New York city - 4 Sep 2010 - Wall street and stock exchange

The Essentials of Investing

Investing is arguably the most challenging and intimidating topic within personal finance.  There’s a lot to know and the terminology can be confusing.

To lower the fear factor and cut through the confusion, here are some of the investing essentials.

Get In The Game

There’s a financial force in the world so powerful that Einstein reportedly once called it the eighth wonder of the world.  What is this mysterious force that so captured the imagination of one of the world’s smartest people?  Compound interest.

In essence, compound interest is interest earning interest.  If you invest $100 and earn an annual return of 7 percent, a year later it’ll be worth $107.  The next year it isn’t just the original $100 that earns interest.  The $7 you earned last year earns interest as well.

Not impressed yet?  Just wait.

Let’s say you invest $400 per month and get that same 7 percent return.  After 10 years, you will have invested $48,000, but it will have turned into over $69,000.  Compound interest put an extra $21,000 into your account.  Not bad.

But let’s give it some more time. After 40 years, you will have invested $192,000, but your account will be worth nearly $1,050,000.  Wow!  The interest earned – over $850,000 – is much greater than the amount you invested.  Clearly, it’s important to start investing as soon as possible.

Once you’re out of debt other than a reasonable mortgage and have an adequate emergency fund, you’re ready to get compound interest working for you.

Estimate How Much You Need to Invest

People who take the time to run some numbers on their retirement, estimating how much they’re likely to need for their later years and how much they need to be investing now in order to hit that target, tend to do the best job of saving for their retirement.

Of the various online retirement calculators you could use, one of the easiest is The Fidelity Retirement Score. Want to run a more detailed analysis? Try the T. Rowe Price Retirement Income Calculator.

Determine Your Optimal Asset Allocation

It’s important to understand, and more than a little counter-intuitive, that how you invest is more important than what you invest in.

More specifically, your asset allocation – what percentage of your money you choose to put in stock-based investments, for example, and what percentage in bond-based investments – is more important to your success than the specific investments you choose.

That’s a little hard to believe, isn’t it?  After all, the financial press is filled with stories about this hot mutual fund and that.  But asset allocation matters more.

One of the simplest free tools available for figuring out an appropriate asset allocation for you is available from Vanguard.

Determine How You Will Choose Your Investments

Once you’ve determined how much to invest each month and have figured out the right asset allocation for you, there are a number of ways you could choose what to invest in, including:

  • Choose your own mutual or exchange-traded funds within the various asset classes and in the right percentages based on your chosen asset allocation.
  • Keep it super simple and put your money in a target-date mutual fund.  Such funds set the asset allocation for you based on your intended retirement age and then automatically make the allocation more conservative as you get older.  Most of the big brokerage houses offer such funds.  Just know that target-date funds are not perfect, and they vary from one brokerage house to another.  Some are more aggressive in their asset allocation than others.  Take the time to make some comparisons so you’re comfortable with the approach used by the fund you choose.
  • Consider subscribing to the Sound Mind Investing newsletter and following one or more of its investment strategies. It’s relatively inexpensive, uses a purely objective process for recommending investments, and has an excellent long-term market-beating track record. I like this organization’s approach to investing so much that I now work for it!
  • Work with an investment advisor who will recommend and implement an appropriate investment strategy. Note that this is likely the most expensive way to get assistance. An advisor may charge 1% of the amount of money you invest through him or her.

Manage Taxes

Not only does long-term investing enable you to take advantage of compound interest, you can avail yourself of some important tax benefits as well. This has to do with the vehicles through which you invest, such as an IRA or a 401(k) plan. To get up to speed, read:

You Can Do It

I realize that even this simplified explanation of investing may sound somewhat complicated. My advice is to subscribe to the free Sound Mind Investing blog and just get started. Following the steps described above will get you headed in the right direction.

Have you taken these steps? What investment-related questions do you have?  Let me know in the comments section.

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4 Responses to The Essentials of Investing

  1. Jon May 11, 2013 at 12:04 AM #

    Investing in my opinion is much better than saving money. Why save when you know you can invest it and earn some more ! Anyways, great tips matt !

  2. Matt Bell March 7, 2012 at 10:34 AM #

    Bonnie – Here’s a more specific idea for earning 7%. Still no guarantee, of course, but a fairly simple strategy with proven results:

    http://www.soundmindinvesting.com/visitor/2012/mar/level4.htm

  3. Matt Bell March 6, 2012 at 9:02 PM #

    I’m sure you’re not the only one with that question, Bonnie. While there are definitely no guarantees when it comes to investing, I believe that if you get the asset allocation piece right and then stay the course through the markets ups and downs, 7% is not unrealistic.

    Unfortunately, people tend to bail out of the market right about when it hits its lows and then they work up the nerve to get back in right about when it’s near its highs.

  4. Bonnie March 6, 2012 at 8:52 PM #

    I’m all for the compound interest concept, but where can one find a 7% annual interest rate these days? We must be doing something wrong!

http://edge.quantserve.com/quant.js