Have you ever thought about starting your own business? Having others work for you and contribute to your success is an appealing idea. Investing is the monetary equivalent of that – your money can work for you. Just like you don’t want your staff to slack off and play Candy Crush all day, you can make sure that your money is working for you constantly by investing it.
Investing is an amazing tool to create wealth. By investing, you put your money to work and use it to create more money. Although it can seem complicated and daunting at first, investing is a habit well worth the efforts to cultivate; it is the key to your financial stability and freedom.
In this article, we will learn about the power of compounding and the tools you need to put your money to work!
Investing is for everyone
“Investing only benefits the rich” is simply a misconception. It is true that larger investments bring in larger returns. But a small investment can also create meaningful wealth with patience. New investors often overlook a crucial money-growing factor – the power of time.
“Investing only benefits the rich” is simply a misconception.
Here is a golden principle that the financial sector operates on: money has a time value. Your money can grow when invested. At first, the growth is small and might seem trivial, but it can speed up year after year. On the other hand, if you let your money stay asleep in your checking account, you are missing out on its potential to grow.
For example, if you invest $10,000 at an 8% yearly return, your portfolio would be worth more than $200k in 40 years as the graph shows. If you look at the growth closely, you would notice that the growth is small and often inconspicuous at first. But over time, it accelerates and the investment starts bringing in substantial wealth. The lesson is that you don’t need to be rich to benefit from investing. The sooner you invest, the wealthier you will be.
The power of compounding
The reason that time is so effective in creating wealth lies in the power of compounding. Compounding is the idea that the money you make from investing can be reinvested to make more money for you. In the previous example, you invest $10,000 at an 8% interest rate. In the first year, you will receive $800 in interest. However, the next year your return will be $864 because that $800 from year one will also generate an 8% return of $64. Each year, your return grows and your money snowballs.
Should I invest all my money?
Since investment is so useful, should I invest all my money then? Well, not really. Before investing, it is critical to first build up an emergency fund. An emergency fund is the money that you tuck away for rainy days. Ideally, you should have enough savings to cover 3-6 months of expenses. We recommend putting this money into a savings account or a short-term certificate of deposits. While these accounts do not generate large returns, the money will be accessible at a moment’s notice to support you in case of emergencies.
It is a good idea not to invest all your money at once. Leaving some extra cash on your hands allows you to take advantage of investment opportunities that might come up in the future!
What are my options for investing?
Today, there are a great number of investing options. If you prefer a professionally managed portfolio, robo advisors and mutual funds are good options. They make investing less time-consuming. For those looking for a more hands-on approach, you can build your own portfolio and investment strategies by purchasing individual stocks and bonds.
No matter how you invest, a basic understanding of different investment options is required. Next, we will go over some of the most popular ways to put your money to work:
Stocks (equities)
Stocks represent ownership of a company. When you own a stock, you own a share of that business. When the company makes money, you, as a shareholder, are entitled to your share of the profit. There are three types of stocks: common, preferred, and convertible stocks. Common stocks have voting rights but might not always receive dividends from the company. Preferred stocks are guaranteed to receive dividends but do not have voting rights. Convertible stocks are preferred stocks with the potential to convert into common stocks. Most investors invest in common stocks.
How to make money with stocks
You can make money with stocks in two ways. The first is by selling a stock that has appreciated, commonly referred to as “buy low, sell high”. This income is called capital gain and often taxed at a higher rate than ordinary income.
The second source of income is dividends. Profitable companies can pay dividends to shareholders in either cash or more stocks. Dividend payments vary greatly by the company and the sector it is in. For example, technology companies pay fewer dividends because they are growth-oriented and reinvest their profit back into the business instead of issuing dividends. On the other hand, stocks of utility companies offer investors regular dividends because these companies are mostly mature with stable income.
Bonds (fixed-income investments)
If you have taken out a student loan or credit debt, you know that banks charge you interests for lending you their money. Bonds work in the same way, except now you are the one lending money. In return, you, as a bondholder, are compensated for your investment with regular interest payments (the coupons) and the final repayment of your initial investment (the principal).
How to make money with bonds
Bond investors make money through the coupon payments they receive regularly.
For example, if a bond has a five year maturity and offers a 5% annual coupon, you will receive $5 dollars each year for five years. In the last payment, you will also get back your original $100 investment. Notice that the return is fixed for each year. This character of bonds is useful in financial planning because you know exactly how much money you will receive in the future. It is also why bonds are also called fixed-income products.
Mutual funds
If you don’t have time to do research or choose your own stocks and bonds, you can still own a diversified portfolio by purchasing shares of mutual funds. Mutual funds pool money from investors and hire professional managers to invest this money. When you buy shares of a mutual fund, you own a portion of a professionally managed portfolio.
Mutual funds can be divided into two categories: actively managed funds and passively managed funds. Active funds aim to beat the market return and passive funds try to replicate the market return. While the goal of active funds seems more appealing, they are not always able to achieve a higher return than the market. Additionally, active mutual funds charge a higher management fee than passive mutual funds.
Mutual funds often require a minimum amount of investment, generally a few thousand dollars. Consequently, they are not available to every investor.
How to make money with mutual funds
As a mutual fund investor, you make money when the fund is profitable. If you own 10% of a fund, you are entitled to 10% of its portfolio income. It includes all interests and dividends the fund receives. The total return of your mutual fund investment equals your share of the portfolio return minus the fee the funds charge.
Exchange-traded Funds (ETFs)
Like mutual funds, ETFs help investors gain access to a professionally managed portfolio. One thing that sets ETFs apart from mutual funds is that you can buy and sell shares of ETFs on exchanges just like a stock. In addition, there is no minimum investment requirement for ETFs. You can buy as few as just one share. This means ETFs are available to every investor no matter how much you have to invest. Most ETFs are passively managed but more active ETFs are emerging in recent years.
How to make money with ETFs
Similar to mutual funds, you profit from the portfolio’s incomes and capital gains as an ETF investor. In addition, because ETF shares are traded on stock exchanges, you can have a capital gain if you sell the shares higher than the original purchase price.
Investment Risk
Investing is a powerful tool to secure your financial future but it is rarely a smooth journey in reality. Your investment will fluctuate and sometimes you will lose money. This happens to everyone from investment newbies to Warren Buffett. Although we can never eliminate investment risks, with a thorough understanding of what they are, you can avoid taking unnecessary risks and minimize losses.
Investment risks can be categorized into two large camps: business risks and market risks. Business risks are associated with individual companies and their financial performances. Market risks are influenced by the larger economy and tend to affect many companies at once.
Business risks
Management risk
How a company manages its business can directly affect the company’s share price and your investment. As a stock investor, you are rooting for the company to succeed. While good management can push share prices higher, a poor decision can reduce company profit and lower share prices.
Credit risk
When a company becomes bankrupt, the company will stop repaying its debts. This means that bond investors could lose their entire investment. Credit risk captures this possibility of a company becoming bankrupt. For bond investors, this is the biggest risk they must watch out for. You can read more about credit risk and how to measure it here.
Market risks
Volatility risk
When you look at the price chart of an investment, you might realize that the price of a stock can fluctuate even when the company is doing well. Market movements are not always rational and the fluctuation can lead to losses in your investment.
Currency risk
Foreign currency risk arises when you have foreign investments. For example, if you live in the US but receive income from a UK government bond, you will need to convert the pound earnings into dollars. The fluctuation of the exchange rate affects your return. If dollar appreciates against the British pound, the same return is now worth less in dollars after conversion.
Interest rate risk
The price of a bond is inversely correlated to the interest rate. With a higher interest rate, your bond investment will decrease in value. Consequently, interest rate movement can be a major risk factor for bond investors.
Make your money work for you today
Investing is a powerful tool to generate additional income and secure your financial future. The best thing is that you don’t need to be rich to benefit from investing. A small amount of investment can grow substantially with time. Thus, the key is to start investing early and make your money work for you today.
