Investing for Beginners
Why Investing is Necessary
In order to invest, you first need money to invest. The first skill that must be learned and formed into a habit is saving. The ability to save money is the first fundamental step in any wealth building. Those who cannot save, rarely become wealthy. For some key tips on how to save money, read up on the tips to save more.
It helps to think of money, or cash simply as a currency. It is exchanged for goods and services. Money is just paper with a value that is dependent on many things. This fiat money is government issued currency not backed by any physical commodity, but rather by the government that issued it. The value of this money is determined by supply and demand, government stability, interest rates, and capital flow. The downside to this currency is it can be at risk of hyperinflation if the government prints too much of it.
Inflation is the steady increase in prices year after year. Each dollar is worth less as time goes on since more dollars are needed to buy the same good. Inflation is normal and typically the rate of inflation is around 2-3% per year. Some years however, have seen inflation as high as 9%. If you are saving cash in large quantities, inflation will slowly erode its value as time passes.
If $10,000 was put in the bank 30 years ago and it grew in the bank with a generous 2% in interest, it would now be worth $18,214. That is a gain of only $8,214 over the course of 30 years! Not to mention savings accounts interest rates are much lower than 2%, more like 0.2%.
Now, if adjusted for inflation, $10,000 30 years ago has the same buying power as $20,606 in today’s dollars. Since the account is now worth $18,214, this is $2,392 less than the break even point. Putting money in the bank for 30 years shows no real benefit.
Even worse, if the $10,000 was held under a mattress for 30 years, it would still be $10,000 30 years later. Adjusting for inflation, that money is only worth $4,852 in today’s dollars.
We can see from this breakdown why those who only save money never become wealthy. Holding onto large sums of cash does not make financial sense.
Moving from the saver to the investor mindset is where the money is made. An investor buys assets to increase their positive cash flow and net worth. Rather than saving the money, the investor puts the money to work to grow in value or produce more money in cash flow.
Here is an example of what could be done with the $10,000 instead. Rather than putting the $10,000 under a mattress or in a bank account earning less than 1 % interest, what would happen if it was invested? There are many ways to invest this money but something with lower risk is desired. On any brokerage there are the options to buy any company stock or bond that is publicly listed. It’s not necessary to put effort in picking individual stocks because there is the option to buy a little stock of every company that’s listed. The total market has grown significantly over time so this method of investing has lower risk and historically, decent returns. On average over the past 80 years, the market has returned an average of 8-10%.
When $10,000 is invested in the stock market and held for a full 30 years, the ending value would be $109,386. This is more than 10 times the initial amount! How does this occur? The main principle here is compound interest. If some amount of money increases by 8% after a year and that ending sum grows another 8% the next year and so on, the value will increase by larger amounts each year. Compound interest works out in the favor of all investors.
If this investment were to grow for 40 years rather than 30, the total would be $242,819. 10 more years vested was able to increase the amount over $130,000. This goes to show that the most influential metric is the time the investment is allowed to grow.
Inflation typically is between 2% and 4% each year so if a 5% or more return on your money can be achieved, it will help you finances greatly over time.
How to Start Investing Today
You can start investing today with just an internet connection and some cash you have saved up. A financial planner is not necessary. In today’s world there are plenty of tools and resources available on the internet to get started.
A brokerage is needed to purchase shares of any stock or fund. There are many different brokerages but most of the popular ones make good choices for a typical investor. My personal choice is TDAmeritrade but others such as Etrade, Fidelity, Schwab, and Interactive Brokers also work. Researching the brokerages before selecting one will make you aware of fees, user interfaces, and included education that differs among them.
Once a brokerage is selected the next step is to create an account. Creating an account can be done in 10 minutes or less. Personal information such as mailing address and SSN are needed for an account. Gains and losses with investments are reported to the IRS. The SSN and mailing address are used to identify the taxpayer and provide documents once tax season rolls around. Make sure the information is accurate as discrepancies here can create problems later.
Once the account is created it’s time to fund it. There are a few options to transfer money to the brokerage account such as wire transfer or mailing a check. The most common and easiest way is to link an existing bank account for an ACH transfer. Funds move quickly and reliably this way and without any fees.
What to Invest In
This post is not financial advice so there won’t be any instruction as to which funds to buy. Based on past data and historical returns, low cost index funds are a good way to build wealth over time. Some funds track the S&P500 index while others focus on the total stock market. There are funds for the US markets as well as international markets. The performance of every fund can be found online. The portfolio allocations are also public knowledge so investors are well informed with what they are buying.
A good strategy is to dollar cost average into funds with low expense ratios. Dollar cost averaging is the practice of buying the same amount of securities at a set internal overtime. This allows an investor to avoid trying to time the market. Sometimes funds are purchased when the market is climbing and sometimes when the market is falling. The idea is that over time it will correlate to a steady growth on the investment. Many people don’t have large chunks of cash to just put in the market. A good strategy is to take a percentage of each paycheck and invest it every pay day. The investing becomes part of the budget and it makes less of an impact on daily finances.
When to Sell / Use Investment Funds
The best time to sell your investment funds is… never. Well at least not all at once when the time does come to start using the funds. When an investment account gets large enough, the gains from year to year can be enough to pay for all living expenses. This is the point of financial independence. Here is where an individual is no longer dependent on a job. Ideally, the gains from each year thereafter will provide sufficient income and the rest of the investment account can remain vested.
The strategy here is that enough income will be provided to live over the next 20 to 40 years while still growing at the same time. Good money habits pay off in the long run and the sooner investing starts, the better. Every investor needs to understand the power of compounding interest over long periods of time. Very small adjustments with day to day budgeting can equate to millions of dollars in wealth over time. Investing is necessary for all individuals despite differences in age, income, and personal goals. A prosperous future can be achieved for all.