Financial companies often portray investing as a complex, highly technical process, to be attempted only by trained experts. In reality, the basic rules of investing are simple. If you follow these basic principles, you can do well investing, whether you’re saving for retirement or your child’s college tuition.
Time is your ally
One of the most important investment principles is “invest early and often.” This allows your money to earn compound interest—the snowballing process where your money earns money. Given enough time, compounding can turn even a small amount into a fortune.
Consider Steve and Jim. Steve began investing at age 25 and contributed $2,000 annually for 10 years. Jim waited until age 35, then invested $2,000 a year for 30 years. Assuming both men earned 10 percent on their investments, who has more money at age 65?
Surprisingly, it’s Steve, who has about $612,000. Jim, however, has less than $370,000. Why? Steve’s money started working for him earlier, compounding its value. If Steve had continued contributing $2,000 a year until age 65, he would’ve accumulated nearly $1 million. The sooner you start investing, the better.
The return you earn on your investments is as vital as the length of time you invest. Using the above example, reducing Steve’s return from 10 percent to 9 percent would produce only $440,000 instead of $612,000. An 11 percent return would earn almost $850,000. A single percentage point of return can make a huge difference over time.
Maximize your return with stocks
To maximize your investment, buy stocks. Stocks have historically outperformed all other investments. Over the last 75 years, they averaged 11.4 percent annual gains compared with only 5.1 percent for bonds. But because stocks are volatile, they carry more risk short-term. So use stocks for long-range goals—10 years or more—to reduce risk. Doing so also will allow you to take advantage of compound interest.
If your time horizon is less than 10 years, you’ll need to move more investments into bonds or certificates of deposit (CDs). As a general rule, the sooner you’ll need your money—within 10 years—the more you need in non-stock investments.
Consider mutual funds
Mutual funds are groups of stocks or bonds chosen and managed by an expert. In exchange for an annual fee and other expenses, you get professional direction and instant diversification. Do your homework and investigate all of the fees involved before buying a fund. Avoid those that charge a sales fee (also called a load), tack on high operating expenses, and lose a substantial portion of your gains to taxes.
Index funds are a wise choice
Index funds are mutual funds for which a manager buys all the stocks in a market benchmark or index average (such as the Dow Jones Industrial Average or Standard & Poor’s 500) rather than actively picking which stocks to purchase. Funds based on an index, by definition, will never outperform the market. But because they minimize trading, tax and sales costs, they outperform the vast majority of actively managed funds over time.
Take advantage of the government
The government has numerous programs to help you invest. The main ones are individual retirement accounts—known as IRAs—and 401(k)s. With these investments, you pay no taxes until you withdraw funds, giving you a better total return on your money. Better yet, contributions to these often can be deducted from your annual earnings, reducing your annual taxable income. And some employers will match your 401(k) contributions, allowing you to earn even more. However, it’s important to know that severe penalties exist for early withdrawal of these funds, so don’t invest money you may need in the short-term.
Another form of an IRA is a Roth IRA, which allows tax-free earnings growth and withdrawal of funds. Roth IRA contributions, however, are not tax deductible and are purchased with after-tax dollars.
These simple guides provide the recipe for you to manage your own investments. Take some cash, add this advice, and allow some time for it to grow. Before you know it, you’ll be well on your way to investing success.