Photo (cc) by rednuht
Which would you rather have: $108,000 or $600,000?
Start with $300, add $300 monthly for 30 years, and you’ll accumulate $108,000. But here’s how much you’ll have by compounding at various interest rates:
- 2 percent — $147,622.
- 5 percent — $245,609.
- 10 percent — $623,787.
The lesson? Saving is important, but what you earn on your savings is super important.
Unfortunately, today there’s no way to earn anything close to 10 percent in an insured savings account. In fact, it’s tough to earn 2 percent. The only way to get higher returns is to take some risk, like that offered by stocks.
Depending on how you measure it, stocks have averaged 8 percent to 10 percent annually over the last 100 years. Of course, stocks entail risk; that’s why they pay more. But avoiding risk creates a different one — the risk of not having enough to survive your retirement years.
So learning about stocks is important. And it’s not rocket science. In fact, you can learn everything you need to know in this one article. Let’s start with this recent video:
Over the decades, Wall Street has spent billions in advertising to convince Main Street we’re not smart enough to invest without paying them for advice. This is a lie, perpetuated for no other reason than to line their pockets with our cash.
All you need to do is follow these rules.
Rule No. 1: Long-term money only
If stocks didn’t pay more than less-risky alternatives over time, they wouldn’t exist.
But the key words in that sentence are “over time.” When it comes to stocks, the longer your investment horizon, the lower the risk.
Day trading is exceedingly risky because nobody knows what’s going to happen on any given day. Investing in quality stocks over decades carries far less risk, because historically quality companies become more valuable over time, and so do their shares.
That’s why you should never expose money to stocks that you’ll need within five years. And that’s the minimum.
Rule No. 2: Moderation
Because the stock market is risky, it’s not the basket for all your eggs.
In the video above, I suggest subtracting your age from 100, and putting no more than the resulting percentage of your long-term savings into stocks. So if you’re 25, 100 minus 25 equals 75 percent in stocks. If you’re 75, you’d only use stocks for 25 percent of your savings.
But as I also said, that’s just a rule of thumb. If you’re nervous, you’ve invested too much.
Rule No. 3: Use mutual funds
I like buying individual stocks (you can see my online portfolio here) but it’s not necessary, or for most people, advisable. You can do perfectly well with a mutual fund, while at the same time lowering your risk and reducing your hassle.
What’s a mutual fund? A giant pool of investments. It could be a pool of stocks: a stock fund. It could be a pool of bonds: a bond fund. Or it could have both stocks and bonds: a balanced fund. The appeal of mutual funds is threefold:
- A mutual fund allows you to spread the inherent risk of stock investing by diversifying among a bunch of stocks instead of investing in just a few.
- Mutual funds have people who do the buying and selling.
- Mutual funds keep track of a lot of the paperwork for you.
Which mutual fund to buy?
Mutual funds fall into two categories: index funds and actively managed funds.
Owning an index fund is like owning the entire stock market, as represented by an index, like the S&P 500. Since all an index fund manager has to do is buy the stocks in the index, a chimpanzee could do it. And because management is simple, the fees charged are minimal.
Actively managed funds, as the name implies, employ wizards claiming they can outperform indexes like the S&P. For their expertise, they demand higher fees.
The sad truth — proven in many, many studies — is that active management often fails to do as well as index investing. For example, in the recent article “Only 24 Percent of Active Mutual Fund Managers Outperform the Market Index,” NerdWallet says that over the last 10 years, the average return of actively managed mutual funds was 6.5 percent, while index funds returned 7.3 percent.
There are two reasons wizards so seldom beat indexes. First, there is no Stanford degree that includes a crystal ball. Second, the higher fees charged by active managers reduce the fund’s returns. In other words, if a fund goes up 8 percent, but charges a fee of 2 percent — not uncommon — you’re left with only 6 percent.
The index I personally use in my retirement account is the Vanguard 500 Index Fund. It charges only 0.17 percent in fees and the minimum investment is $3,000. Another way to invest is through exchange traded funds or ETFs. These are mutual funds that trade on exchanges like stocks, and their expenses are even lower. The Vanguard 500 ETF, for example, charges only 0.05 percent in fees. You can buy as little as one share ($72 as I write this) but you’ll have to open a brokerage account and pay a commission when you buy or sell.
Rule No. 4: No trying to time the market
Try to time the market and you’ll likely find yourself on the sidelines when the market takes off — and over-invested when it crashes.
The best way to approach stocks is also the simplest: Dollar cost averaging, also known as systematic investing. All you have to do is invest fixed amounts, like $100, at regular intervals, such as monthly. This method works for a simple reason: It automatically buys more shares when they’re cheap, and fewer when they’re not. Consider this six-month example assuming a monthly investment of $100:
When you start, the price is $10, so your C-note buys 10 shares. The next month the price drops to $8, so that same 100 bucks buys 12½ shares. In the third month, the price zooms to $15, so your money buys only 6.7 shares. Yada, yada, yada … six months go by. At the end, the fund is back where it started: 10 bucks. But you’ve accumulated 66 shares, now worth $660. You’ve made 10 percent on your money, even though the fund is exactly where it started.
How did this happen? Because your investment was fixed, you automatically bought more shares when prices were low and fewer when prices were high.
Final rule: There are no rules
There’s a reason for the expression “No risk, no reward.” Whether it’s money, life or love, you can’t win without the risk of losing. The trick is to minimize potential nightmares by being smart about it.
There’s no rule saying you have to invest in stocks. If you don’t like stocks, try something else. Real estate, side business, peer-to-peer lending, collectibles: There are lots of ways to beat the bank. Sure, they may involve more risk, time, energy and knowledge than a savings account. But the rewards can change your life.