The short answer is that we want to generate wealth. Investing can provide funds for education, retirement, summer vacations or to be left for our children and grandchildren. Whether we are starting off with only a small amount of money saved or thousands, learning the fundamentals of investing will send us on our way to financial health.
At the most basic level, the first thing we will need to ask ourselves is why we are saving.
- Is it so that we can fund our kids’ education?
- To be able to comfortably retire?
- Or, perhaps we would like to finally buy that dream home we’ve been wanting?
So, where do we start?
If we were to invest just $2,000 of the money we have in our savings account in the stock market and received an annual return of 10% (which is the historical average of the S&P 500), in 30 years that initial $2,000 investment would be worth just under $35,000. It’s not enough to fund our retirement, but it sure is a good start.
Even if we don’t have a couple of thousand in our account to invest, there are ways of saving. For example, we could skip the morning lattes and save the $3.50 we would have spent every day. While it doesn’t seem like a lot, if we were to start this in our early 20’s and do it for 300 days out of the year, that’s over $1,000 in annual savings. Now, if we invested that savings each year, with an average return of 10% for 46 years (right around the time someone in their early 20’s would be retiring), we’d have over a million dollars to fund our retirement.
Also consider that as time goes on and we become more established, we will be able to save more than that initial $1,000 a year. So, let’s say we start saving just $166 per month (which is most likely less than our phone bill and a few lunches thrown in). By upping the contribution slightly, in just 39 years, we’d reach millionaire status.
Making our money work for us
Compounding interest is the reason starting to invest sooner rather than later is so important. The longer we are invested, the more money we will amass over time. Warren Buffett calls it the ‘Snowball’ effect.
Different types of investments will grow at various rates of return. For example, I mentioned that for the stock market, 10% is the historical average rate of return. We can expect around 15% if we become advanced enough to pick our own stocks.
We will notice that just a few percentage points of return can make a tremendous difference in how much we earn over the years. Even a small investment in the stock market at a 10% return will amass a huge amount of money as compared to deposits with a bank.
How is this possible?
The magic of compounding is what makes this possible. Compounding means that as our investment returns earn interest, those returns start to earn interest and so on. Because of this, our investment will begin to grow larger and larger as time goes on. Now, if we gain a higher return or we invest for a longer span of time, we can increase the amount we earn endlessly. By starting young, even a small investment will handsomely reward us in our later years.
Let’s look at a scenario of two women and their financial journey to help illustrate my point:
At age 15, Cloe starts earning money working as a babysitter. She is conservative with her spending and she is able to save $1,000 annually. Cloe decides to invest it in the stock market where it will remain for the next 10 years with an average return of 12% per year. After 10 years, Cloe’s lifestyle becomes more lavish and she starts spending everything she earns partying and traveling. She also stops saving money. However, she leaves the money she has in the stock market.
Cloe’s friend Alisa also began babysitting at age 15, but she loved to shop for the latest fashions and impulsively bought whatever caught her eye. This wild spending went on until Alisa was around 40 and her parents retired. She saw how they struggled to make ends meet with their only income coming from very modest social security benefits. It finally hit her that this could be her and she begins saving $10,000 a year until her retirement 25 years later.
Which one of these women wound up retiring with more?
Let’s do the math. Cloe saved just $1,000 a year for 10 years, totaling only $10,000. Alisa put away $10,000 a year for 25 years, or $250,000 total. We might rush to the conclusion that Alisa clearly wound up with more, but we’d be wrong. Alisa does wind up with under $1.5 million, but Cloe retires on $1.8 million.
While neither of these women will have a hard time making ends meet, the difference in the amounts is because Cloe’s money grew over 50 years and with just $1,000 a year out of pocket, she wound up with more. Alisa on the other hand had to put aside $10,000 a year of her hard-earned money, making some sacrifices along the way to pay the bills, and still wound up with less at retirement.
Just as an aside, had Cloe invested her money in a low tax retirement account like an IRA in the US or Superfund in Australia, she could have had her $1.8 million growing in a very low tax environment, therefore ending with even more.
So, we see how the magic of compounding works. To make money, we have to give it time to work for us.
Avoiding common investment mistakes
Before moving forward, it is important for us to keep some points in mind. If we can avoid the common mistakes investors make, we will be on track to a more secure financial future.
What are those mistakes?
- Not investing– Of course, we have no way of knowing what the market will do. It could go up the next day we invest or we could wait months or even years before we start seeing our money grow. I can make one promise, however. If we don’t invest, we aren’t going to make anything from the market.
- Waiting- I don’t think I can stress this enough- the more time we have our money invested, the more time we have for our money to grow. The more we put investing off, the less money we will have to retire with. Remember our friends Cloe and Alisa?
- Being overly cautious- If we start investing early, we should be putting our money into the stock market. There will be plenty of time to withstand downturns and in the long-run come out on top. As we get older, we could invest in bonds as we begin to depend upon our investments for income, but investors, no matter what stage of life we are in, should have a sizeable percentage of our portfolio in stocks.
- Being reckless- We will need to take some risks, but throwing our money into something that could end in disaster is simply unwise.
- Short-sightedness- Yes, there are times where we are going to need money in the short-term. However, unless we anticipate needing that money before 3 years are up (ideally 5 years or more), we should plan to leave our money in it for the long-term. If we do anticipate needing our money in the near future for something like a family vacation or a new car, our best bet is to put our cash in a safe place like a CD, term deposit or money market account.
- Banking on collectibles- While they may hold some nostalgic value, old comic books are not going to fund our retirement. Neither is hoping we win the lottery. The stock market is our best option for laying the path towards our future financial health.
- Moving around- I’ve said that long-term investing is the best way to make money. If we do our homework and invest in some solid stocks, we will be rewarded. However, by trading in and out of the market daily, not only do we lose the opportunity to enjoy the rewards long-term investors can, but trading fees and tax will also eat away at our returns.
- Not paying credit card debt before investing- Credit cards carry a high annual interest rate of 15% or more. Let’s think about this- if we have $5,000 to invest and $5,000 in credit card debt on a card with an 18% annual interest rate, just to come out even, we would have to get an 18% return (after taxes). Since that is an extremely unlikely scenario, my advice is to first pay the debt off, then invest.
Hope this helps you on your journey towards real financial freedom.