Let’s start with a clear-cut definition: Investing is the activity of purchasing assets in the present with hopes that they will grow in value in the future. Such investments could issue dividends, interest, and other forms of cash upon the maturity or sale of the asset.
Investing provides opportunities for many individuals to improve their wealth. Money not invested may lose value in the long run due to increases in inflation. It is important to remember that any investment earning interest may help to balance the impacts of inflation.
The long-term benefits of investing are an additional appeal of investing; one in particular is the power of compounding. Compounding can have significant effects on returns over time because of the interest earned from the accumulated interest received from previous periods. Theoretically, the sooner you begin investing in products with interest, the more you will profit from compound interest. According to an example from CNBC (2019), if you invest $250 a month at age 25 at an 8% annual rate of return, you will accumulate $878,570 by age 65. However, if you invest $250 a month starting at age 45 at an 8% annual rate of return, you will accumulate $148,236 by age 65 ($730,334 less than if you began investing at age 25). In this example, an 8% annual rate of return is based on the average return in the stock market for a particular class of investments. Keep in mind there are other investments with lower or higher returns. For more illustrations on how compound interest works, watch our personal finance investment basics video. Through these examples, it is clear how essential long-term compounding is to the value of your investments.
There are many different forms of investments, and it is important that you have a general understanding of them before you begin to invest. The most common investments (otherwise referred to as asset classes) are classified as cash, fixed income, and equity investments.
Cash investments are typically short-term investments that are most often considered the least risky asset class, and as a result, provide minimal returns over time. A common example of a cash investment is a money market fund. The benefit of a money market fund is that it is a highly liquid fund that invests in low-risk debt securities, cash, and cash equivalents.
Fixed income investments typically provide returns at a rate higher than cash investments but have a higher amount of volatility in return. Examples of fixed income investments include international bonds, corporate bonds, federal government bonds (such as Treasury bills, or treasury bonds, etc.), and state/local government bonds (municipal bonds), and even junk or high yield bonds which are extremely risky and not generally recommended in conservative portfolios. Fixed income investments that are not high yield bonds represent a happy medium amongst cash and equity investments and can help diversify an investment portfolio.
Equity investments are typically the most volatile compared to cash and fixed income investments and most often have the potential to provide the greatest returns (depending on the market). Equity investments can be broken down into the following categories: mutual funds, exchange traded funds (ETFs), real estate investment trusts (REITs), U.S. large-cap stocks, U.S. mid-cap stock, U.S. small-cap stocks, and International stocks.
The graph below titled Risk vs. Return depicts the returns of stocks and bonds across a 47-year time period. This graph illustrates the positive relationship between risk and return that has been revealed throughout this section. As displayed in this graph, when the percentage of stocks used and held in a portfolio increased, the historical returns rose, as did the amount of risk. However, please note that past performance is not indicative of future results with any investment.
The first principle involves setting clear and attainable financial goals. It is important that you are realistic about your goals and, ideally, create a plan with a professional financial advisor to reduce the chance of future costly mistakes.
The second principle consists of adequately balancing your investment portfolio. An investment portfolio should be created by considering the amount of risk an investor is comfortable with. Once the investor has decided on their appropriate amount of risk, the investor must balance and broadly diversify their portfolio to fit those levels. The graphic below showcases various diversified portfolios with different risk levels. Portfolio A is composed of 30% equity and 70% fixed income making it less risky than portfolio C, which is compiled of 90% equity and 10% fixed income.
The third principle involves minimizing costs throughout the investment process. All else being equal, the lower your costs and taxes, the more transparent return on principal will be. On average, higher cost mutual funds have shown to perform worse than lower cost mutual funds and have shown to minimize portfolio return over time. One way to prevent the harmful effects of higher costs is to invest in index funds, which are typically a more cost-efficient option.
The fourth principle states that an investor must always possess discipline. Investing can be a very emotion-provoking process as it is dependent on the unpredictable market. When the market dips, or a specific investment is performing poorly, it takes a lot of discipline for an investor to remain committed to their investments. It is also important for investors to understand that sudden investment departures may be expensive and trying to outguess and price the market are rarely successful. In times of fear, investors must remember the success of long-term investments and to stay disciplined throughout the short-term turmoil. The Vanguard graph below displays the beneficial long-term effects of remaining disciplined throughout the volatile periods in the market. Investors who were unable to remain disciplined and exited the market during these various market crashes likely neglected to receive the gains when the market rallied back.
One of the first steps that you should take when beginning your investment journey is to find a financial advisor who is right for you. It is important to find a financial advisor whose investment values align with yours as different advisors have different investment philosophies and styles. It is especially helpful to find a financial advisor who is a fiduciary to ensure that they are making the best choices for your portfolio. Some investors neglect to use a financial advisor and instead, manage their own money, which may be less successful. Since advisors are removed emotionally from the situation, they are better able to maintain discipline than an investor. According to Vanguard Advisor’s Alpha (2018), having a financial advisor can increase investment returns by 3% per year.
An additional step when beginning to invest is to assess your personal situation. Age is an important factor to take into consideration when investing because different age groups tend to have different risk levels. A younger investor may have a higher amount of risk in their portfolio, because they can take on more risk due to a longer time horizon. However, an older investor may have less risk, because they may be spending from their portfolio. Income levels are also an important factor to consider because they impact taxation and retirement plans. There are different retirement plans for different circumstances. For example, investors may be able to benefit from a Traditional IRA and/or 401(k) plan if they are currently in a high-income tax bracket and plan on being in a lower income tax bracket upon retirement, whereas investors may prefer a Roth IRA if they are currently in a lower income tax bracket than what they plan to be in when they retire. This way, they could potentially pay the taxes now at a lower rate than they would if they waited to pay taxes upon retirement.
There is a considerable amount of investing misconceptions, especially amongst the younger generations. For example, some think, “I am going to buy stock from my favorite companies,” or “I am going to invest in the firms with the best performances so far.” While their investments based on this logic may result in positive returns, those results may be more attributed to luck. Past performance is not a reliable measure of an investment’s future value. In fact, in the past 5 years, only 21% of top-rated equity funds and 30% of top-rated fixed income funds maintained their leading presence (Dimensional).
An additional ill-advised investment practice is timing the market. Timing the market has not proven to be a successfulopens PDF file method for outperforming the market. Therefore, it is in the best interest of an investor not to try to buy and sell based on predictions of whether the market is going to rise or fall. Instead, investors should “stay in their seats,” sticking to the percentages they’ve allocated to stocks and bonds and rebalancing when those percentages change based on market movements.
An additional detail in the investing process to be mindful of are the headlines delivered through the daily news discussing the market. These headlines may consist of phrases such as “Housing market hit a crash today” or “The stock market is predicted to crash in the next few days” or even “Buy these 5 stocks today to retire as a millionaire”. Investors may react impulsively in response to some of these statements due to their difficulty separating their emotions from their investments. Therefore, it is important to remain disciplined (the fourth principle of investing) throughout the whole investment process, and to not fall under the trap of headlines. An investor must remember that short-term changes in the market are insignificant in the long run.
In general, no matter what your age is or your income, the earlier you start your personal journey in investing, the better opportunity you have for portfolio growth. At Dowling & Yahnke Wealth Advisors we take pride in being with you throughout your life journey, and our goal is to give you the personal freedom to live the life you want to live. Contact our professionals today.