We have now come to the seventh and final post in the How to Get Control of Your Money series. So far we’ve been through the following 6 steps:
- Assess Your Financial Situation – Determine where you currently are financially.
- Set Money Goals – Determine where you want to go financially.
- Organize & Automate Your Bills – Put automated structure around your financial obligations.
- Improve Your Cash Flow – Reduce unnecessary spending and increase income.
- Create an Emergency Fund – Get prepared for life’s unexpected events.
- Pay Off All Debt – Get free from the burden of debt.
With improved cash flow, an emergency fund to handle unexpected events, and no need to direct money towards paying off debts, you are now ready and able to work on the last step in getting control of your money – beginning to invest.
The General Purpose of Investing
Before we get into specifics about investing, let’s first discuss why we should even bother to invest. To invest means to put your money somewhere or into something with the expectation of receiving a return on your money (usually termed “interest” or “yield”) at a later date. Investing is all about making your money work for you through the power of compound interest. As you know from math class, you usually get more from multiplication than through addition (3×3 is greater than 3+3) and the bigger the numbers, the more exponential the multiplication effect (30×30 is a LOT more than 30+30). Saving is simply applying an “addition strategy” to your money plans, while investing is applying a “multiplication strategy” to your money plans. The bigger the numbers involved, the better the strategy works. This exponential multiplication effect is known as the power of compound interest – As your money makes money, that old money + new money makes even more money, and the multiplication effect takes off exponentially! Therefore, the general purpose of investing is to grow your money through means of multiplication (compound interest) rather than simply addition (saving alone), so that the result is exponential growth of your money!
5 Considerations Before Beginning
So we want to make our money work for us through the power of compound interest, but there are a few questions that will come up before you actually begin investing such as the following: How will I know when enough is enough? How do I identify what to invest in? Is it possible that I will lose money (yes, it is)? And so on.. These are all valid questions, each deserving their own full post. However, to lay a foundation for answering such questions and getting you ready for investing, I will review five specific considerations which all investors should tackle:
- Determine Your Specific Purposes for Investing – The general purpose for investing is to exponentially grow your money. However, for what? Answering this question leads to your specific purposes for investing. Your specific purposes could be retirement at age 65, or early retirement at age 40, or having enough to pay for you children’s education, or being able to accumulate enough to begin your own business.
- Determine Your Investment Amount Goal – Now that you know what you are investing for, exactly how much will it take to retire at 65…retire at 40…fully pay for your children’s education…fund that new venture? Put an exact number to your specific purposes as best you can.
- Determine Your Investment Time Horizon – This simply means determining the amount of time that you have before needing to use your investment gains for your specific purposes. The longer your investment time horizon, the more time that your money will have to work for you and grow exponentially. Knowing your investment time horizon will allow you to see the savings rate (how much money you save as a percentage of your annual income) and annual rate of return needed to get you to your desired money destination. A longer time horizon will mean a lower savings rate and shorter annual rate of return needed to reach your goal, while a shorter time horizon, all else being equal, will mean a higher savings rate and annual rate of return needed to reach your money goal. This point leads to the next consideration – Risk Tolerance.
- Determine Your Risk Tolerance – “Risk Tolerance” means how much risk you are willing to take in order to get a desired return on your money. Generally speaking: High Reward = High Risk and Low Reward = Low Risk. Therefore, aiming for higher rates of return generally means taking on more risk. For example, if you want to make 50% on your money in one year, it will call for making some risky investments with the expectation that you could lose much or all of your money. Determining your risk tolerance will help you identify a comfortable rate of return (and therefore, suitable level of risk) and will also help you with the next consideration – Asset Allocation.
- Determine Your Asset Allocation – You will be investing in “Assets” or financial instruments that hold value. The four most typical classes of assets which people hold are Cash, Stocks, Bonds, and Real Estate. Cash is the least risky “investment” meaning it also has the lowest return (if any..inflation actually eats away at the purchasing power of your cash over time, meaning $10,000 in 2050 will actually be worth less than $10,000 today). Stocks are historically riskier than bonds, but stocks also historically produce greater annual returns than bonds. Your specific purposes for investing, investment amount goal, time horizon, and risk tolerance will all help you to determine the right mix – or allocation – of investments among these (and other) asset classes.
Take some time to fully think through each of the above five considerations before you begin to invest so that you make informed decisions about what asset classes to invest in. For example, if I want to retire by 45 with $1,000,000, I’m going to need a pretty high savings rate and annual rate of return to get there, which would mean my investments would have to be riskier in order to have any chance of high enough returns. Knowing this can help me decide whether I’m willing to take on higher levels of risk, should lengthen my time horizon instead, or should lower my investment amount goal instead. As another example, if I know that my investment time horizon is long since I am not planning to retire until age 65, and I am also concerned about losing my gains and/or principal along the way, I may accept lower returns through having an asset allocation strategy which has a greater mix of cash and bonds than would be typical for someone investing at my age.
You can now begin investing!!! But who do you invest with, how, and when?
- Who – There are many, many brokerage firms with whom you could invest, including Fidelity, Charles Schwab, Scottrade, Betterment, Wealthfront, Vanguard, and TD Ameritrade to name a few. Some brokerages are known for their low cost and great customer service (Scottrade), while others are known for their automated investment features (Betterment and Wealthfront), while others are known for their wide array of mutual and index funds (Fidelity and Vanguard). I encourage you to shop around and see which are right for you. I personally use a few brokerages – one for automated long-term investing, one for general shorter-term investing, and one for retirement investing.
- How – You will need to first determine your asset allocation, and then shop at your chosen brokerage for investments within that class that are suitable. If you’re not up for a lot of research, you could take the lazy route instead and still most likely come out like an investing champ!
- When – After completing the first 6 steps in getting control of your money, start as early as possible! Waiting only shortens your time horizon. You want time to work in your favor instead. Personally, I try not to worry about getting in the market at exactly the “right time.” I instead regularly add money to my long-term and retirement investments. If unique opportunities do come up in the market, then I can add money over and above what I usually invest.
Congratulations! You have now completely gotten your money under control. I hope this series has been as valuable to you as it has been to me writing it. Here’s to years of financial health and prosperity.