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Step 5 to Financial Success: Invest Wisely!
"Don't just work for money. Get your money working for you!" If you read financial literature, you'll hear these sentences repeated like a mantra. Why? Because putting your money to work gets that crazy power of compounding interest working for you. Utilizing its power, even small (thus represented by the pinky), regular investments can become millions over time.
Tearing Paper: How Little Things Can Multiply
It just increased one thousandth of an inch. Not much. But the important thing is that it doubled. Now, let's imagine that we could tear that paper 50 times, so that it doubles in height with each tear. How high do you think it would be? A foot? A yard? Up to the ceiling?
The answer? Approximately 17,000,000 miles high, about the distance of 34 trips to the moon! That's the awesome power of multiplication!
Multiplying Money: The Excitement of Investing
Three Strategies for Investing
Pay Yourself First. Here's what it means. So it's Friday and you get your paycheck. How much of that is really yours? "All of it!" you say. But think again. Part of that paycheck goes to car insurance, part to fast food, part to the gas station, part to the video store. Wait until the end of the month and you'll discover that there's none left over for you. You've paid everyone but yourself!
Even if you get a raise, you'll likely fall victim to "The Magical Mysterious Disappearing Raise." That means, your expenses tend to increase with each raise, so that you still don't have anything left over at the end of the month!
The solution? Pay yourself first! The day you get that paycheck, put a portion of it into savings and investments. Then live off the rest. Here are a few example plans to start you thinking:
"The 10% Solution" Take 10% of that paycheck and put it into savings and investments. This well-worn method has worked in the past and still works today. The neat thing about this plan is that it works for small incomes as well as great incomes. If you don't make much, then 10% of "not much" isn't much at all. But it's something. As your salary increases over time, 10% gets larger and larger.
"The Twenty Dollar (TD) Solution" Remember from Step 1: just $20 invested every week at 10% interest becomes $1,385,951.26 in 50 years. So let's say you're a 15-year-old and you have hardly any expenses. You make a little spending money that you blow on fast food and video games. But since you've got school and sports, you don't have time to make significant cash. But what you do have going for you is lots of years for your money to multiply. Remember, one secret to getting all that insanely powerful multiplication working for you is time. So try this: do something to come up with an extra $20 every week. Mow a yard. Baby sit. Sell something on e-bay. Strike a bargain with your parents that you'll do some extra chores during the week to net $20 every Friday. (They'll likely be thrilled to assist when they find that you're investing that money.) Finally, of course, invest the $20 each week..
"The 80% Solution" Don't take 80% literally. I just made it up. Basically it means, "invest almost everything that you earn." That was Buffett's method. In middle school and high school, he was making so much money that he could have had any toys and clothes he wanted. But he had bigger plans. He spent hardly anything and invested almost everything.
Benji is a good contemporary example. His senior year in high school, he took auto mechanics classes in the afternoon at a nearby technical school. Thus, when he graduated from high school, he had a marketable skill. He kept his resume in at local auto repair shops and kept bugging them until somebody hired him. So at age 18 he found himself bringing home about $500 per week, and more as he sharpened his skills.
Now if Benji were thirty years old with house payments and family to support, $500 wouldn't be much. But Benji's expenses are low. He lives at home and eats from his parent's refrigerator. He drives a cheap car that's paid for. His only expenses are gas, car insurance, car repairs, tools, and dates.
So every month he socks away $1600 into investments. Put that into your interest calculator to see how much he'll have in six years, if invested at 8% interest. (Answer: he'll have over $140,000.00 at age 24!) What does he plan to do with that money?
Cool Scenario #1 - "Buy a nice house for cash and never have to make a house payment the rest of my life."
Cool Scenario #2 - "Make a significant down payment ($40,000) on a house so that payments will be low for the rest of my life. Keep the remaining $100,000 in long-term investments. If I never invest another cent and get a 10% annual return, I could take early retirement in 30 years with about $1,750,000.00.
Where to Invest Here are five types of investments that experts recommend.
Stocks Most advisors recommend stocks for the best returns over the long haul. What's a stock? Just look at the first four letters of the word stock:
In other words, if you purchase one share of Wal-Mart stock, you own a single tidbit of Wal-Mart.
Dream sequence for easily distracted guys: You pick up your date at her home. As she sits down in the passenger seat, you move a Wal-Mart document and throw it in the back seat. "What's that?" She asks. "Wal-Mart's yearly stockholder's report. I try to keep up, since I'm part owner." "You're part owner of Wal-Mart!?!?"
Stocks are great for impressing girls. But they're also great for multiplying your money. Over the past seventy years, they've gained an average of over 10% per year in value.
That means that if your granddad had invested $2000 in the total stock market 70 years ago, and never invested another cent, he'd have over $1,500,000 today!
That's why money managers recommend investing some of your money in stocks for the long haul. In the short run, stocks can be scary, losing value over a year or even a period of years. But you only lose money if you sell your stocks during those bad years. Experts recommend that you buy and hold, through good times and bad. If you might need that money in the next five or ten years, don't put it in stocks. But for longer periods, they tend to do great.
The average investor should find a solid mutual fund company and invest in stocks through mutual funds. A mutual fund is a collection of stocks. They are a cheap way to invest in a whole bunch of stocks at the same time. Why go with a mutual fund?
First, it multiplies your bragging rights. Not only can you say you're part owner of Wal-Mart, but you can say you're part owner of IBM, Microsoft, Home Depot, and hundreds of other great companies.
Second, it spreads your risk. Once upon a time, Enron was one of the most respected companies around. Its returns were fabulous and great investment advisors recommended it as a safe bet. But unknown to the investors, Enron's clever accountants had been doing some fancy math to cover up losses. When the truth came out, Enron went belly up. Investors who had bought large amounts of Enron's stock, many of them employees of Enron, lost their life savings.
The moral of the story? By investing in mutual funds, you spread your eggs into hundreds of baskets. Some companies will fail, but other companies will make up for that by doing great. (For more hints on investing in stocks and mutual funds, I'll write more in the future here.)
2. Bonds There are two ways to put your money to work. The first is to buy something that should grow in value. That's what you do when you purchase stocks or real estate. You hope they'll grow in value over time, so that you can sell them at a profit. The other way to put your money to work is to loan it out at interest. Two ways to do that are through bonds and CD's.
Let's say that Chevrolet wants to construct a plant to build a new type of Corvette. They need to raise cash to build the plant, so they sell bonds to the public, promising a return of 6% over a 10 year period. If you buy $1,000.00 worth of their bonds, you just loaned Chevrolet your money in return for getting back your investment with interest.
The risk is that Chevrolet may go bankrupt, leaving you with nothing. If you're willing to take that risk, fine. But many experts recommend investing in many bonds at the same time through bond mutual funds, so that if one company defaults on its loan, others will come through. Again, the mutual fund puts your eggs into lots of baskets.
Historically, stocks have beaten bonds with their returns. So why invest in bonds?
First, bonds are less volatile than stocks. Especially if you're investing for a period shorter than 5 years, you probably don't want to be in stocks.
Second, we can't know for sure that stocks will always beat bonds, even over longer periods. Sure, stocks have beat bonds in the past. But when it comes to investments, past isn't prologue. Since we don't know the future with any degree of certainty, we diversify for safety. (Example: The recent history of Japanese stocks) (For more hints on investing in bonds, I'll write more in the future here.)
3. Real Estate My parents bought a three bedroom, two bathroom, brick house with a half basement in a nice neighborhood for $18,000. It wasn't a bargain. That's just what houses sold for in 1962. Today (2007), it would sell for about $150,000.
That means that real estate can be a good investment. Sure, putting the money in a total stock market index fund at 10% per year would have been better, netting them over $1,300,000.00. But with a house, you get to live in your investment (nobody lives in a mutual fund), and had they never bought a house, they would have been paying rent somewhere for the rest of their lives. Also, in the future, we don't know whether stocks will beat real estate.
Some people buy houses at a bargain, fix them up and resell them. Others purchase houses or apartments to rent.
Still others are scared of putting so many eggs into a few expensive baskets. They invest in Real Estate Investment Trusts (REITS), which are like mutual funds for real estate.
4. CD's Certificates of Deposit are offered through banks. You usually commit to keep the money in for a certain period of time to get the full return. You can shop around for the highest returns, but developing a relationship with a local bank can have its benefits. An advantage of CD's is security. Your money is guaranteed up to $100,000 (at each bank) by the United States Government through the FDIC.
5. Money Market Funds. These funds are very safe, never losing money if they're handled by a conservative, respected company. They typically get better interest if they're with a mutual fund company. But they're safer (insured by the FDIC) if they're with a bank.
6. Valuables Hidden in Your House So you're the nervous type. You worry what will happen if the U.S. Government falls apart, banks collapse, paper money is worthless and anarchy rules. In that case, you'd be wise to have cans of food under your bed and something like gold or other valuables that might be traded. And you might want to trade in your luxury car for a jeep. Activities, Discussions and Questions Define: stocks, bonds, mutual funds, CD's and money market funds. Tell the benefits and risks of each. Homework: Ask your parents what investments they prefer and why. If they had their investments to do over again, what would they do differently?
Discussion Questions
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