What exactly is investing?
The definition of the word invest is:
to commit (money) in order to earn a financial return - Merriam-Webster
Further, an investment is:
the outlay of money usually for income or profit : capital outlay - Merriam-Webster
The purpose of investing is to make an initial purchase of something (the outlay) in hopes of income our profit in the future. The income or profit is typically assessed as a return on investment (ROI) and could come in the following forms:
How can you start investing?
There are actually many ways you can begin investing but perhaps the simplest and most common way is investing in the stock market, online.
Whether you choose to begin with automated savings to a retirement plan with your employer, or elect to manually make deposits into your savings and investing account, you first need to identify if you will "do it yourself" or utilize a professional money manager. Doing it yourself can save a significant amount of money over time, but if you are not willing to learn and study about investing and finances, consider hiring a professional.
Here are some types of accounts where you can invest in the stock market:
With all of the accounts listed above, I like to purchase low cost index funds in either a Roth IRA or 401(k)/403(b) plan due to the tax advantages of retirement accounts. Many in the financial independence community also utilize retirement plans to purchase low-cost index funds due to the specialized tax treatment for retirement accounts. Ultimately, the decision is yours.
For traditional 401(k) and 403(b) and traditional IRA plans, you may be able to lower your current taxable income, but note that you will still have to pay tax later on withdrawals once you retire (based on age 59 1/2 or older for these types of accounts). This "tax break" occurs by notifying the IRS that you set money aside to these tax-advantaged accounts, thereby lowering the amount the IRS can tax you on. With traditional accounts, there is also required minimum distributions (RMD's) starting at age 70 meaning you have to take out at least some money, even if you do not wan to. Keep in mind that their are income limits for these tax breaks so if you are a high earner, find out what income level phases you out of these tax advantages.
For Roth 401(k)/403(b) plans and Roth IRA's, you get to withdrawal the money in retirement tax-free (typically starting at age 59 1/2). The downside is no "tax break" now like the traditional accounts offer outlined above.
Be advised that there are limits to the amount of annual contributions you can make to these types of accounts. Visit IRS.gov for present year contribution limits for all types of accounts.
By no means is this investment advice nor is it designed to be a comprehensive outline of the entire investing world.
The most common problem remains that most people get scared off by the "complexities" of investing. In reality, as highlighted above, getting an account open to start investing is actually quite simple. After your account is open and you put in your first small sum of money, then you can consider yourself a beginner investor. Realize that over time, you will fill in the gaps in knowledge just by having an account and asking questions (and making a few mistakes along the way).
Leave a comment below on how you feel or felt about first entering the "investing world".
First, Let's Clarify a Few Things Regarding Funds
Today we assess the difference between mutual funds and index funds, active and passive funds respectively.
Mutual funds are professionally managed investment portfolios. They are funded primarily by the shareholders (investors) like you and I. Typically, their goal is to generate the highest rate of return annually for the shareholders of the portfolio. They do this by actively trading investments inside of the fund. Marketing and advertising for new shareholders (investors) is typically done by comparing recent returns of the mutual fund to that of a benchmark- typically an index fund.
Index funds are actually a type of mutual fund. An index fund is a passively managed that seeks to match a given index. The Dow Jones or S&P 500 are two of the most common indices.
So why is there so much confusion out there about mutual funds vs. index funds?
Although index funds are technically a type of mutual fund, they differ significantly in almost every other way.
For the sake of clarity, it helps to divide the entire category of mutual funds into actively managed and passively managed. Therefore,
What's the difference between mutual funds & index funds?
Fees and management style.
The typical fees of a mutual fund are in excess of 2%. The typical fees of an index fund are often less than 0.1%. Doesn't sound like much? Well, it is!
Let's look at an example headline from our friends over at NerdWallet:
Millennials have decades to save for retirement, but also decades of exposure to avoidable investment fees. NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
What is even worse is that this only looked at a 1% fee. Compounded over time, the loss of that measly 1% fee is extraordinary as outlined above. Remember, the average active mutual fund fee is well over 2%.
To make matters worse, if you happen to hold an actively managed mutual fund in a taxable brokerage account, you would need to beat the passive fund by 4.3% just to match the return of the passive fund. Why 4.3%? Professor Mark Kritzman of M.I.T. conducted a study reported in The New York Times.
So if your so-called "index beating" mutual fund was held in an taxable brokerage account.
If you held this actively managed fund in a tax-advantaged retirement account, you would still need to generate at least 2% higher returns just to break even with the passive index fund.
The average actively managed mutual fund consists of the following fees:
Why choosing actively managed mutual funds is a mistake
There are professional money managers who spend their whole entire life's work trying to time the market and, guess what... 92% of actively managed funds fail to match the returns of the market (i.e. S&P 500 index) over a 15 year period.
If your investment horizon is 15 years or greater- which includes you unless you plan on dying in the next 15 years- you stand practically no chance of picking the 8% of actively managed funds that will outperform the market. What's worse is that not only would the actively managed fund you chose have to beat the market, but it would need to beat it by at least 1.5 to 2.0%.
Why would it need to beat it by at least 1.5%? Fees and expenses. The average index fund has less than 0.1% in fees compared to the 2 plus percent fees of active funds.
See why you are better off choosing index funds instead.
I know many are thinking that 1 or 2% in fees doesn't sound like a lot, but trust me, it is. For example, saving even just 1% on fees could result in big differences compounded over time. Remember, the cost of a 1% fee could cost you $590,000 over 40 years, which is a very typical investment horizon.
WARNING: Your Financial Advisor Will Sound Very Convincing!
Remember, index funds- passively managed funds- do not generate revenue for your advisor's company. The index funds simply don't make money for your advisor because they do not have all of the above fees associated with them. Beware, your advisor might still charge an "advisor fee" or an "administration fee" which is why I am a firm believer in the DIY method of investing in index funds.
I promise that your current advisor will pitch you something like this:
Our advisement provides you expertly managed portfolios with industry leading research tools that often outperform index funds. We have an experienced staff dedicated to selecting blue chip funds that have demonstrated superior returns in recent market conditions.
This is literally what my advisor emailed me when I exited a high-cost fund through a previous employer's 401(k) program.
It's bullshit. Complete nonsense. Even if they do generate higher returns, it does not last. Never has. Likely never will.
I am certain you will be able to find funds that outperform the market over 1-, 3-, or even 5-year periods. But outperforming index funds over your entire investment lifetime? Outperform for 30 or more years, in a row? They don't exist. Not one ever has.
Perhaps some of you are in a position to require a financial advisor. Some might need to receive tax advice. There are even some of you who are not willing to take just a few minutes to open your own account or call your advisor and inquire about fees and how to lower them by switching to passively managed index funds in your portfolio.
To those of you which this applies, I encourage you to seek the professional help that you require. Do not do so blindly however. Ask. Pick up the phone and have a few conversations with money managers and financial advisors. Be up front with them and ask immediately if this conversation will cost anything. Ask for free consultations as most money managers will be happy to provide a free initial chat.
Ask about fees. Ask about expenses. Ask about commissions. Be inquisitive and remember it is their job to answer all of your questions, even if most of them are about how the advisor gets paid. It's your money and to them, it's a job, so ask them about the costs associated with their account.
Your failure to ask could result in hundreds of thousands of dollars of expenses over a lifetime.
It's not unreasonable to think that if you start investing in your twenty's, and you live to be 90, you may be invested in the market for 70 years! Now imaging what those 2% fees will do to you compounded over 70 years.
Be smart. Be curious. Don't be shy and don't be afraid to ask some questions. Even if you were able to save 1% in fees just by switching to passively managed funds, it could result in you retiring much earlier with a lot more money someday. It's worth it.
Until next time...
Comment below with your experiences with active vs. passive funds. Index funds vs. mutual funds. Run-ins with your advisors commissions. Please share with your community.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” - Albert Einstein
How dramatic is the effect of compounding?
For finances, and most other objective measured, the value of compounding grows in logarithmic fashion. This means that as you move along the horizontal (x) axis, the growth on the vertical (y) axis grows exponentially. More simply put, the line curves upwards (or downwards if in debt) instead of increasing in a straight line -see below.
Frequently, in the personal finance community, we use money on the horizontal (x) axis, and net worth on the vertical (y) axis as follows:
Examples of the effects of compound interest using $10,000 initially and never adding another dime!
After 10 years, your initial $10,000 (assuming you added nothing else), grows to only $19,990. Not bad, but this will not get you rich.
After 20 years, your initial $10,000 (again assuming you add nothing), grows to $43, 157. Again, not too bad considering you never added another dime - which is typically very unrealistic for those interested in saving and investing.
Fast forward to the 50 years mark, your initial $10,000 investment turned into a whopping $434,274. Again, this does not adjust for inflation and just shows you what your initial dollar amount will potentially turn into after 50 years of passive index fund investing.
Initial investment of $10,000 plus adding another $500/yr to your investment
You may feel somewhat underwhelmed after that first example. That is fine. The power of compounding is quite dramatic, however some folks argue and become upset when they hear about 50 plus years of investing. It might just be too far out for most people to imagine and remain motivated on the path to F.I.
This is where demonstrating the power of saving plus compound interest comes into play.
Take our initial investment of $10,000, use the same parameters of hypothetical growth at 8% compounded annually, and add $500 a year.
This time it only takes 43 years to cross the $400,000 mark. At the end of 50 years, your initial investment of $10,000 plus an additional $500/yr, compounded at 8% annually, turns into $720,000.
Initial investment of $10,000 plus an additional $5,000/yr in an IRA
Now what if you simply take your initial investment of $10,000, and add $5,000 per year to an IRA, compounded annually at 8%. Essentially this would be nearly maxing out an IRA every year ($6,000 contribution limit as of 2020).
Following this process of $10,000 initial investment, plus $5,000 contribution annually to an IRA, compounded at a hypothetical rate of 8% annually - you would be a millionaire in 36 years with your investments growing to $1,078,364.
At the 50 year mark, you'd have potentially $3.3 million in the bank. Not too shabby.
There is significant potential waiting for you in the form of "compound interest"
As you can see, compound interest takes time to reveal its' magic. The earlier you start, the longer you have for compound interest to work in dramatic fashion.
When evaluating the role of compound interest most folks refer to the rule of 72. The rule of 72 helps you learn how long it will take to double your initial investment. You discover this by dividing 72 by your expected annual interest rate (8% in our example).
The Rule: 72 / expected annual interest rate = years until initial investment doubles.
In our example: 72/8 = 10.3 years. In other words, every 10 years our money would double.
How do I make compounding more powerful?
As you can see, each of our models demonstrates-after a hypothetical return-a "hockey stick" growth curve. This means your money compounds and grows exponentially upward instead of a straight line.
Of course, this does not happen consistently. Here is a caveat: Actual stock market returns look nothing like a smooth line the way our model shows. It takes many scary nosedives in a few months to high altitude climbs over many years. These fluctuations occur due to many reasons such as investor behavior, consumer sentiment, inflation, pricing, GDP, etc. Many factors determine market returns.
However, according to over 200 years worth of data, the average return of the stock market is in the 8-10% range. Remember, this is just an average. Do not expect these returns on a reliable and consistent basis. Some years will be higher, and some years will be much, much lower. Overall, unless America "goes out of business", you are likely to see a positive return with longer time horizons of 20 years or more.
How To Increase the Power of Compound Interest
There is a very simple, yet often overlooked method of increasing the power of compound interest. How? START WITH A HIGHER INITIAL INVESTMENT.
To illustrate my point, say you start with an initial investment of $100,000, instead of $10,000. Do not add another dime to that $100,000. Ever.
In 50 years, after an 8% return compounded annually, you'd see your initial investment grow to...
This is approximately $1.4 million more than what you would have compared to if you initially invested $10,000 plus $5,000 a year compounded at 8%.
To illustrate this point further, in the model representing a $10,000 initial investment plus $5,000 annually, you will have contributed a total of $260,000 of capital with a final worth of $3.3 million.
By starting with a greater initial investment, not only will you be worth $1.4 million more - at a total of $4.7 million - but you will contribute $160,000 less of your own capital.
The power of compound interest is one of the primary motivators that keeps me steady on the path to F.I.
Consider visiting a compound interest calculator and plugging in your own numbers.
Remember, our models and examples are completely hypothetical and do not represent real returns, nor are they adjusted for inflation. In no way is this a guarantee of returns. Please seek guidance from a financial professional, of which I am not.
Still, the point remains. The dramatic effects of compound interest are on display.
The ideal recipe would be to start with a big lump sum as soon as possible. However, if you are unable to do this, the next best method would simply be to start as soon as possible.
Enjoying our content? Please leave a comment below.
Further, take a look at our favorite resources that built the foundation for our awareness of financial independence, frugality, and investing.
Before we begin, this is absolutely not investment advice and I am certainly not a financial professional. Please understand this is entirely for informational purposes only and in no way are we making any claims about this style of investing. Use your head people, this is a blog, not a financial consultation.
How to Begin Investing
How do you actually become an "investor"? This is a common question to which the answer is actually quite a bit simpler than you think.
First and foremost, to be an investor, it takes having a little extra pocket change for which to invest. Remember, it takes money to make money.
What does this mean for you? It means you need to start saving some extra money.
Previously we discussed what it means to have a margin of potential for savings. Your margin of potential is calculated by subtracting your expenses from your income (margin of potential = income - expenses).
Without having a positive margin of potential, you will lack the most sufficient tool required for investing, money. I am not interested in discussing using other people's money or marginal investing because that is not what this community is about.
You can increase your margin of potential two ways:
I do have a basic tenant that I believe all should follow. I believe that you should eliminate your debt first before worrying about becoming an investor. The only debt I believe that you can keep around is a mortgage, provided that you have at least 20 percent equity in your home.
This is a community filled with people searching for financial strength. You do not get to a financially fit position by borrowing. End of story. If you do believe that you can borrow your way to wealth, stop reading right now and find something else to do with your time (like read a personal finance book or two). This community is the type that pays off their credit card bills, in full, every month. That's what brings us security.
Deciding where to save it
Once you've broken free from spending every single dollar you earn, and you have eliminated debt, you have some choices.
Where can you begin investing?
Here are some of the primary investment vehicles where you can save your money and have access to investing in "the market" (not supposed to be an exhaustive list, just the most common):
I just happen to use Fidelity and Vanguard because I have found they offer the lowest account fees and best customer support around. I have tried MANY other investment companies for various accounts without much success. They will remain nameless.
To open an account in order to begin investing, just visit the company site or call the company directly, and seek advisement for how to open any of the following accounts - or even ask about one's I haven't listed such as a 457 plan, etc.
I do not use a financial professional and choose to pick the funds myself. I do this for the lowest possible cost and the greatest potential return. Read the two books below if you think that you cannot do it yourself when it comes to investing.
How To Start Investing (once you have eliminated your debt)
The simplest way to break into the investing circles is through low cost index funds.
If you are uncertain about investing and you need more confidence built up before enbtering the stock market, here are two must-read books for you:
How to Start Investing (steps)
Step 1. Choose which type of account you will begin investing in from above (Roth IRA, Traditional IRA, Brokerage Account, 401(k), 403(b), etc.)
Step 2. Choose your Financial Service Provider (Fidelity and Vanguard are my favorites - however your 401(k) and 403(b) plans might not offer these companies)
Note: I primarily use Fidelity and Vanguard due to the low cost nature of their funds and little to no fees associated with their accounts.
Step 3. Link your checking account to whichever account you opened after following steps 1 & 2 above. Start depositing money into this account.
Step 4. Choose your investments (by searching the following "ticker symbols"):
My belief is that the younger you are, the greater the percentage of equity index funds you should have in your overall investing portfolio. My preferred choice is low cost index funds that track the total market or a major index.
Step 5. Keep investing in this account and buying shares of the above for years and years to come to take advantage of compound interest.
That is it. Be advised, there are some limits for the types of accounts listed above for how much you can deposit into your account each year. To find up to date contribution limits, visit the IRS website here.
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I started this blog because friends and family often asked me similar questions regarding personal finance. I was surprised just how much people were interested in improving their financial situation, yet had no idea where to start. It made perfect sense to start a blog and share all the information that I have learned along the way with others. You will find many resources and links referred throughout the blog. I have found all of this information useful and continue to grow my knowledge and understanding in the personal finance space. Admittedly, even I struggled heavily in the beginning with understanding how to improve my financial situation. The power of reading and note taking got me where I am today and will continue to provide a return on investment for years to come. I look forward to sharing with you along the way.