The Essentials of Investing
- Wednesday, July 11, 2012
Investing is arguably the most challenging topic within personal finance. There’s a lot to know and the terminology can be confusing. Throw a scary economy into the mix and investing can seem like an unsolvable puzzle.
To lower the fright factor and cut through the confusion, here are some of the investing essentials — the key steps to take in order to follow the seventh of my 11 principles for simple, meaningful success: Patiently Pursue Interest.
Get In The Game
There’s a financial force in the world so powerful that Einstein once called it the eighth wonder of the world. What is this mysterious force that so captured the imagination of one of the world’s smartest people? Compound interest.
In essence, compound interest is interest earning interest. If you invest $100 and earn an annual return of 7 percent, a year later it’ll be worth $107. The next year it isn’t just the original $100 that earns interest. The $7 you earned last year earns interest as well.
Not impressed yet? Just wait.
Let’s say you invest $400 per month and get that same 7 percent return. After 10 years, you will have invested $48,000, but it will have turned into over $69,000. Compound interest put an extra $21,000 into your account. Not bad.
But let’s give it some more time. After 40 years, you will have invested $192,000, but your account will be worth nearly $1,050,000. Wow! The interest earned – over $850,000 – is much greater than the amount you invested. Clearly, it’s important to start investing as soon as possible.
Once you’re out of debt other than a reasonable mortgage and have an adequate emergency fund, you’re ready to get compound interest working for you.
Estimate Your Needs
People who take the time to run some numbers on their retirement, estimating how much they’re likely to need for their later years and how much they need to be investing now in order to hit that target, tend to do the best job of saving for their retirement.
Of the various online retirement calculators you could use, one of the easiest is Fidelity’s myPlan Snapshot.
Don’t Put the Cart Before the Horse
It’s important to understand, and more than a little counterintuitive, that how you invest is more important than what you invest in.
More specifically, your asset allocation – what percentage of your money you choose to put in stock-based investments, for example, and what percentage in bond-based investments – is more important to your success than the specific investments you choose.
That’s a little hard to believe, isn’t it? After all, the financial press is filled with stories about this hot mutual fund and that. But asset allocation matters more.
One of the simplest free tools available for figuring out an appropriate asset allocation for you is the Lifetime Allocation Indexes(scroll down to “Investing” and click on “Asset Allocation Guidelines from Morningstar”).
Choose Your Investments
Once you’ve determined how much to invest each month and have figured out the right asset allocation for you, there are a number of ways you could choose what to invest in, including:
- Choose your own mutual or exchange-traded funds within the various asset classes and in the right percentages based on your chosen asset allocation.
- Put your money in a target-date mutual fund. Such funds set the asset allocation for you based on your intended retirement age and then automatically make the allocation more conservative as you get older. Most of the big brokerage houses offer such funds. Just know that target-date funds vary from one brokerage house to another. Some are more aggressive in their asset allocation than others. Take the time to make some comparisons so you’re comfortable with the approach used by the fund you choose.
- Work with an investment advisor who will recommend an appropriate investment strategy.
You Can Do It
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