A Starting Point for Those About to Invest
How many times do you need to fold a piece of paper to reach from here to the moon? The answer has a lot to say about why you should invest today. Is it:
At a standard thickness of 1/250th of an inch per page, it would take almost 38 million and a half pieces of paper, stacking one page on top of another, to reach the 238,607 miles from here to the moon.
But we’re folding paper, not stacking it. The first fold doubles the paper’s thickness. The second fold increases the thickness by four. The third fold by eight… and so on. Notice what’s happening. The paper’s thickness is growing not arithmetically but exponentially.
To get to the moon by folding a single piece of paper, turns out you would only need to fold it 42 times.
Incredible. That’s the power of exponential growth—or, as it’s called in investing, compound growth. For now, hold onto that very important idea, and we’ll return to it in a minute.
So far in our Financial Literacy series we’ve been talking about how to spend money wisely. We haven’t addressed an obvious question: what should you do with your savings?
You may want to consider investing it. You know what your goals and objectives are, but do you have a plan to reach them? Establishing an investment plan may help.
It’s a straightforward process that goes like this:
Your goals > Your plan (investment strategy) > Your investments
Image Credit: https://twitter.com/behaviorgap/status/545292485673910272
Goals come first. Then creating an investment plan that can help you reach those goals. And then (and only then) choosing investments that are most likely to make your plan a reality.
Some people create their own investment plan and choose investments themselves. While others work with a qualified financial advisor (see below). Whichever way you choose, it will help you to know some basic information about investments—their benefits, their risks, and how they might be used in an investment plan.
Whatever your goals are, there are two big reasons to invest your savings sooner than later.
The first reason is that your savings, if left alone, will slowly but surely lose value. This is because of inflation, which is the long-term tendency in a healthy economy for prices to rise.
You have experienced this. Remember what a dollar used to buy when you were younger, or what a week’s groceries used to cost.
Now think of your savings. If left alone, the amount you have today is the amount you’ll have 30 years from now. It’s a good bet that money won’t buy as much in 30 years as it does today. It will lose value due to inflation.
So one reason to invest is to help make sure your savings at least keeps its current value over time. While investments are not immune to inflation risk, investing may lessen the impact of inflation.
The second reason to invest sooner than later has to do with that folded piece of paper—the power of compound growth.
Compounding means to generate more growth on assets by reinvesting your earnings and giving them time to grow. This is how your investment may grow exponentially. All things equal, the longer you invest, the more your money will grow from compounding.
Chart source: Business Insider
So if you’re young and can only set aside a small amount, take heart—you have time on your side. And if you’re older, you still may have decades before you’ll need your savings for your retirement and healthcare expenses.
Either way, invest today.
You can think of different types of investments as tools to get specific jobs done:
- Cash Equivalents
Money market funds, CDs, savings accounts, checking accounts, and similar investments that are designed to keep your money relatively safe and provide modest rates of interest (after subtracting inflation). We say ‘relatively’ because no investment is 100% guaranteed.
Stocks are designed to provide higher rates of growth over the long term, in return for higher risk to your invested money (“principal”). Stocks can range widely in their potential for return and risk, from moderately risky stocks such as U.S. large-company stocks to high-risk stocks such as those of small companies based outside the U.S.
- Fixed Income
Bonds and other fixed-income investments are generally designed to provide a higher rate of interest income than cash while offering safety of your principal somewhere between that of cash and stocks. As with stocks, there’s a wide range of bonds, from less risky, shorter-term U.S. government bonds that provide lower interest to high-yield corporate bonds that offer more income but higher risk.
Notice what we've been saying about risk and return. There is an iron law of investing: the greater the potential return, the greater the potential risk to your principal. And the lower the risk, the lower the potential return. It’s a trade-off, and there is no getting around it. So be on guard for any claims to the contrary.
All investments have risk of some kind. You can’t eliminate investment risk. But you can manage it.
The saying “don’t put all your eggs in one basket” has a one-word translation in investing: "diversify". By spreading your savings across a number of different investments, you lessen the effect that one poor-performing investment will have on your entire set of investments (your “portfolio”).
Diversification works on many levels. Consider just stocks. Investing in many stocks lowers the risk that one poor-performing stock has on your overall stock performance. Investing in many kinds of stocks—large- and small-company stocks; growth and value stocks; technology and industrial stocks—lowers your overall risk should one of those styles or sectors fail. And investing in stocks around the world lowers your overall risk if the stock market in one country does poorly.
Diversification works the same way with fixed-income investments. Investing across a wide range of government and corporate bonds with different maturities can lessen the impact that poor performance of one bond or type of bond may have on your overall investment.
Finally, diversification works across different kinds of investments. Investing across stocks, bonds, and cash will lessen the impact of poor performance in any one of those investment types. Of course, if you’re not 100% invested in stocks, you won’t get 100% of a rise in the stock market. But you will have taken less risk.
This blending of stocks, bonds, and cash is called asset allocation. Most financial advisors will recommend an asset allocation whose mix is determined by your goals, the time you have to invest, and your tolerance for risk.
Diversified mutual funds and exchange-traded funds (ETFs) offer a simple way for almost all types of investors to benefit from diversification, and from the experience and knowledge of a money manager.
*Diversification does not ensure a profit or guarantee against a loss.
Remember the incredible potential of compound growth. Every day that you are invested in the market is one more day your money can work for you.
Consider working with an advisor
A qualified financial advisor can examine your goals and develop a diversified investment strategy to help manage risk and position you to reach your investment goals.
The more you know about investments, the better able you’ll be to protect yourself and make smarter investment decisions.
When it comes to investing, it is important to focus on your long-term goals and your investment plan.
An advisor can help. Investors who are patient and understand the cyclical nature of financial markets can reap the benefits of long-term market expansion. Investors who shy away from investing due to fear of a market correction could be missing out on market gains.
An advisor can help investors to stay the course and offer objective guidance through an experience that is often emotional.