I like to simplify things that are really complex. Investing can be as complicated as you want it to be. You and I probably don’t have time to dedicate ourselves to understanding every investment opportunity, but I have 3 rules for retirement investing.
- Put your money where it averages the greatest returns long term (10+ years)
- Treat retirement accounts as insurance for not having money when you’re old
- Passive indexing and rebalance periodically
Sounds simple enough, but it is somewhat complicated by taxes, deductions, interest rates, inflation, and sales people selling terrible financial products (whole life insurance). >_<
Starting with the Basics of Investing
First you need to first understand the fundamentals of investing.
What is an Investment?
Investments by definition comes with risk. If you invest money you may earn a return or you can lose your money. What you should care about is what the average returns on a particular investment is.
Generally speaking, the higher the average returns on an investment, the more volatility it comes with. Volatility is the potential fluctuations in your investments. Investing in stocks (S&P 500) returns about 10% a year, but has some pretty big swings, which means you can be down big in any given year, but over a lot of years it averages a positive 10% growth.
Bonds on the other hand average about 5-6% growth a year and has less volatility. Even less volatile is a savings account that grows currently about about 1% and is pretty much guaranteed.
401k, IRAs, Brokerage Accounts
401ks, IRAs, Brokerage Accounts are all just accounts that you place your money into. Once it’s there, you have to decide what to invest in. You can invest in specific stocks, bonds, ETFs, or funds. Retirement accounts like the 401k and IRAs may have penalties for withdrawing early as they are made for withdrawing when retired.
401k is an Employer sponsored type of retirement account provided by your company. Not all companies offer this benefit, but if your company does, you should open a 401k account.
IRA stand for Individual Retirement Account and is a retirement account anyone can open
Brokerage Accounts is another type of account for trading investment products but without the retirement tax benefits.
Annual Percentage Rate. It’s usually a written as a percentage such as 5%.
Example: If you invest $100 for a year at 5%, you will have $105 at the end of 1 year.
It means earning interest on interest. In terms on investing it’s a fabulous thing.
Example: If you invest $100 for 2 years at 5%, you might think you will end up with $110 at the end of 2 years. But after that first year, you will earn 5% on $105 and you will actually have closer $110.50 depending how frequently the interest is paid out to you.
Over long periods of time, compound interest can make a BIG difference.
Invest $100 at 5% for 30 years with no compounding and you’ll have $250 in 30 years
Invest $100 at 5% for 30 years with continuous compounding and you’ll have $448 in 30 years. That’s 79% more money!
The loss of buying power expressed as a percentage. You know how prices of stuff keep going up in general? Basic goods such as a dozen eggs cost $0.79 back in 2006, but now cost like $1.49. Why inflation occurs is hard to pin point, but for the purposes of investing, it’s at about 3% a year on average in the US.
Example: On average, that $100 item you want will cost $103 next year. That means, if you’re stashing your cash under you mattress, you’re losing about 3% buying power a year!
At 3% inflation prices will double every 24 years! Prices don’t always follow this as it’s price is affected by many factors besides inflation as well, but inflation is a real thing and prices will continue to go up.
Stocks and Bonds:
Stocks in for our conversation purposes is ownership in a company whether it’s direct ownership or through another financial vehicle such as an ETF or mutual fund.
Bonds are loans. You buy a bond, you loan out money with interest. Generally stocks on average earn higher interest rate than bonds, but bonds are safer.