Hope for your financial life and beyond

Investing Made Easy: The What and the Why

Target on moneyWelcome to the Luke1428 investing series. Over the next couple of weeks I will be unraveling the world of investing and setting you on a path towards long-term success. Success in our personal financial life is something we all shoot for and investing can help us hit the target. This series will be a primer for the beginning investor and a reminder for those of us who are more seasoned as to why we invested in the first place.

There are many reasons why people choose to ignore investing. I remember first delving into this topic in my early twenties and feeling extremely overwhelmed. I would glance through a brochure for a mutual fund I was considering and didn’t understand most of what I read. I felt uneducated and uneasy. And I didn’t know anyone who was knowledgeable enough about the topic to explain it to me. There also were no really cool personal finance blogs to educate the public then either.

Mostly though, I remember being afraid of losing money. I was old enough in 1987 to comprehend that something terrible happened to the U.S. stock market on October 19th. I didn’t exactly know how people made or lost money investing, but I knew that Black Monday sounded bad. The people screaming and sweating on the nightly news looked bad. And a $500 billion paper loss in one day seemed to make people feel real bad. So if that can potentially happen, why should I risk losing my money through an investment in the stock market?

This investing series will give the answer to that question and others like it that I had to figure out for myself when I began. The topics I will cover include:

What is investing?

Why should I invest?

When should I invest (or start)?

How do I invest?

Where (in what) should I invest?

Who can help me invest?

Which risks should I consider?

Today I will deal with the most basic questions, the “what” and the “why” of investing.

What is Investing?

Investopedia defines investing as:

“The act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.”

The last phrase in that definition is really key to our understanding of investing. When we place our money into an investment, we are anticipating that our principle (the amount we originally put it) grows to be substantially more. We really aren’t investing by definition if we don’t expect our money to grow even just a little.

In essence, our investment buys us a piece of whatever entity into which we place our money. The more money we put in, the bigger the piece we own. The more money we put in the bigger our potential return (or loss) could become.

So if I owned a business, I could let you buy into that business with some of your personal money. If my business did well, the overall value of the company would grow. You, as a part owner, would see the value of your share of the company grow as well. If in time you wanted to cash out your portion of the business, you could sell it back to the company or to another investor and receive the increased value of your principle (in other words your profits). You would have just left the investment with more money than what you originally put into it. That’s an investing success.

As the definition implies, there are many places we could choose to invest our money. For the remainder of this series, I will mostly be discussing investing as it pertains to placing our money in the financial markets.

Why Should I Invest?

You have probably figured out already that investing does involve risk. If the business in the example I stated above did poorly, then an investor could lose money. In fact, if the business failed and went bankrupt, an investor may lose all their money. So, if that is the case, why should we invest? Wouldn’t it be better to keep our money locked in a fire safe behind the clothes in our closet? (I have no money there so don’t come to my house and check.) Or at the least, we could deposit our money in a bank account where we know it is insured by the federal government.

Why take the risk? Is it worth it?

This is really the first barrier every investor has to confront and there are no cut and dried answers. All of our financial situations and risk tolerances are different. For now I would say that if you feel the investment risk is too great for your situation then you shouldn’t invest. I will get back to this point in more detail later in the series.

There are, however, several very legitimate reasons why we should invest, the first being the desire to build wealth. If I put $1,000 in a cookie jar and leave it there for 10 years, I will still have $1,000. The money has done nothing but sit there. I haven’t lost any but it hasn’t grown and contributed to an increase in my net worth. We need all the increase in net worth we can get to deal with the increased costs of a college education for our children and to fund our own retirement.

But you are thinking, “Yeh, but I still have my $1,000 to buy stuff.” That thought leads me to the second reason investing is important – keeping up with, and hopefully outpacing, inflation. In economics, inflation refers to the general increase of prices on goods and services over time. What a gallon of milk cost in 1970 is not the same as today. Generally, inflation creeps up slowly each year so that a consumer may not notice a huge difference. But when we compare 10 or 20-year periods of time, one would easily see a noticeable shift upward in prices. Therefore, the $1,000 you had stuffed in a cookie jar does not purchase the same amount of goods and services that it did 10 years ago because prices have gone up.

The third reason to take the risk is that the odds are in our favor as investors, especially when we look at investing in the financial markets. Let’s take a look at the U.S. markets, by observing the long-term track record of the S&P 500 (an average that gauges the performance of the 500 biggest and most stable companies in the New York Stock Exchange). Do a Google search and you will find that most financial computations place the S&P 500 average annualized return to be around 10% since it’s inception in 1926. In that time, there have been big up years, bid down years and slow, plodding, just-break-even years. All in all, it averages out to a very decent return on one’s investment.

(Even if you feel that number is a couple of percentage points too high which some statisticians suggest, I would still take an 8% annual return on my money in the financial markets than the less than 1% return I could get on my money in a savings account at the local bank.)

For examples sake, let’s take our $1,000 cookie jar money and invest it for 10 years at the 10% historical average of the stock market.  In 10 years, our $1,000 would have grown to $2,707. And if I also invest $1,000 more each year for those ten years, I’ll have close to $20,000 by the end of the time period. That’s how investing regularly helps grow our money and why it’s worth taking on some risk.

Next week in part two of this series I’ll explore when we should start the investing process.

What is the biggest barrier you had/need to overcome to start investing?

Image Credit: FreeDigitalPhotos.net

Next Post: What’s Rich to a 6-Year Old?

Prior Post: Is It Worth It To Be Inconvenienced?

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Comments

  1. Shannon Ryan says:

    I went back into private practice at the height of the Great Recession (fabulous timing on my part, I know!) and it was interesting to see the varying mindsets of clients. Some gritted their teeth and prepared to ride out the volatility whereas other let fear rule them. I understand the power of fear but I also know the dangers of letting our emotions cloud our judgement. Some pulled their money and are now ready to go back into the markets because it’s doing so great. When I point out what they lost by pulling their money, they are shocked. Looking forward to your series, Brian. Have a great weekend!

    • I’ve got a funny story that relates to what you are saying. My wife and I have started college investment accounts for each of our four children. The three oldest all had their funds started before the huge financial meltdown occurred. It just so happens that our youngest son was born after things had started to collapse in the stock market. We started his fund at that time when the markets spiraling downward. Now that the markets have rebounded nicely since the 2008-09 lows, his account is far outpacing the others in terms of his annual returns. We have a running joke that all three of the older kids will be bitter at us when they find out how much more his account has grown. To your point, if we had let our emotions control us at the time, we would not have invested and missed out in some tremendous upside.

  2. Mike@WeOnlyDoThisOnce says:

    While 2009 is still a sobering example, it is important to note, as you do, that short term fluctuations will likely balance out if you have a properly balanced portfolio.

  3. John S @ Frugal Rules says:

    Very nice breakdown Brian and I am looking forward to your series. I remember back to when I was fearful of getting started with investing so much of it came down to education for me. The nice thing is that there is so much free education out there that people can benefit from.

    • Thanks John. I enjoy doing these focused type of series from time to time. But boy…are they harder to write so they are clearly understandable. I agree education is huge and there are many more resources now available that can help people through the process.

  4. MoneySmartGuides says:

    Nice break down on what investing is. Also, I’m glad to see you touch on inflation. Many people “fear” the stock market because they don’t want to lose money, so they keep their money in a bank account that yields zero. While you don’t lose physical money, you lose purchasing power, meaning you can buy less with that money each year.

    • Thank you. I believe fear is probably the biggest reason people choose not to invest in the stock markets. Our media does not help people overcome their fear either. Most of the reporting contributes to it. And I agree about inflation, in that it is a big deal that most people overlook when making financial decisions.

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