1. How Investing Works
When you think about investing in its simplest terms, it’s not a complicated process. You use the money you have now to build more wealth for the future. But throw in a little terminology, like index fund, preferred stock, diversification, or dividend yield, and suddenly a simple concept starts to feel a little overwhelming.
It’s no wonder that a recent BankRate Money Pulse survey showed that 52% of Americans report not owning any stocks or stock-based investments. When asked why they haven’t taken the steps to start investing, these were their responses:
- Twenty percent plead ignorance, saying they “don’t know enough” about the markets.
- Nearly 10% don’t trust the professionals that are meant to help them (stock brokers and financial advisers).
- Seven percent of respondents think stocks are too risky.
- Fifty three percent of those who don’t own stocks say it’s because they can’t afford to.
It’s time to overcome the uncertainty of the unknown, and let go of the stereotype that you need a wealth of funds to get started. Investing is still the best way to put time on your side and grow your money for future needs such as homeownership, college, or retirement.
Growing Your Money With Investments
Investing is all about putting your money into different investment tools in an effort to grow your funds over a period of time. Using tools of investment, your money grows faster than it would in a typical savings account.
Compound Interest is Your Friend
Investing money means earning money due to interest. Many savings accounts utilize simple interest, where your account earns the same amount interest each year. Most investments operate with compound interest, which lets you earn interest on top of your interest. Let’s take a look at two scenarios comparing simple and compound interest.
1. Simple interest: You open an account with $1,000 and the account yields 5% in simple interest. This means you will earn 5% on your original deposit of $1,000 every year. At the end of year one, you will earn $50 (account total: $1,050). After year two, you will earn another $50 (account total: $1,100). By year ten, you will have $1,500.
2. Compound interest: You invest $1,000 in an account yielding 5% in compound interest. This means you will earn 5% on your original $1,000 plus the additional interest you earn each year. At the end of year one, you earn $50 (account total: $1,050). At the end of year two, you will earn 5% on your new account balance. So instead of earning just $50, you’ll actually earn $52.50 (account total: $1,102.50). By year ten, you will have $1,628.89.
How Much Money Do I Need to Begin Investing?
The answer is that you probably don’t need nearly as much as you think you do. Investing is not just a “wealthy man’s game,” and you don’t need thousands of dollars to get started. In fact, here are several scenarios of starting your investment strategy with different dollar amounts:
- Most financial advising groups require a minimum investment of $1,000 to open a new account
- Investing just $100 a month (less than $3.30 per day), starting at age 25, can earn you $1,000,000 by age 65.
- Many online investment apps allow you to begin investing with just a $5 account.
- You can open an IRA account at your credit union with just $1.
2. Before You Get Started
Your very first step in starting an investment plan is getting a clear picture of your monthly income and expenses and determining how much money you can commit to “invest in yourself.” But, before you jump into investing your money for future growth, there are two items you need to check off your “financial to-do” list.
Pay Off Non-Mortgage Debt
An investment strategy cannot reach its full potential if you’re being dragged down by a lot of non-mortgage debt (credit card debt, student loan debt, auto loans, or other personal loans). These examples, with the exception of student loans, are classified as bad debt as they do not work towards increasing your net worth. Earning 5% in compound interest makes less of an impact when you are paying 16% interest on a credit card balance each month.
If your monthly expenses includes a $300 student loan payment and a $400 auto loan payment, think about how that $700 a month could begin earning compound interest from long-term investing.
Establish an Emergency Savings
Placing your money into long-term investments isn’t nearly as important as ensuring your financial security right now. You can do this by starting an emergency fund. Your emergency savings should be enough to cover three to six months of expenses and will help you in situations like loss of employment, a major car or home repair, or medical emergency.
Open a bank investment account, such as a money market or share certificate, for your emergency fund, where it can earn a higher interest. The key is to keep the money in a separate account where you won’t be tempted to access it regularly, but also choose an account where you won’t be penalized for accessing your money quickly if the need arises.
And, don’t forget, your emergency savings should not be “set it and forget it.” As your income grows, and your monthly expenses increase, readjust the amount in your savings to ensure you still have the ability to cover several months’ worth of expenses.
3. Types of Investments
It’s this step in the process, choosing the types of investments to put your money into, which throws off most new investors. Here is a rundown of the options that are available to you.
401(k) and Individual Retirement Account
Do you have a 401(k) or IRA account? Then guess what, you’re an investor! These types of accounts are an easy way to get started in long-term investing.
A 401(k) is a great investment tool for several reasons, first of which is the tax benefits. The contributions you set aside for your 401(k) are taken from your paycheck before taxes are withdrawn. This lowers your taxable income and you end up paying less in taxes. Additionally, the money you earn in interest in your 401(k) account is tax-deferred, meaning you don’t pay taxes on the earnings until the funds are withdrawn.
The other benefit that many investors receive from a 401(k) account is an employer match. Many employers will match your 401(k) contribution up to a certain percentage, essentially doubling your investment.
If you employer doesn’t offer a 401(k) benefit, or if you’ve already maxed out the contribution limit set by your 401(k) plan, you also have the option of opening an Individual Retirement Account (IRA).
IRAs are not tied to employment and can be opened at your bank or credit union. Roth IRAs and Traditional IRAs are the most common accounts available to you, and like a 401(k), you can grow your money and enjoy tax benefits. A Traditional IRA allows you to make tax-deductible contributions but withdrawals from your account will be taxed as income. With a Roth IRA, your contributions are taxed, but withdrawals from your account are not taxed.
Investing in stocks means you are buying a share of ownership in a corporation. Companies issue stock for public purchase when they want to raise money for future growth. The two main types of stocks are common stock and preferred stock.
Common stock gives share owners the right to vote at shareholders’ meetings and to receive dividends. Preferred stock does not guarantee voting rights, but has first claim to assets and earnings if a company goes bankrupt or is liquidated.
The value, or price, of a company’s stock goes up and down based on the evaluation of the company performance and the result of market forces.
In simple terms, a bond represents a loan to a company or government entity. You are paid back in an agreed upon number of years, and in the meantime, you earn interest on the loan. When investing in bonds, the key information you should know is the face value, the coupon or yield, the maturity, and the issuer of the bond.
- Face value is the value of the bond at the time it was issued and represents the “principle” of the loan.
- The coupon is the interest rate that the bond issuer agrees to pay the bondholder over the life of the loan. This can be a fixed-rate or adjustable/variable rate. Some bonds do not pay a coupon. These are called zero-coupon bonds. Instead of earning interest, they are purchased at a discounted price and repaid at the full price at maturity.
- Maturity of a bond is the date that the bond’s principal is due and bondholders are repaid in full. The further out the maturity date, the higher coupon it must carry because there is more chance that company will not be able to repay.
- A bond issuer is the company or government agency that issues the bond. Government issued bonds are seen as more secure, because the government always has income (taxes) to repay its debt. However, if a corporation fails to make profits, it may be unable to repay on their bonds.
When comparing stocks and bonds, stocks are considered a riskier investment because unlike bonds, there is no guaranteed return on your investment. With stocks, you can make a lot of money, but you can, just as easily, lose a bulk of your investment.
When you invest in mutual funds, you are making an investment into a collection of stocks, bonds, or securities, also known as a portfolio that is overseen by professional management. As an investor, you buy a share of the mutual fund and the income it generates. Mutual funds allow those with little investment knowledge to get into the market by relying on the expertise of a professional management team.
The most common types of bonds include:
- Equity fund which invest in stocks
- Fixed-income funds which invest in bonds
- Balanced funds which invest in both stock and bonds
- Money market funds which are risk-free
4. Your Investment Strategy
When determining which investment vehicles are right for your money, it’s important to consider two key elements of any investing strategy: risk tolerance and diversification.
Determining Your Risk Tolerance
Before you start any type of investing, you should have a firm grasp of what your investment goals are. You may be saving long-term for your retirement or paying for your child’s education, or you may have more short-term needs for your money, such as buying a home.
With these goals in mind, you’ll know how much risk you can take in your investment strategy. A general rule of thumb is that younger investors with long-term goals can take more risk, while older investors with short-term needs should be more conservative. But risk tolerance should really be determined by your own personality.
When determining your risk tolerance, ask yourself questions like:
- When do I plan on using the money in my investments?
- Will I use my savings for a one-time purchase, access it over the course of a few years, or access it over the course of many years?
- If my investment lost value over a short period of time, how would I react?
- Am I trying to make as much money as possible, slowly grow the money I have, or simply not lose my money?
Risk profiles typically fall into one of the following categories:
Extra Cautious: These investors are looking for returns from investing, but also want to preserve their money. Dips in the stock market may cause them to worry, especially if they need to access their money in five years or less.
Cautious: Cautious investors are willing to accept a little more risk. Small market dips are no need for concern because cautious investors typically don’t need to access their money for at least ten years.
Assertive: Assertive investors are ready to face some risk in order to grow their money. Because they won’t need access to their money for 20 or more years, drops in the stock market won’t cause them too much panic.
Aggressive: Aggressive investors know that big risks — but smart risks — will increase their long-term investments. When the market drops, they know there is plenty of time to recover, because they won’t access their money for at least 30 years or more.
Diversify Your Investment Strategy
One way to manage the risk in your investments is to employ diversification in your investment strategy. Diversification simply translates to, “Don’t put all your eggs in one basket,” and can ensure that one bad choice doesn’t become a costly mistake.
Diversification should take place at all levels, meaning you shouldn’t invest all your money in one single stock (Apple), or one single sector (tech), or even one single investment type (stocks).
When compiling an investment portfolio, be sure to include a mix of assets (stock, bonds, mutual funds), as well a mix of risk levels (conservative, balanced, aggressive). Your portfolio of investments should be rebalanced periodically as financial circumstances change, as you get close to your investment goals, and as you age.
With a little more knowledge on growing your wealth through investments, now is the time to get started! Learn more about the financial planning services offered to members of LRRCU.