While this quote might not seem groundbreaking, the truth is most investors don’t often understand the basics of investing beyond simply wanting the market to go up. While asset appreciation is certainly a goal, there is more to wealth building—even if you don’t have large sums to invest.
The key to becoming a good investor is to understand the core concepts of wealth building. This includes understanding compounding as well as the importance of risk and return. Beginning investors need to understand their options regarding how they wish to invest in the markets. Armed with this knowledge, investors can be smarter and more efficient in their approach to investing.
The Power of Compounding
One of the most important concepts for investors to understand is the power of compounding, because that’s how your money grows. Compounding is basically what you start investing, increased by what you earn.
For instance, let’s say you have 1,000 jelly beans. If the jelly beans compound by a yearly rate of 10%, you’ll have 1,100 jelly beans at the end of the year. If you let the 1,100 jelly beans grow at 10% for another year, you would then have 1,210 jelly beans—100 additional jelly beans at the end of the first year and 110 additional at the end of the second year.
This is the beauty of compounding. While this seems like a clear concept, many investors miss the point of compounding. The longer you hold an investment, the longer it compounds, and the greater the likelihood that your money will grow. This is why it’s so important to start investing as soon as you’re able. Compounding requires patience, and the earlier you start, the better the outcome (and your income).
Risk and Return
Beyond the concept of compounding, investors must understand the relationship between risk and return. Risk is defined as the possibility of loss or that the outcome might not be as projected. In comparison, return is the difference between the original investment and the profit. Higher returns often require taking on higher risk. As a result, investors must consider their risk tolerance to bear a loss.
That is where the psychology of money kicks in. Ask yourself if you are comfortable with watching your investment drop in value in the short term. Many investors are okay with short-term drops as their focus is on the longer-term upside. Other investors may want to limit their risk exposure if they are not comfortable with loss.
New investors in the stock market should have an understanding that while you may see losses in the short-term, the general best practice is to not panic and weather the storm. Historical stock market returns have shown that down years are often followed by good years.
Types of Holdings
When investors understand these concepts, there are still important decisions about how to actually approach the capital markets. Investors have the option of investing in companies either through debt or equity.
Debt is typically accessed through the bond market. A bond is an instrument of indebtedness issued to the holder, usually in the form of either government bonds or corporate bonds. Bonds generally have a lower level of risk than stocks, meaning they also have a lower projected return. Since they are a lower risk, lower reward type of investment, bonds are more heavily utilized in portfolios of older, more conservative investors.
Most investors want to access the capital markets through equity, or stocks. A 2020 Bankrate Survey found that 28% of Americans prefer investing for the long term with stocks. Buying a stock is the same as buying a piece of a company. Companies can be of different sizes and cover different sectors of the markets. Shareholders are able to participate in both the upside and downside of owning a small piece of a company.
While investing in stocks can provide greater return, it is not uncommon for investors to want to own shares of many different companies, which can be challenging if the investor has a limited amount of funds to invest. An alternative is for the investor to invest in either mutual funds or Exchange Traded Funds (ETFs) or both.
A mutual fund brings together money from many people and invests it in stocks, bonds, or other assets. These combined holdings comprise the portfolio. Investors own shares of the mutual fund, not the underlying stocks. As a result, the price of a mutual fund is called its net asset value, or NAV per share. The NAV is derived by dividing the total value of the securities in the portfolio by the total number of shares outstanding. This amount does not fluctuate throughout the day; rather it is settled at the end of each trading day. Shares are purchased or redeemed based on the fund's daily NAV.
In comparison, investors can also access a diverse portfolio of stocks through an ETF. In an ETF, a group of stocks are typically tracking an underlying index. This group of stocks is listed on exchanges, and these shares of these funds trade throughout the day just like an ordinary stock. Some of the most common ETFs are the S&P 500 or the Russell 2000 Indices.
One of the benefits of ETFs is that they trade live on the market throughout the day. Further, they tend to be lower cost than their mutual fund counterparts. The downside, however, is that an ETF is often considered merely a fund that tracks the index. If you want a more active managed approach, ETFs may not be able to meet your goals.
ETFs are called exchange traded funds because they are traded on an exchange just like a stock. An ETF holds multiple underlying assets rather than just one stock. As a result, they can hold hundreds if not thousands of stocks and can provide instant diversification.
Once you are ready to start investing the challenge is how to best implement, but there might already be tools at your fingertips to help make investing easy.
For the majority of investors, the best vehicle to use would be your retirement account. Whether this is a 401(k), 403(b), or IRA, the goal is to save as much as possible in these accounts. A common rule of thumb states that investors should have a goal of having at least 10 times their salary saved by age 67.
Further, with 401(k)s and 403(b)s, you are buying in every pay period, which allows you to invest a set amount monthly or ‘dollar cost average’ into the market. The money that you are investing can grow tax deferred, which enhances compounding.
For most investors, keeping it simple is the best course of action. A great way to simplify your approach to investing is to use a Target Date Retirement Fund. This is a mutual fund that operates under an asset allocation targeted to your projected retirement date. It is a way to get instant diversification among all asset classes, while tailoring your risk tolerance to your retirement age goals.
Putting It All Together
As investors master these basics, they will be motivated to expand their portfolio beyond retirement accounts. They may invest in taxable accounts and seek professional help. But regardless, knowing the key basics of investing will allow for a better investment experience and potentially greater returns.
Like investing, life insurance is a financial decision that is advantageous to act on early. Our Financial Legacy Index found that while a strong majority of Americans (82%) value leaving behind a strong financial legacy, a significant number of people (38%) lack confidence they will do so. Investing and life insurance are both critical pieces to shoring up your financial legacy, helping secure a stable financial future for both you and your family.
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