If you’re new to investing, chances are that you’ve been running in to a lot of intimidating information and confusing industry buzz words. As if risking your hard earned money isn’t daunting enough, trying to learn about the DJIA, REIT’s, 401(k)’s, bull markets, and bear markets (oh my!)—is another challenge entirely. It’s enough to make anyone want to throw up their hands and just stash their savings under the mattress!
Fear not—here are some bite-sized concepts that will make investing more approachable for first-time investors.
“Compound interest is the most powerful force in the universe.”—Albert Einstein
Compound interest is generated by reinvesting the interest on a principal sum of money. Over time, compounding interest allows you to increase the earnings on your initial investment exponentially more than you would by simply pulling your earnings out every year.
For example, if you make an initial investment of $1,000, and that investment receives earnings of 20% (compounded yearly), over the first year, you’d make $200 giving you a total of $1,200. Let’s say you allow this money to sit for another year and receive another 20% earnings. Instead of only getting 20% of your initial investment of $1,000 ($200), you’d be receiving 20% of $1,200 ($240).
A $40 difference may not seem like a lot, but that’s where the importance of time comes into play. Over the course of 20 years, the compounded investment of $1,000 reaches nearly $32,000! Compare this to a non-compounded investment over the same time period, which would be less than $5,000.
When Should I Invest?
The secret ingredient to earning more on your investments is time. The younger you are, the more time you have. The more time you have, the more time your investments have to compound, and the greater your earnings will be.
If you’re considering whether it’s best to start investing now, the answer is a clear and resounding yes. Waiting just five or even 10 years means you would be missing out on a greater payoff.
If you’ve never invested before, this may sound like an intimidating prospect. But, think about all the little investments that we make every day for our immediate comfort or entertainment. In a year, you might treat yourself and a friend to a $50 dinner a handful of times, buy a top-of-the-line smartphone, or go see a few shows.
If you want to set yourself up to live comfortably in the future, instead of splurging on that new HD TV or the newest version of the iPhone, consider investing that money into something that could really benefit you in the long run.
What type of investments are available to me?
One of the most common forms of investing is buying stock, which is a share of legal ownership in a business. You might also hear stocks referred to as “securities” or “equities.”
If you buy shares of a company, you’re betting that the price of that company will go up over time. The amount of risk with stock investments varies, depending on the company you decide to buy into. Having a “diverse stock portfolio” means that you have stock in various businesses.
At the most basic level, bonds are "I owe yous" (IOUs) from corporations or governments. When you buy a bond, you become a lender for the entity that issued it. The issuer must pay the loan back—with interest. The interest payments on the bond price generate a profit for the holder at a predetermined rate and schedule.
Bonds are considered to be a less risky form of investing because the investor knows exactly how much he or she will earn on a particular bond if it is held to maturity.
Mutual funds are a popular and easily accessible option for new investors to start building their wealth. A mutual fund pools money from individual investors, companies, and other organizations’ portfolios. That pool is then responsibly invested by a fund manager with specific goals in mind. For example, a long-term growth manager would invest the pool of money differently than a fixed-income fund manager would.
Mutual funds are a great place to start for new investors because they are attached to an informed money manager who is responsible for investing the fund according to your mutual financial interests. That way, you don’t have to worry about keeping close track of the markets or understanding complicated formulae—you’ve got a professional to do it for you.
There are many different flavors when it comes to mutual fund managers, and it’s important to find one that matches well with your own goals, criteria, and investment strategy.
A 401(k) retirement plan is one of the smartest ways you can use compound interest to your advantage and plan for your financial future.
Created by Congress in the early 1980’s, a 401(k) is a retirement savings vehicle available to most employees in the United States. If you opt in to a 401(k) plan through your job, a pre-tax deduction is made from your paycheck to fund an attached account. The deducted amount varies depending on the percentage of each paycheck you want to invest, and some employers contribute an additional percentage of your personal contribution. The funds in your 401(k) account are then invested across a number of different channels, including stocks, bonds, and mutual funds, based on your preference and risk tolerance.
The money in this account is deferred from being taxed on any interest, dividends, or capital gains until it is withdrawn. Because your 401(k) plan is meant to provide for your financial security after retirement, there is a hefty penalty for withdrawing from the account early, but you are entitled to do so.
Related Reading: Should You Borrow from Your 401(k)?
Individual Retirement Account (IRA)
An IRA is a savings vehicle where you save money for retirement and receive a tax advantage for doing so. The federal government allows all Americans to save $6,000 per year if you’re under 50, or $7,000 per year if you’re 50 or older, and that money is tax deductible. There is one exception for higher earners: contributions are tax deductible unless you are also participating in an employer's qualified retirement plan.
Here’s a breakdown of how a traditional IRA works:
You invest tax-free money now.
Your account grows, tax-deferred, during your working and investing years.
When you retire, you may be paying taxes at a lower rate than you were during your working years.
You may pay less in taxes overall if you are in a lower tax bracket in retirement.
The best advice that I can give to first-time investors is to educate yourself, ask for help, and don’t get so intimidated that you end up not investing. If the idea of greater investment options sounds overwhelming or you're unsure how to decide on your best course of action, you may benefit from some personalized financial advice.
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