cash-5083256-small.jpg
Investing is arguably the most complicated and intimidating topic within personal finance. Understanding (and making use of) two key investing concepts will go a long way toward demystifying the process while dialing down the fear factor. Let's get started! (See also: The 10-Step Staircase to a Comfortable Retirement)
Compound Interest
At first glance, this one seems like no big deal. Compound interest is simply interest earning interest. For example, if you invest $100 and are able to earn 10% on that money, in a year it will have turned into $110. The next year, assuming you are still able to earn 10%, it isn’t just the initial $100 that earns interest, but the interest you earned last year will earn interest as well. So, you won’t end up with $120 at the end of year two; you’ll end up with $121.
Okay, so it’s not that impressive. But wait. Let’s put more money to work and give it more time.
Imagine investing $200 per month for your retirement beginning at age 20. And let’s assume you can get a 7% return on that money. By age 30, you will have invested $24,000. That’s $200 per month for 10 years. However, because of the 7% return, your $24,000 will actually be worth $34,617. Not bad, right? You racked up more than 10 grand in interest in just 10 years!
Don't Stop Believing
But wait. The longer you give it, the better it gets. Let’s run this all the way out to age 70, which, let’s face it, will probably be considered "early retirement" by then.
The $200 you’ve been dutifully tucking into your 401(k) plan all that time adds up to $120,000, an impressive amount unto itself. But because of the power of compound interest, that sizeable sum has become much, much more sizeable. In fact, it’s now worth more than a million bucks. Now that’s impressive. You’ve earned about $970,000 in interest through the power of compound interest.
This is why Albert Einstein reportedly called compound interest "the eighth wonder of the world." Even if he didn’t say that, it doesn’t take a Nobel prize-winning scientist to understand that compound interest is a relatively powerful concept.
Speaking of Einstein, there's a complicated looking formula for calculating compound interest. It's actually pretty straightforward once you understand the terms.
Even better, here's an online tool that calcualtes it for you.
On a side note, this is exactly why it takes so long to get out of debt. Debt takes the strong wind of compound interest and flies it in your face. Keep the wind at your back by investing.
“Fair enough,” you say, “but where can I get a 7% return?”
Asset Allocation
Pick up any personal finance magazine and you’re likely to see breathless headlines about the latest mutual fund to rack up impressive returns. But you’re not fooled. You realize that last month’s hot performer might be tomorrow’s dog. So which fund will do well next month?
Surprisingly enough, generating a respectable return on your investments isn’t so much about the specific investments you choose. It’s how you spread your investment dollars around. This is known as asset allocation. It may have a boring name, but asset allocation has been found to account for about 90% of investment returns.
Choosing Between Stocks and Bonds
The key asset allocation decision is what percentage of your investment dollars to put in stocks and what percentage to devote to bonds (or stock-based and bond-based mutual funds). Stocks are riskier than bonds, but they have the potential to earn a higher return. In general, the younger you are, the more your investment mix should tilt toward stock-based investments, but your risk tolerance matters as well. You can find lots of free asset allocation calculators online.
The calculators will typically suggest something a bit more detailed than stocks vs. bonds; they may recommend that you devote different percentages of your money to large-cap stocks (the stocks of large companies), small-cap stocks, foreign stocks, and bonds. Most brokerage houses, such as Fidelity, Vanguard, Schwab, and others, offer index mutual funds in these categories, which can provide a low-cost, relatively simple way to invest in those categories.
So, those are two key steps toward becoming a knowledgeable, successful investor. First, make use of the power of compound interest by getting started with investing as early as possible (although it’s best to wait until you’re out from under any credit card or vehicle debt and have a base of savings totaling three to six months’ worth of essential living expenses). And second, base your investment decisions on an intentional asset allocation plan that’s tailored to your age and risk tolerance.
What are your key investment concepts?
