Everyone knows that they are supposed to save money, but not necessarily why. If you are accustomed to living paycheck-to-paycheck, you may not even realize how much peace of mind having savings can give you. In addition, investing your money properly for the long term is one of the best ways to build wealth.
Even though it’s doubtful that Einstein ever said that compound interest is the most powerful force in the universe, it’s indisputable that it is an incredible tool that can work for or against you.
Compound Interest for Investing
When compound interest works in your favor, an asset that you own earns a return and increases in value. Then that increased asset earns a return and increases by even more. The growth is exponential.
As an example, see how a one-time investment of $5,500 will grow over time if invested with an average rate of return of 8%. After 30 years, the investment balance has grown to over $60,000, with over half of that growth occurring in the last 10 years.
Investing on a regular basis is how Millennials are likely to provide for their own retirements now that pensions have all but disappeared and Social Security is uncertain. If you max out a 401(k) every year for 30 years with an 8% average rate of return, over 30 years you will have contributed $524,880 but your investment balance at the end will be $2,172,944.
You can create your own projects of the effect of compound interest using Illuminations.
Compound Interest in Debt
Compound interest can work against you in the case of debt. When you owe a given amount at a certain interest rate, the amount you owe will also increase exponentially unless you make payments that more than keep up with the growth.
Compound Interest in Inflation Risk
One great reason to invest that most people don’t consider is inflation risk. The average historical inflation rate is around 3-4% per year. That means that every year your money goes 3-4% less far in terms of real purchasing power and the prices will double approximately every 20 years. If you don’t invest at a rate that at least keeps pace with inflation, the value of your money decreases with time. To build wealth through investing, you must earn a return that exceeds the average rate of inflation.
Risk and Return
In general, in investing there is a correlation between risk and return. Over the long term, being willing to take more risk generally results in a higher overall return.
Further reading: Risk-Return Tradeoff
The three primary asset classes are stocks, bonds, and cash. Within stocks and bonds, there are a variety of sub-classes. Within the stock asset class, you can have US vs. international, large-cap vs. mid-cap vs. and small-cap, growth vs. income, etc. Within the bond asset class, you can have various time horizons, risk ratings, and organization types. There are also more minor asset classes (alternative investments), which include commodities, real estate, etc.
Further reading: Stocks – Part II: The Market Always Goes Up
Your asset allocation is the percentage of your investments that are in each asset class or sub-class. You can create an asset allocation that reflects your desired balance between risk and reward. A higher-risk, higher-reward asset allocation would be heavier toward stock investments, while a lower-risk, lower-reward asset allocation would be heavier toward bonds and cash. Your asset allocation will reflect your personal risk tolerance as well as your timeline on your investment. Traditionally, an individual with a consistent risk tolerance will move her retirement investments from more aggressive to more conservative investments as she draws closer to starting to withdraw the money.
Further reading: 9 Common Investment Mistakes and How to Avoid Them
Active vs. Passive Investing
Active investing usually involves a lot of activity, such as picking individual investments and trying to buy low and sell high. Passive investing, conversely, applies a buy and hold strategy in which the investments are held long-term. A subset of passive investing is index investing, in which the investor holds a representative sampling of a subset of investments, such as the S&P 500.
Getting started with investing is simple, though perhaps not easy. Many young people, graduate students included, are intimidated by investing. They may even be unaware that you can buy investments yourself; you don’t have to go through a broker or financial advisor.
1) Ask yourself if you are prepared to start investing.
Do you have a lump sum of money that you want to invest and/or do you have an ongoing savings rate that you would like to invest? Have you met your other financial priorities, such as saving an emergency fund? Are you emotionally steeled to stomach the volatility that is likely to come with a long-term investment?
2) Determine the timeline for your investment.
Are you investing for retirement, many decades away? Or are you investing for a mid-term goal? The timeline on your investment will influence how much risk you should take.
Further reading: How to Invest Differently for Short, Medium, and Long-Term Goals
3) Research the type(s) of investments that you want to buy and develop an (initial) investing philosophy.
This is the most daunting step for someone who wants to start investing, but there is plenty of material available to help you do your research. While you should make a few determinations about your personal investing philosophy, you do not necessarily need a fully worked-out plan to start investing, especially if you keep it simple at the start. The important part is to get started, even if you don’t have the perfect, complete plan from the beginning.
Some questions to ask yourself are:
- What is my risk tolerance?
- Do I want active or passive management?
- How important is fee minimization?
- What are my ethical considerations for my investments?
Great resource: The Bogleheads
Further reading: How to Keep Investment Costs Low (and Returns High)
4) Choose the brokerage firm you want to invest through.
There are many brokerage firms to choose from online for the DIY investor and also many firms that will manage your investments for you through financial advisors. Your investing plan will help you decide which firm to use.
How much money you have to invest may influence your choice of firm. Most firms have some kind of minimum investment necessary to open an account, which may be a lump sum or a recurring transaction.
If you plan to buy mutual funds or ETFs, you must verify that the funds you want to buy are offered through the firm you are considering. Look at the expense ratios of the funds that you plan to buy to compare between firms. (Generally speaking, Vanguard is the industry leader in minimizing expense ratios.)
If you plan to buy single stocks, look at the firm’s trading fee structure (both on the buy and sell) to find the best price for your anticipated volume of trades.
5) Open your account and buy your investments.
Once you have decided on the brokerage firm you want to use and the investments you want to buy, open an account with the firm. You can choose to open an IRA (only if you have taxable compensation) or a taxable investment account. Once you have your banking information linked to your brokerage account, you can transfer money and buy your desired fund(s). Consider setting up an auto-draft of a regular savings amount from your checking account each month.
6) Monitor and maintain.
While you don’t have to look at the balance every day, it is a good idea to periodically check up on your investments to make sure they are behaving as you expected (against the relevant benchmarks, etc.). If you are doing your own rebalancing, make sure you stick to your investment plan in terms of how often to check and execute the rebalancing.
7) Refine your philosophy.
As you learn more about investing and through the process of buying and monitoring your first set of investments, you will likely evolve your investing philosophy. Once you have the next iteration of your philosophy well thought-through, you should change your investments to reflect it. In the process, minimize turnover to the extent possible to avoid incurring new fees and taxes. And don’t halt your learning process! Your philosophy and certainly your implementation will probably change many times throughout your life.