Investing Basics

There are so many different ways to invest. What matters at the end of the day is that you let your savings work for you. When you live frugally and have surplus funds, you need those funds to earn more for you.

There are endless books and online resources that specialize in the seemingly infinite options available to invest in. I’ll be just be covering some fundamental principles here.

Return on investment

The reason we invest is to earn a return on our investment. We put away $1,000 and hope that by the end of the year it’s worth $1,090. Setting aside $1,000 in hopes to make $90 may sound crazy if there is a lot you would like to do with that $1,000 today. But over time, this really adds up.

Making a $90 return from $1,000 invested is a 9% return (90 / 1000 = .09, .09 x 100 = 9%).

Compounding

Where this gets exciting is the following year when the $1,090 earns $98 instead of $90.

$1,090 x 1.09 = $1188.1. Pull up your calculator and do 1000 x 1.09 and enter (or =) 10 times and watch that number go up over 10 years. $1,090, $1,188, $1,295, $1,411, $1,538, $1,677, $1,828, $1,992, $2,171, $2,367.

My more experienced readers are rolling their eyes right about now, as they should. I personally get sick of those compound interest stories that say a 20-year-old can save $200/mo and be a millionaire when they turn 60. While the concept of compounding interest is absolutely true, you will never find a guaranteed 9% return and the stock market does not move in a straight line. And the concept of what a million dollars can buy in 40 years is totally unknown. There are flaws with those examples.

How returns really work

There are ups and downs in most investments. Sure, the historical long-run return of the stock market is between 7-10% depending on when the measurement was made and whether or not the author is adjusting for inflation. But in reality, some years it goes down 50%. Other years it goes up 50%. Most years it goes up somewhere between 0-15%. Average it out, and you’re looking at 7-10% per year.

The S&P500 peaked at 1561 on October 12th, 2007. We didn’t know at the time that we were about to enter the Great Recession and the S&P500 would fall to close at 683 on March 6th, 2009. The market lost 56% of its value. If you put your $1,000 in on October 12th, 2007, you would have $437 on March 6th, 2009. You might be wearing a Che Guevara shirt and sitting in at Occupy Wall Street protests.

Hopefully, you didn’t sell. On April 12th, 2013, the S&P500 was back to 1,588 and the years following the all time low have proven to be the buying opportunity of my generation. These buying opportunities happen a few times in a lifetime. Expect them to. It could be tomorrow (we are now “due” for a recession, but it’s possible it won’t come for a long time).

Every day is a buying opportunity

Jeremy Siegel wrote a great book called Stocks for the Long Run. I recommend reading it. I’ll give you a little spoiler. Over any extended period of years, the stock market has been a good investment. Even if you buy at an all time high, if you plan to hold for a decade or more, you’ll come out ahead (at least for the past 100+ years). This has held true in our most recent example of the 2008-2009 crash. If you bought at the all-time high of 1561 in 2007, you broke even in 2013, and are now up 43% as of this writing on December 30, 2016 (S&P500 is now 2238, 2238 / 1561 = 1.43, a 43% gain). Your $1,000 invested at the 2007 high is now worth $1,430, even though the market crashed right after you bought.

People are now afraid the market may crash in 2017. Maybe it will. So what? If it does, you might still be up 43% in 2027, but up even more than that because you will be a disciplined buyer and be buying when everything is on sale, right?

If you were one of the brave people who bought at the bottom of 683, you are now up 327% on that investment. You $1,000 is worth $3,276.

Hope you weren’t scared and bought gold and guns from hucksters selling you a story of armageddon. I actually shorted gold from $2000 to $1200… but that’s a story for another time.

Real world returns

The market zig-zags and you really don’t know if it will zig or zag after you buy. I am talking about stocks here but this really holds true with almost any investment. Bonds can go down. Rental houses can need foundation repair or have vacancies or rent can actually go down (it does happen). Commodities can move all over the place. The investments that offer guaranteed returns such as annuities do actually still have risk – the company selling you the investment may go out of business, inflation may be higher than you expect thus eroding the value of your cash stream, and even if all goes well, you are likely giving up higher long-term returns to settle for a steady lower return.

So, here are some charts to illustrate. I am going to use our $1,000 example for some charts and I’ll up that to be $1,000 per month saved and invested to illustrate some more impressive real world numbers to strive towards. These charts are generated using Portfolio Visualizer, one of the tools I love. I’ll be writing a story later to show you how to get full use of it.

$1,000 invested in S&P500 in January 2007 to November 2016:
1000spy

$1,000 per month invested in S&P500 from January 2007 to November 2016:
1000permonthspy
What crash? Let’s say you are starting to invest right now. You hear people in the financial press stoking fears of a market crash coming soon and that sounds scary. So what? Look at that chart. Do you want to have almost a quarter million dollars in 10 years? You should hope the market does crash tomorrow. Look at how awesome it is to be able to buy low every month after a crash.

Ok, maybe you are halfway through your career and you have a $200,000 in your 401k and the prospect of a crash is scarier. You have a lot to lose. Same chart, starting with $200,000, adding $1,000 per month:
200k100permonthspy
Want to have $600,000 in 10 years? Sounds good to me. Having your $200,000 drop down to $124,000 in 2009 would have been very scary. It’s reasonable for someone to be afraid of investing after a drop like that. But that is fear, not statistics. Don’t let fear control your investing decisions – other than the fear of being 75 and penniless – which means you need to invest.

Let’s take it up a notch. You’re married and you both have good careers. Maybe with enough budgeting prowess, you can live on one of your incomes and invest the other’s income. What if you can save $40,000 per year? That’s a $1,538 take home pay bi-weekly paycheck. Or $3,333 per month. You have been getting your 401k match but not much else. You have $100,000 between the two of you. Here is what that chart looks like after you up your saving to the next level:
100k3333permonthspy
You’re probably a millionaire by this time. You probably own your home and maybe have other savings. Add that to your investment accounts and you’re a millionaire in 10 years. Even though you put in $40k per year up to and during the crash, look at that chart. So what if the market crashes tomorrow?

History rhymes

People say history doesn’t always repeat but it often rhymes. This holds true in the stock market. My experienced readers were probably rolling their eyes at my charts looking back 10 years with 20/20 hindsight, and rightfully so.

Enter the Monte Carlo simulation. The market performs differently each day, year, and month. This data is recorded. Let’s say that during a given year, the market was up on 50% of the days and down on 50% of the days but the up days were fortunately up more than the down days and the market ended up for the year. In a Monte Carlo simulation, those days or years are scrambled up randomly hundreds or thousands of times and other equally likely outcomes are produced. Think of it like alternate realities. Now instead of the market going up 9%, you see that it could have gone up only 4% or as high as 20%, but probably would have gone up 10%. Nassim Taleb covers this well in his book The Black Swan, which always seems to be popular right after a crash.
trollface

$100k starting, $40k per year for 10 years:
100k40kperyearmontecarlo

If you are unlucky, you’ll probably end up with the blue line, $728,038. If you are lucky, you get the yellow line, $1,208,516. The red line is the median (middle) of $943,025.

Personally, I make my plans based on the blue line. If I get red or yellow, awesome!

Conclusion

This focused on the stock market because it is the investment option most widely available to all. For those who choose to go this route, you can set up very easy hands-off savings plans and ignore them and one day you’ll notice you are a millionaire. Other styles of investing may take more work and may offer higher returns. But the concepts hold true no matter what you are investing in: save money, expect a certain return for a certain risk, either get it or don’t.

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