This week, we are going to focus on your understanding of core concepts & definitions when it comes to investing.
These are basically the things you should know before you delve into setting up investment accounts and allocating your money.
This is challenge 2 of 4 in the investing series.
Note: If you are outside of the U.S. be sure to research the equivalents in your country for the tools/suggestions mentioned throughout this investing series.
Core Concept #1 - Paying off debt vs. Investing
One of the most common questions I get asked is whether to pay off debt or invest. My opinion is that you can pay off debt and invest at the same time BUT there needs to be a plan in place.
Like I mentioned in last week's challenge, the stock market has averaged about ~7% to 8% in returns over the long term (long term being since the inception of the stock market). However, if you have debt with interest rates above 8% e.g. high interest credit card debt and other loan, then it makes sense to focus on paying that debt off as quickly as possible first before fully diving into investing in the stock market.
That being said, when it comes to investing, starting early means you can contribute over time, take advantage of the power of compounding (we'll get to how this works in a minute), be more likely to realize increased gains and weather market storms.
And so I recommend that at the minimum you start investing small percentages of your income towards retirement, focus on paying off your debt and then once your debt is gone, increase your retirement investment contributions and look into non-retirement investing i.e. investing to buy a home, towards generational wealth or other mid to long term goals (Longer than 5 years).
In addition, before you dive into investing you want to make sure that you have a funded emergency account that will be your buffer in the event something unplanned happens (e.g. car breaks down, job loss etc), this way you are not forced to make an unplanned sale of your investments to cover your emergency (especially if the market is down and also because of potential penalties you will have to pay if you withdraw your retirement savings, particularly in the US).
Core Concept #2 - The power of compounding
Compounding is what really grows your money! It is the process by which your money grows from reinvesting your earnings over time in addition to the potential earnings rate (%) you can gain. Let's look at a very basic example -
Let's say you invest $1,000 today and you earn 8% on it, at the end of one year you’ll have $1,080. If you leave the $100 that you earned alone and don’t invest anything else, at the end of the 2nd year of earning another 10%, you will have $166 in earnings with an overall total of $1,166.
After 10 years, without you ever contributing more than your base of $1,000, you will have $2,158.92 - more than double your original contribution! Now imagine if you contributed more and kept contributing every month - THAT is the power of compounding. Have some fun with THIS calculator!)
Below are some key definitions and terms you need to know about investing at the very minimum:
1. Brokerage Firm
A brokerage firm is a financial institution that manages or facilitates the buying and selling of different kinds of investments e.g. stocks, bonds, funds etc between buyers and sellers. They typically charge commission fees on trades and can provide you with update to date research, market analysis and pricing information on the various investment.
A stock is part ownership of a company. Stocks are also called shares or equities and the more you own the bigger your ownership stake is in a company.
In simple terms, a bond is when you loan money to a company or the government who in turn pay you back in full with interest.
4. Mutual Fund
A mutual fund is a pool of funds from a group of investors set up for the purpose of buying securities like stock, bonds etc Mutual funds are typically managed by a fund manager or a money manager associated to a brokerage firm. Their job is to make investment decisions for the fund and set the funds objectives.
5. Index Fund
An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P 500 (US Specific). The S&P 500, which you may hear time to time on the news, is simply 500 large companies that have common stock listed in the stock exchange e.g the New York Stock Exchange).
6. 401(k) Plan,403(b) & 457 (b) Plans - US Specific
These are employer sponsored retirement savings account into which you can contribute part of your income pretax. There is however an annual cap on how much you can contribute. Many employers who offer the 401(k) plan will offer a match up to a certain percentage which does not count towards your annual cap. Within these accounts you can purchase stocks, mutual, funds, bonds, index funds etc depending on what's made available by your employer.
7. IRAs - US Specific
These are another type of retirement savings account that you can set up individually, independent of an employer examples include traditional IRAs, ROTH IRAs etc. IRA contributions are also limited and are much lower than employer sponsored plans like the 401(k). Within these accounts you can purchase stocks, mutual, funds, bonds, index funds etc
8. Expenses / Expense Ratios
These are the annual fees that funds e.g. mutual funds charge their shareholders. These fees include fund management fees, administrative fees and other fees related to operating the fund on your behalf.
There is no worksheet to download this week.
Instead, your challenge for the week is to fully understand the concepts & definitions I have listed above and to do some reading / research to become more comfortable with them. We will be continuing the investing series next week.
P.S. Don't forget to share your progress in the Facebook group!
Important to note
It's important to understand that your investments in the stock market are not guaranteed and neither are they insured, as a result, investing in the stock market means you are assuming risk. However, if you have the right objectives and a proper investment plan based on those objectives you should be just fine.
To learn more be sure to check out the investing section on the Clever Girl Finance blog HERE.
I also recommend a great book on investing for beginners called "A Beginner's Guide to Investing: How to Grow Your Money the Smart and Easy Way" by Alex Frey HERE.
And finally be sure to reach out to a financial advisor if you have specific investing questions.
It's week 15 of The 26 week savings challenge!
This week, your savings deposit amount is $59.00
(If you've been consistent with your deposits, this week's deposit will bring your balance to $465!)
- Make your transfer.
- Check off this week's amount on your savings challenge schedule.
- Share your progress in the Facebook group!
Note: This challenge will be on-going throughout this accountability program in addition to your other weekly challenges.