benefits of index funds

What You Need to Know When Starting to Invest

Shawn Financial Education, Markets Leave a Comment

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When you’re new to the world of investing, it is easy to get overwhelmed.

There are so many things to consider: what to invest in, how much you should invest, whether you should do it monthly or a few times a year, and more.

Sometimes, when you’re just starting to learn about a new subject, you can get so overwhelmed that it keeps us from doing anything at all.

However, learning how to invest and grow wealth over time is achievable.

In this post, you’ll learn about what investing is, learn about the concept of compounding, and understand why the financial markets make sense for many investors.

If you’re a first time investor, this post will be a great resource for introducing you to what you need to know about investing!

Disclaimer: I’m not a financial adviser or financial professional. Please do your due diligence and research before buying or selling financial securities and assets.

What Is Investing?

Investing is the act of “expending money with the expectation of achieving a profit or material result by putting it into financial schemes, shares, or property, or by using it to develop a commercial venture.”

Essentially, investing is the purchase of something of value with the intention and expectation of the value of this something bringing increased value in the future.

By investing, you are looking to put your money to work for you.

Investing is one of the key steps to becoming the master of your money.

There are a number of different products and assets you can invest in:

  • Stocks
  • Bonds
  • Mutual Funds
  • ETFs
  • Index Funds
  • Real Estate
  • Businesses
  • Cryptocurrencies
  • Precious Metals

This post is will be mostly concerned with investing in the equity and fixed income markets, I won’t be talking about investing in real estate, businesses or alternative assets.

Let’s go into more details about these different investments.

What are Stocks?

Stocks, also called equities, are one of the most well-known investing options out there.

Stocks are securities, typically issued in quantities known as shares, that give shareholders part ownership in the company.

There are two main ways investing in stocks pay us:

  • capital gains (you make money when you sell an asset which has gone up in value)
  • dividends (a cash payment given to investors by the company)

Throughout history, stocks have been great for growth over the long term. This is why they’re typically the largest part of the average investor’s portfolio.

For people far from retirement, their portfolio may be anywhere from 80 to 100 percent stocks.  For people at retirement, this number is usually below 50 percent.

A general rule of thumb when projecting stock returns is to use a conservative estimate of 6% a year.

What are Bonds?

Bonds are another common investment found in people’s portfolios.

Also known as fixed income products, bonds are debt securities, issued by borrowers to raise money from investors.  Bonds are like an IOU issued to investors that pay interest for the life of the loan as payment for lending your money for a certain period of time.

While bonds can increase in value over time, the main benefit of buying bonds is the fixed income.

Investors typically buy bonds to use as a hedge against the more volatile nature of stocks, and for the additional income from the interest payments.

A general rule of thumb when projecting bond returns is to use a conservative estimate of 3% a year.

With stocks and bonds, these can be packaged up into single securities (you buy 1 share of a stock for example), or into funds (where you can buy many different stocks at once).

Let’s talk about these different financial products a little more in detail.

Mutual Funds

Mutual funds are portfolios that are professionally managed by financial companies and portfolio managers.

Typically these funds can be specific to a certain sector or asset class.

Mutual funds pool investors’ money together and invest in products such as stocks, bonds, and other short-term debts in various allocations.

Similar to stocks and bonds, mutual funds pay us in three ways:

  • dividends
  • capital gains 

Investors typically buy mutual funds because they are actively managed, can be very specific, are relatively low cost and are generally liquid.

Mutual funds are known for their growth and income potential, depending on the particular fund.

ETFs

ETF stands for Exchange Traded Fund.  ETFs are similar to mutual funds in that they are a collection of stocks, bonds, or other securities pooled together.  One major way they are different from mutual funds, however, is that they are traded on the stock market, and thus, their price changes throughout the day.

Similar to stocks, bonds and mutual funds, ETFs can pay us in two ways:

  • capital gains
  • dividends

Investors typically buy ETFs because of their low cost, high diversification and liquidity.

ETFs can be used as growth or income investments.

Index Funds

An index fund is a mutual fund or ETF that seeks to track the return of a market index.  For example, there is a mutual fund that tracks the S&P 500 Index, which seeks to mimic the performance of the S&P 500.

Similar to an mutual fund or ETF, an index fund is a security that can be bought and sold on the stock market.

Similar to stocks, bonds and mutual funds, ETFs can pay us in two ways:

  • capital gains
  • dividends

Investors typically buy index funds because they are highly diversified, have very low fees, are fairly liquid and offer different investment options.

Index funds are typically used for both growth and income investments.

Now that you’ve learned about the different market products, let’s dive deeper and talk more specifically about the stock market.

Why Should You Invest with the Financial Markets?

There are a number of reasons why we invest in the financial markets:

  •  Make income through dividends
  •  Make income when we sell through capital gains

The main reason we do so, however, is because of compounding.

What is compounding?

The best way to think about compounding is to talk about compound interest.

According to Investopedia, “compound interest is the financial principal that dictates that interest is calculated not just on the initial principal amount of the deposit, but also all of the accumulated interest of previous periods of a deposit or loan.

Compound interest is commonly known as the eighth-wonder of the world, and it’s no question why – it’s an amazing thing.

In order to best look at how compound interest works, let’s look at a real life example.

How Compound Interest Affects Your Investments

Let’s say that you’ve invested in an asset which returns, on average, 7% each year, and let’s say you invest $10,000 the first year.

After one year, you have $10,000 of your original investment, and $700 of growth.

While yes, $700 would be great to take out and spend, you decide to leave it in because now, that $700 is going to grow at 7% interest in addition to the rest of your $10,000 original investment.

After the second year, you now have $11,449 ($10,000 + $700 + $700 * 7%)

Again, you decide to leave it in, since now, both $700s are going to grow in addition to your original investment.

Over 30 years, the growth is quite large: your original $10,000 investment is worth $76,123!

After 1 year, you barely had anything more than your original investment. But after 30 years, you had over 7 times your initial investment!

That’s the power of compounding!

Compound interest graph

 

Starting amount: $10,000 | Additional yearly: $0 | Growth Rate: 7.0%

Value after 30 years: $76,122.6

Now that we know why we should invest, the next question is what should you invest in and what are the next steps to start growing you money?

How Should You Invest Your Money?

At this point, investing probably sounds like a good idea. Over time, you can increase your wealth and money through investing.

Now, you may ask, “how should I invest my money?”

How to invest and what to invest in are two of the most important, yet complicated questions, to answer.

Every person has a unique financial situation, and have many different variables affecting their lives.

These different variables make it difficult to say one particular way of investing is best for everyone.

It depends entirely on what your goals are, and the amount of time (and income) with which you have to do it.

However, there are some different things to consider when looking to answer what you should invest in and how to invest.

Active Investing

If you prefer to be a more active investor, you can invest directly in a new product, real estate, a business, or a start-up.

Active investing is more hands-on and will typically require a bigger time and capital commitment. With active investing, the potential returns can possibly outweigh risks, and this is what many finance professionals try their hand at.

You could also invest in single stocks and buy and sell to your liking, though this active form of investing in the financial market can carry additional transaction fees and risk.

If you want to spend more time researching and learning about investing and different products, active investing may be for you.

However, if you want a more passive approach to building wealth, there is passive investing.

Passive Investing

If you don’t have a lot of money or time to invest, and you want a pretty hands-off approach, then it’s likely you’ll want to weigh heavily in more passive forms of investing, like index funds.

Index funds are like a bundle of stocks or bonds that give you exposure to a wide variety of companies, all in different sectors and market-caps.

Index funds look to track a certain index, such as the S&P 500 or Dow Jones Industrial Index.

By investing in these index funds, you can capture the general trend of these indices and own a number of different companies.

How Often Should You Invest?

The next question when thinking about how you should invest is to talk about the frequency of your investing.

Before you decide how often to invest your money, you need to know the various ways of doing it. You can either do it in a lump sum, or over time in irregular amounts, or over time in predetermined amounts.

Dollar-cost-averaging is the idea of investing specific amounts of money, at specific periods of time, in order to offset any volatility.

For example, if you have $1,000.00 to invest over a one-year period, then you would buy approximately $83.33 worth of your investment every month.

What is Dollar Cost Averaging?

Dollar cost averaging is a powerful concept and something many people do to avoid timing the market.

By dollar cost averaging, you avoid guessing and trying to time the market. Trying to out beat the market by investing only when you get a gut feeling may not be optimal for your investing returns.

Here’s an example of the benefits of dollar cost averaging (DCA) from an article on Investopedia:

“Let’s assume an investor invests $1,000 on the first of each month into Mutual Fund XYZ. Assume that over a period of five months, the share price of Mutual Fund XYZ at the beginning of each month was as follows:

Month 1: $20, Month 2: $16, Month 3: $12, Month 4: $17, Month 5: $23

On the first of each month, by investing $1,000, the investor can buy a number of shares equal to $1,000 divided by the share price. In this example, the number of shares purchased each month is equal to:

Month 1 shares = $1,000 / $20 = 50, Month 2 shares = $1,000 / $16 = 62.5, Month 3 shares = $1,000 / $12 = 83.33, Month 4 shares = $1,000 / $17 = 58.82, Month 5 shares = $1,000 / $23 = 43.48

Regardless of how many shares the $1,000 monthly investment purchased, the total number of shares the investor owns is 298.14, and the average price paid for each of those shares is $16.77. Considering the current price of the shares is $23, this means an original investment of $5,000 has turned into $6,857.11.

If the investor had spent the entire $5,000 on one of these days instead of spreading the investment across five months, the total profitability of the position would be higher or lower than $6,857.11 depending on the month chosen for the investment. However, no one can time the market. DCA is a safe strategy to ensure an average price per share that is favorable overall.”

By dollar cost averaging, you help offset volatility by spreading out your purchases, while also maximizing profitability.

In the example above, it’s possible to have made money by just putting in a lump sum. However, the chances of you picking the “right” month is low. It makes much more sense to use DCA. If you are a first-time investor, investing a lump sum right before a market crash can be demoralizing. DCA helps to ensure that this doesn’t happen.

Acting based on emotion, or how we think the market may or may not react can lead us to buying or selling stocks just because.  Acting with emotion can cause you to make some bad decisions.

How Long Should You Keep Your Investment?

Another question to consider is how long should you keep your investments.

This question is pretty simple.  Are you investing for now, or for your future?

the guide to banking for non-bankers

If you’re investing for retirement, then it’s likely you’ll keep your investments going for the rest of your life!

If you’re investing as a way to bring in extra income, and not necessarily fund your financial freedom, then a good rule of thumb is to keep your investment for about five years.

The main reason for this is because five years is a fairly lengthy period of time when it comes to investing.

It’s short enough that it’ll hopefully allow you to recover from a loss, but long enough for you to potentially get some good profits.

If you’re trying to reach financial independence, you should be prepared to leave your money in for much longer. Some investors literally leave their money in an investment account for decades, as this is a way to maximize profits while reducing volatility and loss.

Should I Invest or Pay Off Debt?

Another question to consider when thinking about investing is should you invest or pay off debt?

Many financial advisers suggest paying off debt before investing any money into the stock market.

This is because the interest that accrues from high-interest debt like payday loans, credit cards, etc., cost you much more than what you will earn from your investments.

For example, if you have $1,000 earning 7% interest a year in a brokerage account, you’re earning $70 a year.  On the contrary, if you have a $1,000 balance on a credit card with an interest rate of 18%, your debt is costing you over $180 a year.

Keeping your money locked into an investment instead of using it to help pay off your debt is actually costing you over $100 a year!

On the other hand, if the interest rate on your debt is super low, it may make more sense to invest your free cash, rather than paying off the debt.

For example, if you have an auto loan at 4%, it might be better to invest your cash in the stock market because you can earn higher returns than 4%. The stock market has historically returned 7-8% on average over the last century.

By investing in the stock market, you can theoretically grow your wealth 3-4% more than by paying off debt.

Questions to Ask Yourself about Debt or Investing

Before deciding to invest or pay off debt, you should ask yourself the following questions:

  • Do you have enough money each month to cover your debt payments? Do you have additional money at the end of each month to invest?
  • How much debt do you have? What are the interest rates? Do you feel debt has a grip on your life or finances?
  • If you have extra money available to you, will you actually invest it? Or will you spend it?
  • Do you have an emergency fund?
  • What are the terms of your debt? Are there any penalties for prepayment? Is your interest rate adjustable?

By considering the questions above, it will be easier to decide whether to pay off debt first or to invest.

Start Investing Today and Build Wealth for the Future

Investing in the financial markets is commonly thought of as hard or confusing. While investing has some confusing jargon, the basics of investing aren’t too complicated.

Now, with this article, you have the basics for investing.

Investing can be as simple or as complicated as you want it to be.

The main takeaway is investing, whether it’s in stocks, bonds, or a different investment, is critical to building wealth.

By investing, you can grow your wealth over time and reach your financial goals.

Investing is the greatest wealth builder of all time – you can’t afford to miss out on it!

Beginner Investing Tips

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