What Is Investing and How Does It Work?
The financial services industry has done a great job confusing everyone, but investing doesn’t need to be complicated. A good place to begin is to note that investing isn’t a get-rich-quick scheme. Taking control of your personal finances will take work, but it will be worth it.
So What Is Investing, Exactly?
Investing is transitioning from a tool to help you retire to a necessity to be able to retire at all. You can work only so many hours in a day. Investing is a way to give your money a job and have it go to work for you to earn more money over the long term (ultimately while you sleep). Think of it as a way to have a bunch of little green soldiers working on your behalf.
What Is Investing Not?
It is not gambling. It is not day trading. It’s definitely not trying to find the next hot or sexy stock that will double in the next month, or risking your extra money in highly volatile cryptocurrencies.
Investing takes thorough analysis and planning with the expectation that over the long term it will help you reach your goals. It is a long-term strategy or plan used to help you achieve your goals, which differ from person to person.
We constantly see stats in the news about how few people are saving enough to retire. Not saving enough combined with poor decisions with investments make for bad math.
For most of us, our ability to save and plan for retirement falls on our own shoulders. If you want to be able to retire, you need to save, invest, and be able to make good decisions along the way. Itmakes sense to have a general understanding of what you’re doing.
How Does Investing Work?
Great question. Thanks for asking! The simple answer is compound interest.
“Excuse me?” I hear you ask. “What on Earth is that?”
Stay with me for a moment. Albert Einstein referred to compound interest as “the most powerful force in the universe. He who understands it, earns it. He who does not, pays it.”
Compound interest is a math concept that you can actually use daily without trying to solve the square root of x or using a protractor.
It’s like your money’s powerful army (or Marines — ooh-rah!). To feed it, you need time and reinvestment of earnings. The more time you give it, the more potential money you’ll be able to make from your original investment.
A Hypothetical Scenario
Let’s walk through a hypothetical example to illustrate the concept.
Pretend you invested $10,000 and were able to get a five percent return. After one year, you’d have $10,500. Now if you reinvested the $500 you made into the original $10,000 at the same five percent return, after the second year you’d have $11,025.
The second year you actually made $525 instead of $500. This is possible because you were able to get five percent on a larger number when you reinvested the earnings. It is only $25 more, but you didn’t have to work any more hours for the $25.
If you reinvest the earnings again at the same five percent return, after the third year you’d have $11,576.25. You would have made $551.25 that year, which is over $50 more than the first year. This trend will continue as long as you keep reinvesting and earning interest. Imagine the impact this could have over 20 to 30 years!
And here’s how it will look after 10, 20, and 30 years:
|Years||Balance Without Compounding||Balance With Compounding||
Compound interest is a powerful tool. The earlier you start investing (even if it is a small amount), the more time you give your investments to work for you. By reinvesting the earnings, you’re able to boost the growth of your original investment and maximize the earnings potential.
Final Investing Tips
There are many different investments out there with varying degrees of risk and reward. We will get into that in future posts. It’s important to have a solid foundation before exploring that. There are many apps and websites available for novice investors that you can try.
Stash is a great tool for beginner investors. You can start off small and invest with as little as $5. The app allows you to save and invest automatically and sends you advice on investment strategies that reflect your individual interests, beliefs, and goals. This way, you keep learning while you’re investing.
Meanwhile, M1 Finance is an ideal option for intermediate investors. It’s a combination of traditional brokerage accounts and robo-advisers, meaning that it doesn’t have a “set and forget” feature. This allows you to have control over your investments without having the day-to-day responsibility of managing the portfolio.
Hopefully you now have a better understanding of what investing is and the power it yields. Remember, Spiderman once said, “With great power comes great responsibility.” It is on you to take an active role in your finances.