Investing Optometrist
Shivan

Shivan

Simple Investing: Step 6 of 8 to Financial Security

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Investing is using money to make more money. Money made or return can further your financial security.

After you have dealt with:

Let’s look into the option of investing. After reading this, you will see the reasons you should consider investing. We will also cover what investing actually is, forms of investments, and how investment generates wealth.

Why should I consider Investing?

Investing does more for you in the long-term than putting money away into a bank account. There are two reasons for this:

  • Inflation
  • Compound interest

Inflation

Inflation is when your money’s value decreases over time.

That money sitting in the bank is slowly reducing in value. The price of goods and services will be more in the future compared to now. A loaf of bread today will be $3; in the next decades, maybe worth $10. Thank you, inflation.

Before you start an anti-inflation social media movement – the modern way of getting your fellow villagers to brandish their pitchforks and fire-lit torches, inflation is necessary.

Inflation encourages the movement of money through spending. To understand why, compare this to the opposite, deflation. Deflation, you might guess, is when money increases in value. In this situation, people will be hoarding their money and not spending on goods and services companies provide. Production in companies reduces because they are not getting as much money. Layoffs occur because less work is needed. Ultimately, the gears of the economy begin to cease.

On the flipside, inflation incentivises companies to use their cash, building income through their goods and services instead of holding on to cash. Individuals are encouraged to spend and even invest. The gears of the economy are spinning, again.

Too much inflation results in the local currency losing its value almost overnight. The wheelbarrow might be worth more than the cash it’s carrying.

The best situation is to have neither inflation nor deflation, but this is very hard to maintain. So, Government’s centralised banks aim for the lesser of two evils, slight inflation.

Inflation in New Zealand is at about 2% ($100 now will be worth $98 in one year).

In the short term, money lost by inflation is small and not worth worrying about. Money kept for the short term like your emergency fund, or savings for holidays and big items is fine in the bank account. You need to have that money accessible for the unexpected. Trips away and fun stuff won’t likely increase dramatically in price when the time comes to splurge.

In the far future, however, cash stowed away for retirement as an example won’t be as much. Plus, things you decide to buy at this time will cost a lot more.

What can you do?

Avoid grabbing your pitchfork. Start investing, instead.

Investing money will beat value-reducing inflation. Later in life, money won’t be worth peanuts but peanuts made of gold.

Compound Interest

Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.

—Albert Einstein

Compound interest is what really will secure you financially in the future.

Like a small snowball rolling down a mountain, what seems tiny at first slowly becomes impressively large later on. Let’s look at an example of investing in the stock market as an example.

The average return of the stock market is around 6% per annum ($1000 you put in will become $1060 in one year on average).

A $60 return may seem small compared to the $1000 you put in. But next year we base the return of $1060 instead of $100. So we now get $1123.6, a return of $63.60. Still small, but the returns are increasing. Now imaging this over decades. A table will be much easier to see this effect:

YearReturn for YearTotal Balance
0$0$1000
1$60$1060
2$63.60$1123.60
5$75.75$1338.23
10$101.37$1790.85
20$181.54$3207.14
40$582.21$10285.72
Table showing $1000 invested

Remember this is based on averages. We have not accounted for any fluctuations. The graph below shows how invested money grows. This type of growth is now what you expect if you keep that money in a bank account.

Investing Optometrist
Compound interest, small returns become large with time

To get the most out of this compound interest is to invest early and invest regularly.

What is Investing?

Investing is when money is used to make more money.

When I first thought about investing, I imagined an individual sitting in a dark room, watching complicated graphs on a computer screen. A complicated game that required a lot of knowledge and a lot of money. The reality is a lot more plain. Trade the darkroom and computer screen to watching the grass grow in the backyard.

There are a variety of ways to invest. Some examples include but are not limited to:

  • Index Funds
  • Property

Index funds are the simplest way to get started in investing. Property investing might be regarded as the king, but requires knowledge and has a high barrier of entry with a considerable amount of capital.

Index funds only require you to have already sorted out your budget, have a system in place, an emergency fund set up, and debt demolished. On top of this, spare income to put away for investing.

What is an Index Fund to you?

An index fund is a managed fund that is passive. Two terms we need to explore in more depth:

  • Managed Fund
  • Passive

Let’s break it down.

Managed Fund

Similar to what happens in KiwiSaver fund, a managed fund is money pooled together from other individuals. This collection of cash is then invested into an asset which is diversified. Two more terms to break down:

  • Asset
  • Diversified / Diversification
Assets

Here is table to explain what they are:

Asset TypeWhat is it?How it generates incomeRisk
SharesOwnership in a companyDividends (share of profit), resellable value, but lost if the company failesHigh
PropertyA collection of land, commercial and residential real estateIncreased value in the property, but lost if the value dropsHigh
BondsOwnership on a loan made out to an individual or groupThe interest received from the loan, but lost if loan defaultedMedium
CashCash in savings accounts/term depositsInterest on savings/term depositsLow
Table of Asset Types

These asset types have their own ways of generating income. Risk is the reliability of these assets to make a positive return. High-risk means better returns in the long run, but this can go the other way. You are open to greater losses, short term.

For example, stocks and property have a high risk, as opposed to bonds, which are medium risk, and cash, which is low risk. Stocks and property may bring in the most returns. But if there is a crash in the market, like the 2008 global financial crisis, then these assets types can come crashing down. This is why it is important to have a good understanding of your financial timeline. And it is paramount that you are prepared with an emergency fund.

If you are looking to cash out a lot later (e.g. 10+ years) and you have a healthy emergency fund, then dips in the market do not concern you. On average you will make higher returns. Your emergency fund would have health with any unexpected expenses in the interim, while your investment will go back to normal. As the economy kicks into high gear again, your investments grow larger than before this economic slump.

A less risky asset type, like bonds, would be appropriate if you are looking to cash out a bit sooner (e.g. 5 years). There is more gurantee of a positive return, albeit sacrificing potentially higher returns.

For money you would expect the spend sooner (e.g. 1-2 years) like emergencies and fun money, rather than invest, you can just keep this money in the bank. Nothing is worse than losing your job to the global financial crisis and seeing your emergency money kept in shares plummet off a cliff.

Diversification

Diversification involves investing in multiple of a particular asset types. Not one company but many, not one property but a group, not one loan but a whole collection, not one term deposit but others too. Safety in numbers.

In addition to this, diversification also involves investing in multiple countries. This means if one country’s economy fails (even your very own!), then you are hedged on the victories of other nations.

This is also relevant when selecting your KiwiSaver.

Passive

Passive management has the lowest fees, saving you more money in the end.

To manage your money, a management fee is charged. This is normally a percentage of your returns, just like KiwiSaver.

To understand this fully, we have to look at active against passive management.

Actively managed funds involve a team of experts to make predictions on what are the best investments. The fees of these funds are higher since these experts have salaries. However, predicting the market is a very difficult thing to do. In fact, some might say impossible.

On the other hand, a passively managed fund involves a computer tracking a market index, like the S&P. A computer is much cheaper to run than a group of experts. If a group of experts can’t perform as well, then why pay extra?

How do I best use Index Funds to generate wealth for my future?

They key to riches in index fund investing is to:

  • Do early
  • Do often
  • Then, get on with life

Let’s go back to our spreadsheet.

Investing Optometrist
What is left to invest

After accounting for all our expenses and short-term saving, some more of the leftovers can be put into an investment account.

I’m going to introduce you to one more term, dollar-cost averaging. Simply put, this means investing the same amount of cash at a regular period. Just like putting money into a savings account.

Be fearful when others are greedy. Be greedy when others are fearful.

—Warren Buffett

Simplified, purchase more when the economy is low and purchase less when the economy is high.

Buffett’s ‘buy-more-when-low, buy-less-when-high’ principle is already set up for you when you invest in an index fund. When you are investing, you are buying units of this index fund.

The index fund units are worth more when the economy is going well. This means for the same amount of cash invested, you buy less of these units compared to when the economy is doing poorly, when these units are worth less.

All you need to do is set up an automatic payment to your investment account and then set your money to auto-invest.

What the market is doing is immaterial. Your bills have been taken care of. You have an emergency fund to deal with anything unexpected. You’ve done the research. You know when you will need this invested money next. Or it can build you wealth while your feet are up and you’re enjoy life with good company doing things you love.

House Deposit or Investment Portfolio?

This tripped me up personally. A tricky question to answer.

Once, you have sorted your budget and have enough in the emergency fund, the timing comes to purchase a house within a few years. But the advice for investing is to start early.

You have to commit a lot of money soon for this house deposit. What a dilemma, right?

Personal finance is personal. You could put a majority of savings into a house deposit and look at investing just a small portion of what is left over. Even 5% of your take-home pay. It is better than nothing and you won’t be missing out on early compound interest.

After you get your home, you can look at either paying off your mortgage faster or investing the difference. However, I would love to hear other opinions.

How do I get started Investing?

There are a number of online methods to get started in the wonderful world of index fund investing. Here are a list below, but there are many more out there:

I would encourage you to do your own homework to see who is the best for you. Please note that I have no affiliation with any of these services.

Conclusion

Investing uses money you already have to build wealth: a requirement in financial security.

You have learned the reasons to invest invest. Investing beats inflation through higher returns and compound interest compared to idly sitting in the bank.

There are a variety of investment vehicles. Index funds is the simplest.

Index fund are passive providing low fees. Additionally, they are well diversified.

Index funds can come in a variety of asset types including shares, property and bonds. Shares and property have the greatest risk but the highest average return compared to bonds and even cash.

High risk is better for more long term goals because the high average returns will overcome any dips in the market.

Emergency money and any fun money should be kept in an easily accessible bank account rather than invested.

The key to success in index fund investing is to start early and do often. Dollar-cost averaging involves investing the same amount of cash regularly. This can be done with automatic payment and auto-investing.

There are variety of investment platforms to get started.

After reading this, you should be well informed about investing. I hope you found this helpful, and if you did please comment and share this with friends and family as well. Thank you for reading!

Finally, as a disclaimer, I am not a financial expert or professional. I would encourage you to do your own research or seek an expert opinion. All decisions are up to you.

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