The Why: Compound interest, Social Security
If you’ve made it this far in the article, you’re probably wondering “Brent, why do I need to worry about this now? I still have tons of time until retirement.” Well, when it comes to investing, the earlier you start, the higher potential gains in the future. Due to compound interest (interest on interest over time), 5 to 10 years could mean an exponential difference on how much your money grows. Let’s look at an example:
Say you are 20 years old and invest $1000 with an annual interest rate of 7%. If you left that money until you were 60 years old, you would end up with about $15,000.
However, if you started when you were 30 years old with the same amount and interest rate, you would have about $7,600. As you can see, those extra 10 years allowed your investment to double.
A second reason why you should invest is because of the uncertainty of Social Security. A lot of people are skeptical if Social Security will be around by the time we retire. According to the 2016 annual report from the Social Security and Medicare Board of Trustees, there is enough asset reserves to “offset Social Security’s annual deficits until 2034.”(Trustees, 2016) This means that after the year 2034, the cost of Social Security will be more than the income they are taking in. At this point, the Social Security benefit would be reduced to about 75% of what it currently is. If Social Security is a major part of your plan for retirement income, you may want to reevaluate.
The last reason for why you should invest that I’m going to mention has to do with inflation. Inflation can be described as the increase in prices and the fall of the purchasing power of money. According to the Federal Deposit Insurance Cooperation (FDIC), the average savings account has an interest rate of about 0.06% (Federal, 2016). In contrast, the forecasted inflation rate is about 1.1% annually (Inflation, 2016). This means that if you hold your money in a savings account, you could be losing about 1% of its value every year. In order, to have your money grow or keep its value, you must put it into a vehicle that can surpass the annual inflation rate.
Unfortunately, the traditional savings accounts that we are all familiar with do not seem to be the best option. To visualize how small the interest rate on savings accounts are, here’s a recent investing experience I’ve had. I managed to purchase a stock that saw a 40% gain in less than one year*. If I had my money in a savings account with an interest rate of 0.06%, it would have taken me almost 550 years to make the same amount of money. (*Note that 40% yearly gains are not typical)
How to Start
In my opinion, the most important thing you can do in regards to investing, is research. While this may sound boring and like a waste of time, it can really be the difference between a successful experience, and losing money. Finance is something that is used by everybody in their life, but is not mandatory to learn in school. Therefore, it is your personal responsibility to educate yourself on this topic. A few things you may want to start with are:
- Investment options/vehicles (stocks, bonds, funds)
- Fee structures (expense ratios, advisor fees)
By learning a few basics, you will reduce the risk of making a bad financial decision, and decrease the likelihood that you will be fooled by bad advice. A few educational resources that are available to you include:
- Podcasts put advice in simpler terms
- Stock and investing websites
- Online brokerage accounts usually offer free educational tools with account
After you’ve done the necessary research, you can choose which way you want to invest. Here is a brief breakdown on where to go when you’re ready to invest:
- Financial Advisor
- Can give you advice on where to put your money
- Professional experience
- May have fees and commissions
- Online Brokerage Account
- Autonomy (good if you want to be hands on)
- May have minimum balances, will probably have transaction fees
- Requires research and knowledge
- E-Advisors/Management Programs
- Low maintenance
- Hands off investing style
- May not be able to choose specific investments (usually fund based)
As some of you may know, investing your money comes with risk. The market may crash, or the company you invested in may go bankrupt. However, if you’ve done the proper preparations, you can significantly reduce the risk of losing money; or in the worst case scenario, minimize your losses. Here are some guidelines to consider when choosing an investment option:
Establish a Timeline
Is this a short term investment, or a long term one? Is the product/company viable over a long period of time? At what point do you plan to exit this position/investment?
Have a Goal
Are you investing to save for a house, retirement, or just extra spending money? If you need your money to grow over a short period of time, you will probably need an investment with high growth potential. However, high growth potential is usually paired with larger risk. The longer period of time you have to invest, the lower the risk usually is.
This term, popularized by Warren Buffet, refers to the ability of a company to maintain an advantage over its competitors to maintain long term profits. What makes this company unique and special? How does it stack up to its competitors? Is it a luxury and fad, or a staple resource? Does the company have proprietary technology and products?
Is there something going on in the market effecting performance? Things such as lawsuits, product releases, acquisitions, and legislation could influence how well that investment does.
If you put in the time, investing can be a powerful tool to help you achieve your financial goals. Many people like gambling for the instant gratification and the chance to “win big”. Investing holds the same benefits, just over a longer period of time. In a casino, the odds will be stacked against you, but with research and smart decision making, you can increase your chances of winning.
Disclaimer: The information contained is intended for general informative purposes. It is not a substitute for advice from an appropriate, licensed professional. Opinions stated are my own, unless otherwise stated. I do not assume liability for financial decisions based on this material.
Federal Deposit Insurance Corporation (2016). Retrieved October 07, 2016, from https://www.fdic.gov/regulations/resources/rates/#one
Inflation Rate in the United States of America (2016). Retrieved October 07, 2016, from https://www.statbureau.org/en/united-states/inflation
A SUMMARY OF THE 2016 ANNUAL REPORTS. Trustees: B. T. (2016). Retrieved October 07, 2016, from https://www.ssa.gov/OACT/TRSUM/PDF download