The thought of investing in the stock market kind of freaked me out. I used to think you needed a lot of money to get started and that in most cases hand holding from a pro, aka, an advisor who “knew” more than you did was absolutely required. Well, as it turns out I was plain wrong.
Let me share other factors that I believe influenced my behavior around the idea of investing:
Lack of interest: learning about money was not something I was passionate about
Complacency: things are ok at the moment
Fear: I’m gonna lose my money, investing is the same as gambling … oh the horror stories
Only for the wealthy: I need a lot of money to get started
Cultural: parents never invested so why should I?
No appreciation of time: it can wait
Do you really know what investing is? or more importantly, do you know why you may want to do it? Before answering the what, I think is better to start with the why… here it goes: I invest because I see it as a vehicle that will facilitate achieving my personal goals. Nothing magic or fancy it’s just that simple.
Now, investing is a term that can be used in different settings. You can invest money or a resource in things like your education, a business, a job, people or even yourself. But what do all these things have in common:
You need to have a GOAL
You need TIME
You need to have a starting point or a PRESENT VALUE
You hope to get a RETURN
Now, what does this mean?. Let’s look at the decision to quit my job to go back to school:
GOAL: I wanted to be a petroleum engineer
TIME: spent two years in grad school
PRESENT VALUE: willingness to learn more about this new field of expertise
RETURN: friends all over the world, knowledge and great compensation when hired on right our of school
Simply put, investing is the action of committing a resource with the expectation of a future reward. Is about aligning your personal goals with the appropriate types of investment vehicles with the hope of making your money grow over time to satisfy your future needs.
So if key ingredients for investing are time, present value and returns, how can we use this to our advantage? Let’s look at an example where two individuals started investing $2000. Person 1 started at the age of 20 and Person 2 at age 30. We will assume the average annual rate of return is 10% and both expect to retire at age 65.
Look at the difference after 45 years, $145,781 vs. $56,205. By starting earlier person 1 was able to save 2.5X more than person 2. You might be thinking two things: how in the world is this possible and a 10% rate of return… really? For the first question, I have two words for you … time and compounding, and for the second one … get over it, 10% is an assumption that may not be completely realistic but it doesn’t change the bottom line.
I hope the example above hit home for you, but I need to remind you of something; person 1 and 2 started with an initial investment but they did not make additional contributions. What if there was a person 3 that started at age 20 but also decided to invest $2000 every year (or $167/month). Well, let me show you the results.
You have got to be kidding me right?. Person 3 invested $2000 per year for 45 years and was able to save $1,581,590? … In short, yes. Again, I know a 10% rate of return might be causing some discomfort but I’m hoping you’re not missing the forest because you’re still focused on the trees. Person 3 not only highlights the value of starting early, but also the importance of having the discipline to live within your means, i.e. spending less than what you make so that you can save and invest the rest on a regular basis.
If you’re still thinking there’s a perfect time to start investing your money then in the most respectful way I would like to say that you’re a fool and you’re just wrong. The sooner you start, the more time your assets have potential to grow. Not only can you add money to your investment accounts for a longer period but they can also increase exponentially in value through the miracle of compounding.
So, I’ve been talking about compounding but what is it? according to Investopedia, “Compounding is the process of generating more return on an asset’s reinvested earnings“. I know it sounds simple but so many people consciously or unconsciously take it for granted. Compounding has to be the one if not, the best investing tool ever made by mankind. For it to work, you need two things: reinvestment of your earnings and time … that’s it. For all investors, especially young individuals, it is the greatest investing tool possible that I wish I had come to know when I was in my 20s. It is simply the #1 reason for starting now. The math for estimating the impact of compounding is shown below:
Future Value = Present Value x (1 + annual interest/compound periods)(compound periods x years)
Following our previous example, let’s look at compounding at different periods to see the impact on the numbers.
Future value (annual) = $2,000 x (1 + 0.1/1)(1 x 45) = 145,781
Future value (semi-annual) = $2,000 x (1 + 0.1/2)(2 x 45) = $161,461
Future value (quarterly) = $2,000 x (1 + 0.1/4)(4 x 45) = $170,344
Future value (monthly) = $2,000 x (1 + 0.1/12)(12 x 45) = $176,708
Future value (weekly) = $2,000 x (1 + 0.1/52)(52 x 45) = $179,258
Future value (daily) = $2,000 x (1 + 0.1/365)(365 x 45) = $179,923
The math seems straight forward so why don’t we do a sensitivity analysis based on what a SMART goal might look like. For instance, let’s assume I’d like to know how much I should save per month to get to $1,000,000 by the time I’m 60. I could use the equation mentioned earlier, but I’m going to be lazy and use the Future Value function in Excel that requires: annual rate, total number of payment periods, the contribution amount and starting balance.
For this example, I’ll continue to assume a 10% annual rate of return compounded monthly, 23 years until I hit 60 (crap!) and a monthly contribution equal to $250. Based on these numbers I get $268,607, so not even close. Instead of playing around with the amount, allow me to use Goal Seek to calculate the exact amount. The magic number is $931. This seems tough, doesn’t it?. This means I’d need to save almost a grand every month to hit my mark.
So where is the magic of compounding? believe me, it’s there is just that I have a fixed number of years to get to the finish line, i.e. 23. But what If I had started investing when I was 20 (40 years investing), 25 (35 years investing), 30 (30 years investing), or 35 (25 years investing)? This is what my savings per month would have looked like:
Today, I’m 37 and If I had started in my 20s saving $157/month I could hypothetically and “potentially” be enjoying a nice stash equal to $84,167.47 (17 years investing).
Conversely, If I had just saved the $157/month in a brick and mortar bank that pays 0.01% APR, I wouldn’t necessarily be crying (maybe I should!) but it would be frustrating to see my balance at $32,018.41. The difference between the two approaches is just stunning at $52,146.06. This may not be a lot of money to you but it is a hell of a lot for me.
Now, let me ask you something … what is the reason that would drive you to miss that difference? Please fill in the blanks in the following sentence:
I will make the conscious decision to miss on the opportunity
to potentially make $52,146.06 because
Let your answer sink in for a few minutes, hours but not weeks, months or years because you need to start investing now!
In the context of personal finance and financial independence, investing is nothing more than the process of using money to make money.
Compounding is the real deal. If you don’t invest your money you’re missing out big time.
If you don’t invest your money you’ll either spend it, give it away or stuff it underneath your mattress aka savings account making 0.01% a year.
Investing is a tool for building wealth, but it is not only for the wealthy.
Anyone can get started investing and there are various investment vehicles that make it easy to begin with small amounts. Stay tuned for future posts on this one.
Investing is not gambling because it takes time so forget about a get-rich-quick scheme. If that’s your approach getting into it then stop and take a trip to Las Vegas.