(This is the first part in a three part article series designed to bring anyone up-to-speed on how to start investing)
- Let your money help you generate more money by investing it
- Compounding interest is the most powerful tool to grow your money
- Investing is risky but there are ways to make it less risky
The Power of Investing
There are only two ways to make money in life:
- Work for money
- Have your money generate more money
Let’s take the first one and walk through an illustrative example of a 30 year old person, who we’ll call Jennifer.
- Jennifer has $50,000 in her checking account
- She saves $25,000 a year and expects to save a similar amount going forward
- She wants to retire by the time she’s 60 and expects to spend around $50,000 a year (in line with what she spends today)
- The estimated life expectancy for a female in the US is 79 years old
By the time Jennifer is 60 years old, she will have saved $775,000 – quite an accomplishment and one that would take a significant amount of dedication. However, when you look at her retirement you can see that she quickly depletes that savings as she has no new source of income – and by age 75 she is completely out of savings. Of course this is a drastically simplified example, but it illustrates the main problem of not investing – that you have to work for each and every single dollar that you spend and save.
So let’s move onto the second way to make money, letting your money generate more money (in other words, investing). And let’s use the same illustrative example of Jennifer as above but have her invest in a portfolio with an average annual return of 5% (a fairly conservative return estimate).
As you can see above, there is a stark difference if Jennifer chooses to invest her money. Not only does she not run out of money but she now has the ability to spend much more during her retirement and still have her savings grow. To understand more about why this difference is so stark, learn about compounding interest.
Returns and Risks
The next logical question you are likely asking yourself (and rightfully should be) is, ‘What evidence is there that my investments will go up overtime and at what rate?’. Unfortunately for us, the only evidence we have available to us is historical data. Fortunately though, we a have significant amount of this historical data dating all the way back to before the 1900’s and there has been significant amounts of academic research using this data.
Above, you can see the annual return of the S&P 500 from 1966 to 2015 was approximately 10%. Just to put that number in perspective, that means if you invested $100 in 1966, let it grow for ~50 years and took it out in 2015 you would have $9,834. So if future returns look anything like these historical returns, you would be wise to start investing now.
However, I certainly don’t want to understate the risks of investing. In the above images, in 2008 the S&P 500 return was -37% which would be a scary experience for any investor. Most of all, there is absolutely no assurance that future performance will look anything like historical performance.
If you’re someone who is looking to mitigate these investment risks as much as possible, there are a number investment strategies that you can still do. The benefit of investing is that you can control (to a certain extent at least) the risks that you take by investing in less risky assets, such as treasury and corporate bonds – which we will explore in further detail in the next article in the series.
Lastly, I want to leave you on a more personal note. If you read all of this and feel overwhelmed with all of the investment terminology or fear losing your hard earned money by investing it, I want you to know that there are many different types of investment products and portfolios out there for you. My sole purpose of writing this is to help you make the smartest personal finance decisions and steer you away from the over-hyped and extremely costly financial products that are likely marketed towards you.