Investing is about putting your hard earned money into productive use with an expectation to grow that money in the future. Right investment planning is an essential part of financial planning and is necessary to achieve the best mileage out of the money you earn. Whether your goal is to retire early or send your kids to a top notch university, you need the right investment plan to achieve your goals. In this post, we will cover the basics of investing, and will then introduce you to the various investment options – from CDs to stocks.
Knowing your financial goals
Before you begin to invest, you must clearly write your broad financial goals. Have a plan for both long term as well as the short term. Your plan should incorporate how much you can afford to invest and how much you would need at various points of time in your life. The long term plans could include sustaining your family after retirement, paying for medical care or starting your own business 10 years from now. The short term plans could include saving for your vacation in 2 years, your wedding with your high school sweetheart or a plan to buy your own home. The time frame of the plans would dictate the type of investments you will make. Shorter time frames call for less risky investments such as Certificate of Deposits (CDs) and money market accounts, while longer time frames could help you afford investing in stocks, bonds and real estate.
Understanding the power of compounding
Albert Einstein once described compounding as “one of the greatest forces in the universe.” Your money grows with time and the longer you keep it in a good investment, the bigger the size of your final reward. Assume that you save $1000 in an investment earning 12% interest. At 6 years you would have doubled your money to $2000, at 12 years your money quadruples to $4000, at 18 years your money grows to $8000, at 24 years your investment will be worth $16000 and at 30 years your investment will be worth now $32000. That is the magic of compounding.
A good investment needs both a higher interest rate and a longer period of investing to fully utilize the power of compounding. So, start your investing early in your life and scourge for investments that earn as high an interest rate as possible, without adding too much risk.
Liquid vs. Illiquid investments
In financial terms, liquid investments are those that can be cashed in at the market price any time. For instance, your gold coins or money market deposits could be sold at any time to take your money out without significant penalties. These are therefore liquid investments and are ideal for short term needs. However, investments in your home or business cannot be cashed out at a short notice. You would have to price the investment too low or have to put a 2-3 month effort to get the ideal value for them. These are illiquid investments that cannot be used for emergencies or temporary cash needs. Depending on your financial goals, you must have an adequate mix of both liquid and illiquid investments to tide over temporary requirements with the liquid investments while at the same time making higher returns from the illiquid investments.
Where can I invest my money?
Money market accounts and CDs – You can open these accounts at any major bank in your neighborhood. These investments pay a low interest rate (3-4%) but they are as less risky as any investment could be. Also, these are pretty liquid and can be used for your short term financial needs.
Stock investing. Stock investment is about getting a tiny fraction of ownership in a major enterprise. This is one of the ideal investment choices if you have a longer time horizon (minimum of 10 years). Stock markets have proven to make 10% annual returns over a long period of time. Using stock markets you can invest your money in the entrepreneurial abilities of top businessmen in the market and grow along with them. To pick the right stock, you need to understand how profitable a business is, how the broader economy is doing and the future potential of the products and services they provide.
Bond investing. Bond investing lets you lend money to governments and enterprises at an attractive interest rate compared to an ordinary CD issued by your bank. For instance, US government periodically issues securities called Treasury bonds, notes or bills that can be bought by individual investors. These are considered to be the safest investments in the financial world. You could also invest in the debt issued by many blue chip companies such as Johnson & Johnson, General Electric, Exxon Mobil etc. Bond investing, in general, is considered less risky than stock investing and can be used more by investors close to their retirement age.
ETF and Mutual fund investing. If you do not have sufficient time to pick the right stocks, you can buy an index fund that tracks the broad market. Most mutual fund companies provide you the funds that track the performance of stock indices such as Dow 30 and S&P 500. If you have a particular liking to a particular sector or geography, you can get a fund for that too. For instance, you have mutual funds that track the performance of oil companies, Russian stocks, small cap stocks in Europe etc.
Real Estate Investing. Investing in real estate can be a lucrative option if done well. The advantages include high leverage and in built protection against inflation. You can buy a rental property at a location you know about, or get a share in a REIT (Real Estate Investment Trust) that lets you invest in real estate even at very low amounts ($100+).
Gold and commodities. Gold is a great addition to most small investor portfolios. A 10% allocation to the yellow metal in your portfolio can be a great insurance against market collapse or inflation. The advantage with gold is that it is recognized as a stable investment by cultures across the world, thereby giving you the best liquidity possible, and it is proven to track inflation in the long run. While small purchases of gold can be done by the novice investors, other commodities such as oil and wheat should be played only by seasoned investors.