Monday, August 6, 2012

Investing 101 Part 1

Stock MarketPhoto by Tax Credits
Hmm, lots of "ones" going on there. Since it is or just was the start of a new month, I went through our financial accounts and recorded the balances. Why? Because you have no satellite tv and that is all you do for fun now? No, well maybe there's a little truth to that, but the main reason is because now that I have a personal finance blog, it seems like it would be wrong not to. One thing that stood out to me is that over 70% of our net worth is invested in the stock market. Add bonds in and it accounts for 80%. Since I'm such a believer in investing (Mrs. K could take it or leave it), I thought it would be a good idea to have a post explaining why. Plus, it will also keep me from freaking out because 80% of my net worth is invested!

What is investing?

Since this is a 100-level post we'll start out pretty basic. What is investing? Well, for our purposes it is purchasing some type of asset (stocks, bonds, rental properties, etc) with the hope/belief/expectation that it will increase in value. Essentially, it is turning your money into an employee that works to make you more money. Each investment can be your own little employee. Some have high potential and get a lot done, but they also could be unstable and end up burning the place to the ground. Think Milton from Office Space. These are the high risk/high reward investments like hedge funds. Others go at their own pace and are pretty stable like bonds. Finding the right mix of employees will help you build your financial business.

Why invest?

Well, the simple answer is to make more money. You're probably thinking that your savings account is already making you more money, especially since you opened an online savings account after reading WINN-ING. While that is true, there is an evil force out there limiting its effect. My spouse? I'll pretend I didn't hear (or think) that. The evil force is actually inflation.

Inflation is defined as a sustained increase in the price of goods or services. It's why Oreos went from $4.29 for 18oz in 2004 to $4.59 for 15.5oz in 2012. That's 7% more for 14% less which is a 24% increase per ounce in 8 years. It's also why I no longer buy Oreos. Well, that and they made me fat in college. Let's look at how inflation affects the buying power of $100 over the course of one year.

Starting AmountReturnInflation
(Historical Avg.)
Buying Power
$100 under mattress0%3.43%$96.57
$100 online savings (Current Rate).8%3.43%$97.37
$100 online savings (Est. Historical Avg.)3%3.43%$99.57
$100 stock market (Historical Avg.)9.6%3.43%$106.17

Before you start yelling at me, let me say, past returns are no guarantee of future returns (or whatever every brokerage tells you before you invest). Having said that, $100 under your mattress is guaranteed a 0% of return and I don't think that is going to change anytime soon. If it does, I'll write a post about it, so make sure to subscribe to email notification of new posts. If your mattress money doesn't generate positive returns, which it won't, you will continue to lose buying power every year there is positive inflation. Which was 87 out of the last 98 years. Yikes!

As you can see by the above table, even the awesomeness of an online savings accounts is barely a match for the evilness of inflation. A lot of people are afraid of losing money in the stock market, well now they can also be afraid of losing money out of the stock market. Without investing, it would appear that it is only a matter of time before inflation eats away at your wealth. However, combatting inflation isn't the only reason to invest.

Albert Einstein may or may not have said, "the most powerful force in the universe is compound interest." Well, we'll say he did say it, because it gives me more credibility to the importance of compound interest. So listen or read up. Compound interest is when the interest that you gain on your investment also starts gaining interest. Which means, not only is your money making you money, but the money your money is making you is making you money. And anything that results in the word money being in a single sentence that many times must be good.

As an example, if you invest $1000 and get 5% interest, after one year you would have $1050. The next year instead of having $1100, another $50 increase, you would have $1155 instead. Compound interest allowed you to gain an additional $5 the second year because of the interest on your interest. Then the next year you earn interest on that interest and so on and so on and richness ensues. That alone may not be impressive, but check out what can happen to $1,000 over the years depending on your interest rate.


There are a couple things to take note of from the above table. Obviously, when you have a higher rate of return you are going to see a jump in value, but when you combine that higher rate of return with a longer time period, you start to see the exponential earning potential of compound interest.

Hopefully now you have some idea of how investing with the power of compound interest can keep you ahead of inflation and on the path to increased wealth. Or if you already knew all that, now you know that I was fat in college. Either way you learned something.

Has the power of investing got you excited? Part 2 about investment types and risks will be coming in near future.

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