You have a reliable source of income, all of your debt is paid off, and you’ve made sure to put a reasonable amount of money on the side for any financial emergencies that may or may not come up. Well done.
Now is the perfect time to really think about your financial future. Since your primary financial needs are covered, creating wealth is the next logical step.
And if you don’t plan on working for the rest of your life, have bigger savings goals, or if you are thinking about leaving something for the next generation, investing your money is the way to go.
But before we start, I want to remind you of something important. The goal of this article is to get you into the right mindset, tell you about the do’s and don’t’s of investing, and give you an overview of the most common types of investments and investment strategies.
None of what is written on this page constitutes actual investment advice.
So, please consult your financial advisor before you make any investments. Are we cool? Great. Let’s do this.
Why don’t we start by thinking about which financial goal you want to achieve by investing your money?
This will, later on, help us better decide which investment strategy is the right one for you, as some investment products and strategies are better suited for one goal and so well for another.
Start by writing down your investment goals and try to be as precise as you can.
You want to save up for your (early) retirement? That’s a great reason to invest your money! Think about when you want to retire and how much money you think you are going to need.
Making sure your children will have it easier someday is another excellent reason.
You want to enter the stock market and do a little day trading? Exciting. You might want to take a different approach here and think in terms of how much money you are willing to lose. I’ll take about this in more detail in a minute.
Remember that merely creating wealth in itself is a perfectly fine reason to start investing. Especially when you have some money you don’t need right now and which would otherwise succumb to low-interest rates and inflation.
When you look around the internet to try and figure out how to approach your first investments, you’ll find a lot of different rules and guides. They are mostly perfectly fine and some of them are actually very helpful, but they fail to adequately communicate what I think is the most important rule for (first time) investors:
“What do you mean, ‘Say goodbye’? I invest in order to have more money, not less.”
Right. Here’s the thing: People pick an investment strategy over leaving their money in a savings account because they want to maximize the return on their investments. When some savings accounts can’t even beat current inflation rates, it’s a no-brainer to look for as high of an interest rate as you can get. This is where it gets tricky.
You see, you’ll receive a higher interest rate on some investments because you’re taking on a much, much higher risk. And that risk is real.
You may have heard of people going bankrupt over some bad investments in the stock markets or losing their investments during a financial crisis. These are sad stories that turned into sad realities for a lot of people.
This where rule #1 comes into play: Say goodbye to your money.
If you don’t feel comfortable with losing your money, you shouldn’t invest it. If losing your investment money means you won’t be able to make it to the next month, you shouldn’t invest it.
Maybe we can even rephrase rule #1 to give it a broader appeal:
Don’t invest anything you can’t afford to lose.
Since we just talked about the possibility of losing money, we should go into more detail of what it means to take a risk and how to minimize those risks as much as possible.
Investing is one of the best ways to increase your wealth but, as I’ve said before, all investments come with a certain amount of risk.
You might go into investing thinking that you, too, can become a millionaire overnight by picking that one stock that’s really going to hit it out of the park. After all, you’ve heard the stories about penny stocks and how some kid made big bucks by trading during his lunch break.
Well, good for that kid.
But these people are statistical outliers. In fact, so few people have found this kind of success that we can call it a rounding error and effectively make that number zero.
You shouldn’t start investing to make a quick buck. This isn’t gambling.
In fact, taking the time can be one of your most significant advantages. If we look at the history of the stock market, for example, we would realize that investing money over a period of one year could lead to a one in four chance of losing your money. If we extend that period to ten years, that chance will turn into one in 25. And after 20 years, it would effectively become zero.
However, this isn’t a guarantee that you’ll definitely make money if you start investing now and wait for 20 years. Picking the right stocks can make a huge difference, too.
Nobody knows which stock will really take off in the future. And the people that say they do are usually just trying to sell you something.
You’ve heard of companies that had a pretty good run and then went bust overnight, with Enron being one of the most used examples. Now imagine having all of your money tied up in this single company. Oh boy.
So, if you want to be smart about your investments, you would want to diversify your portfolio.
Diversification means spreading your money out over a number of different investments, therefore reducing the risk of losing everything at once. This could mean buying an index fund that owns a little bit of every company instead of putting all your money in what could (or could not) be the next big thing.
Ideally, you would pick an index fund that covers multiple industries, as well as multiple countries.
This strategy works, because over time, there tend to be more winners than losers. And the profit you get from the winners tends to offset the losses of the losers.
Furthermore, diversification is the only strategy that effectively minimizes risk without decreasing your expected returns. Since nobody knows which stock is going to outperform the others, they all have the same expected return.
Besides time, there is another thing you can take advantage of to grow your investment exponentially: compound interest.
Compound interest is the thing that can make investing so much more fun. Especially for younger people that start their investments early, it is the most significant investment tool imaginable and an excellent reason to start as soon as possible.
For the sake of argument, imagine you make a one-time investment of €1000 on which you will receive a yearly interest rate of 10%. After one year, your investment will be worth €1100.
This is where it’s getting interesting, because after the second year already, compound interest starts to work its magic.
See, instead of receiving another 10% interest on your initial €1000 investment, you will now receive 10% on the €1100 from the first year, resulting in a total value of €1210.
The third year will leave you with €1331 and so forth.
Here’s an interesting example of how much money you need to invest on a monthly basis to become a millionaire by the age of 60. I’ve used the same 10% interest rate (which is only slightly below the average annualized return of the S&P 500 Index from 1973–2016).
A 20-year-old needs to invest €158.13 per month to become a millionaire by the age of 60. The 20-year-old invests a total of €75’902.40 during these 40 years.
A 30-year-old needs to invest €442.38 per month to become a millionaire by the age of 60. The 30-year-old invests a total of €159’256.80 during these 30 years.
A 40-year-old needs to invest €1316.88 per month to become a millionaire by the age of 60. The 40-year-old invests a whopping €316’051.20 during these 20 years.
As you can see, starting as early as possible is a huge advantage!
These calculations assume that the monthly invested amount stays the same. But as you grow older and hopefully progress in your career, you might be able to increase your monthly investments periodically, which may lead to an even higher growth rate. It’s a beautiful thing if you think about it.
By now, you should have a pretty good idea of how to prepare yourself for your first investment, how to minimize risks, and how to use time and compound interest to your advantage.
Let’s end this article by giving you an overview of the most common investment options you as an investor have.
Investopedia groups the different types of investments into these basic categories: ownership investments, lending investments, so-called cash equivalents and funds.
When you’re thinking about an investment, chances are you’re thinking of buying an asset that you actually own — and that you expect to increase in value over time. That’s an ownership investment. These investments include:
Stocks: Stocks are certificates that say you own a portion of a company and have a stake in its profits. The value of a stock is decided by the market. So if you own stocks in a profitable company, other investors might want a piece of the cake too. Demand will drive up the price, and you might be able to turn a profit — if you decide to sell.
Precious Objects: Precious metals, collectibles, art and the likes are considered an ownership investment when you bought them with the intention of reselling them for a profit.
Real Estate: Any real estate you buy and resell or rent out is an ownership-investment. But like precious objects, it has a risk of physical depreciation and requires upkeep.
Lending investments allow you to lend your money in return for an interest rate — just like banks do. They are usually lower on the risk scale than ownership investments and offer a lesser return on your investment.
Bonds: A bond is a loan, or an IOU, where the investor serves as the bank. You can loan your money to various entities, like the government, cities, or companies for a set amount of time and interest rate. There are different types of bonds with varying degrees of risk, but they are regarded as safer than ownership investments.
CDs: A certificate of deposit is a kind of savings account where you agree to leave your money in the bank for a set amount of time, during which you can not access your funds. The interest rate of a CD usually depends on how long you invest your money.
Savings Accounts: Putting money in a regular savings account can also be considered an investment. You are basically lending money to banks, which they can use to fund their operations and products. In return, you get a relatively low-interest rate. A regular savings account holds a relatively low risk, as your savings are protected by governmental regulations and insurances up to a certain amount.
Cash equivalents are highly liquid and can quickly be sold on the market to be converted back into cash. The expected return is usually somewhere between one and two percent. Some cash equivalents, like a money market fund, could be categorized as a lending investment, but aren’t because of their low returns and their high liquidity.
Funds are more of an umbrella term for a group of investments, but they warrant their own category. A fund is basically a pool of money managed by an entity. Whenever you invest money into a fund, a manager uses that money to buy assets for you. You will pay a fee for this service, but might end up with assets that provide a better return than what you might pick yourself.
Mutual Funds: A mutual fund gives individual investors access to a portfolio managed by professional money managers. By investing into a mutual fund, the investor buys a stake in the mutual funds company and its assets, therefore taking a stake in the company’s profits. This process is similar to buying stocks from any other company with the difference being that the mutual fund company is in the business of making investments.
Index Funds: An index fund is a type of mutual fund that mirrors the return of an entire stock market index. An index fund that tracks the S&P 500 stock-market index aims to own the stocks in that market in the same proportions as they appear in the market.
Index funds, by design, don’t need any active management, which results in lower expense ratios and better profits for you.
ETFs: Exchange traded funds (ETFs) track an index or measure a specific market, like an index fund. The difference to an index or mutual fund is, however, that ETFs can be traded just like regular stocks, with prices adjusting throughout the day.
When we were talking about risk and how to reduce it earlier, we talked about diversifying (or balancing) your portfolio. But what does this actually mean for you? It means that you need to sit down and re-evaluate your goals. What is your primary objective in investing your money, and, equally important, how much time do you have to achieve these goals? You need to do this because there is no one-size-fits-all when it comes to balancing your portfolio.
Someone in their 20s or 30s who just began to invest might pick a more aggressive investment strategy, putting most of their investment money in stocks. Time is on their side, so they have a good chance to deal with the uncertainty of the stock market and recover from the occasional downs.
Someone who is closer to retirement might want to pick a more conservative strategy that involves a lesser risk.
Whichever way you choose to invest your money, you should make sure to avoid putting all of your eggs in the same basket. A balanced portfolio includes various types of assets from various industries. Don’t put all your money in a tech fund just because you have a thing for technology. Make sure to have a backup.
That sure was a lot of new information, wasn’t it?
Now, before you start throwing all of your money into the next best index fund or start buying gold in a frenzy, I highly recommend that you sit down with your financial advisor and talk about which investment strategy is the best for your personal situation.
This article should only be seen as an introduction to investing, not as an actual action plan.
Let me know if you have any further questions in the comments; I’d love to hear from you!