An investment is putting your money somewhere it will work for you. Each of your dollars can do one of three things: work for you making money while you get on with your day, be given to someone else (spent) to work for them, or sit around in your wallet or current account doing nothing for you and just making money for your bank.
Obviously, getting your money to make money for you is the best option, and that is investing.
There are two main ways of investing:
The markets: Where someone pays you to use your money for a set period of time and you receive a periodical interest payment, these are bonds. Or buying stocks in a company that pays a portion of its earnings to each shareholder, these are stocks, which pay dividends. Investing in the markets has the added benefit of compound interest, where you make money on both your investments and your profits (so long as they are reinvested).
Purchasing something that will increase in value over time: Where you buy something you think will increase in value over time and sell it to release the increased capital at a later date. This is a riskier investment unless you are an expert in a particular field. However, the returns can be great if you choose the right items.
Being invested in both methods is a great way to diversify your holdings. Diversifying (the act of having your money in multiple investments) reduces your risk to fluctuations in any one market. Many people do this without thinking about it by investing in the markets and owning a home, the home being something you purchased hoping that it will increase in value.
However, for our purposes, we are going to look at the markets, as they are readily available to all, cheap, and easily invested in with the use of Robo-Investors.
For both the beginner investor and the experienced pro, compound interest is a key factor in investment success. Let’s take a look at a quick example of how compound interest drives long-term investment earnings.
If you saved $5,000 per year in your current account for 10 years, you will have a total of $50,000. However, if you take that same $5,000 per year and invest it in the markets (at an average market return of 7%), after 10 years you would have $73,918. That is nearly $24,000 extra just for moving your money into an investment account.
Below are three charts each showing the effect compound interest can have on your savings, at the market average increase of 7% per year.
As you can see, the more you invest the higher the compounding return is; over 10 years you very nearly gain an additional 50% on your savings.
Here is a link to a compound interest calculator to which you can add your savings and see what outcome they will have over time (based on the market average return of 7%): Compound Interest Calculator
Common mistakes to avoid:
- Starting late: As you can see from the compound interest calculator above, the longer you have your money invested, the more money you will make as your investment ages. If you have not started yet, start now! You can invest for free with Wisebanyan (with which I have no affiliation) and a host of other sites. You can open an account with as little as $10 and start to get your money working for you.
- Not paying off high interest debt first: If you have savings of $3,000 and Credit Card debt of $3,000 at 18% interest investing your money will lose you money. Get rid of your high interest debt first, then invest. If it is long-term, low-interest debt (a mortgage or student debt with a good rate), then you can do both at once. However, anything with over 6% interest should be paid off prior to thinking about other investments, unless you are really sure your investment will pay off at a higher rate that your debt interest payments.
- Not being aggressive enough: If you are young, you can afford to take additional risks and have a higher percentage of your portfolio in stocks (which have a higher risks, but also higher returns). Then, as you age, you gradually increase your percentage of bonds and lower your percentage of more risky stocks.
- Being too aggressive: Though you get higher returns from stocks, be sure to always have a diverse portfolio, with a percentage in secure bonds with a guaranteed return.
- A matching 401(k) is free money: If your company matches your 401(k) payments, ensure you max out your payments. This really is free money, and if it is a percentage, the more you put in, the more free money you get. Plus you get the benefits of not paying capital gains tax until you start withdrawing.
- Playing the market: If you have a lot of time and do a lot of research, you can increase your earnings by regular trading. However, there are fees and increased risks associated with this strategy. The real power of investments comes from investing for the long term in reasonably secure stocks.
Investing top tips:
- Start early (or as soon as possible if you have missed early train), and invest as much as you can. The earlier you start, the quicker your investment will grow.
- Diversify you portfolio; help to protect yourself against risk by spreading your investment across multiple asset types.
- Reinvest all your dividends, and continually add to your investment in order to reap the benefits of compound interest.
- Rather than investing what you have left over at the end of the month, decide how much you are going to invest and set up a direct payment the day after you get paid. Then live on what you have remaining in your bank account. This way, you will not be tempted to go over budget and nibble away at your monthly investments.
It should be noted that investing your money in the markets such as bonds, stocks, and mutual funds does carry a risk. The market can go down as well as up, and you could end up not making any money, or worse, losing the money you put in initially. However, if you have a diverse portfolio of stocks and bonds, you start as soon as possible, and you can weather the low periods by working, the market always increases over time, and you will make money in the long term.
For further info on market trends check out these unaffiliated websites: