depends on how you react. If you buy one share of a company for $100 and tomorrow the market says that one share is now only worth $50, you still own the same number of shares. At this point you have not realized any loss. You only lose money, realize the loss, if you decide to sell that share at the new lower value.
If you wait a bit longer and now the market says your one share is now worth $150, you again haven’t realized any actual gains unless you decide to sell your stock at that increased price.
Think of the stock market as a roller coaster. The ride will take you up and down but the only people who are truly affected are those who jump off.
Roth or Traditional?
Very good question! If you can, Roth, Roth, Roth, and here’s why! Recall from the opening example where the 20-Year-old you invested $100/month until age 67. In that example you contributed $56,400 to that account however, due to the magic of compound interest and time it grew to an outstanding $2.2 million.
In a Roth account, all of that growth is tax free, meaning that, since you already paid the taxes on the $56,400, the growth is not taxed as well. Now I am not spectacular at math but the majority of this $2.2 million appears to be growth!
Always take the roth!
Conclusion
This is a lot of information, I know. It is a huge topic and one that many of us shy away from due to our lack of understanding. I promise you the concepts are fairly straight forward.
My goal is not to have everyone become the next Warren Buffett, however I would encourage each of you to at least gain a working knowledge on the topic so that you can become excited enough to call your investment broker and begin the process of having your money work for you!
