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Investing 101 – What Is Investing & How It Works

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Investing your money to make more money

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If you’re new to investing, it might seem intimidating at first. But it doesn’t have to be. We are going to give you a primer on investing and talk about what investing is and how investing works, Investing 101 if you will.

By the end of reading this article, investing should no longer seem so mysterious, and you should be ready to start letting your money make you even more money.

Because after all, that’s what investing is.

Why Investing is Important

We all only have 24 hours in a day and out of those 24 hours, we only have so many hours we can (or want to) devote to working for money, even if we love what we do.

So how can we make money even when we’re sleeping, vacationing, or hanging out with friends? We need a form (or multiple forms) of passive income. In other words, we need money being directly deposited into our accounts without physically working for the money.

What is a source of passive income? Yep, investing.

Some of us choose a career for love and not money. The teachers, the artists, the caregivers. Many times those careers are not going to pay enough to make us rich.

So how can we get rich, or be financially stable, if our job isn’t going to get us there? You guessed it, by investing your money.

Some of us want to retire early, not 60 early. Ridiculously early like 35. How can we do that, win the lottery? Keep dreaming. You know what has better odds? That’s right, investing again.

For the vast majority of us, investing will be our number one wealth building tool.

When Should You Start Investing?

Investing should be done like voting was done during the Capone era in Chicago, early and often. Early is especially important because time is crucial to successful investing.

it's better to save and invest early

via Business Insider

The more time your money has to grow, the wealthier you can become, even if you don’t have lots of money to invest.

When you have more time, you can compound your investments. Compound interest investing is when you reinvest the profits that your money made. Bit of a tongue twister but that’s the concept.

If you invest $1 and you get a 7% return on your money, that means you turned your $1 into $1.07 after one year.

With compound interest, the next year you will have $1.07 invested instead of just $1. So now your original $1 will be making you money and the profits your dollar made ($0.07) will be making you money as well.

Now imagine that happening over and over for decades and with a lot more than just $1 invested.

If you save $5 a day, everyday, from the day you turned 20 until the day you turn 65, you would have saved just over $82,000. Not bad.

But, for the sake of this example, if instead of saving that money you invested your $5 a day into something with a 10% annual return and you reinvested all of your profits, your $82,000 savings would now be worth almost $1,500,000.

That’s why Albert Einstein called compound interest the 8th wonder of the world.

Sure, maybe you can’t guarantee a 10% return every year, but this concept is crucial to understand if you’re trying to build wealth.   

As long as you don’t sell off or pull some money out of your investment, your money will keep accumulating and growing, so long as your investment stays strong.

This chart shows you how powerful time is when it comes to investing. The investor who invested the least amount of money for the most amount of time came out far, far ahead of her fellow investors.

Compound Investing Chart - the earlier you start investing the more you will have

via JP Morgan Funds

Even investing four times more money did not make up for the lost time.

The longer you wait to invest, the more money you are leaving on the table.

How Much Money Should You Be Investing?

You don’t need a lot of money to start investing. But how much should you invest?

If you’re young and don’t have many expenses, you can be more aggressive with your saving and investing. If this is you, aim to invest a minimum of 30% of all your earnings.

If you’re older and have more liabilities, you should aim to invest a minimum of 15% of all your earnings.

Invest in yourself first.

The best way to do that is by automating your investing. You want that money invested before you see it, or you want it moved into a separate account with funds that will be invested. Out of sight, out of mind. You can’t spend it if it’s not sitting in your checking account.

One thing to keep in mind is that your investments are not your emergency fund. This is separate, and you need to budget for that.  

Some Key Financial Terms

Like anything else, investing has lots of specialized terms, and it can all sound like Greek to the uninitiated. So, here are some key investing terms that you do need to know.

  1. Asset: Something you own that has the potential to make you money.
  2. Asset Allocation: How the assets in your overall portfolio are divided up into different kinds of investments.
  3. Bonds: A sort of IOU. You lend money to an entity, usually a company or a government with the promise the amount you lent will be returned with interest by a certain date.
  4. Diversify: Having more than one kind of asset in your portfolio.
  5. ETF’s: An Exchange Traded Fund. A “basket” of stocks that lets investors own stocks in multiple companies in a particular sector or index without having to own individual stock.
  6. Index Funds: An index fund is a type of mutual fund that gives investors wide market exposure.
  7. Mutual Fund: An investment that pools money from many investors into one pot to purchase stocks, bonds, and other securities.
  8. Portfolio: An investor’s overall collection of investments.
  9. REIT’s: Real Estate Investment Trust. A REIT is a way for a group of investors to pool their money to invest in real estate they could not afford to buy outright on their own.
  10. Return on Investment: The amount of money gained or lost on an investment.
  11. Securities: Investments traded on a secondary market, stocks, and bonds are the most common.
  12. Seed: A Minority Mindset term. Seeds are things that you buy with the expectation of making money. You buy the seed once and then the fruits of the seed should continue to pay you into the future. Examples of seeds include real estate investments and stocks.
  13. Stock: A share of ownership in a company.

Common Types of Investments or ‘Seeds’

  1. Stocks: Stocks are the investment most of us are familiar with. When you buy stock, you own a fraction of a company, the more shares of a stock you have, the more of the company you own. You can buy individual stocks, ten shares of Amazon for example, or buy a collection of stocks through a mutual fund or ETF.
  2. Bonds: When a company or government need money, they can sell bonds rather than borrow from a bank. The bondholders become the debt holder. The bond issuer agrees to pay the bondholder back with interest at a set date in the future.
  3. Real Estate: Real estate investments can include owning residential, commercial, mixed use, or industrial properties.
  4. Peer to Peer Lending: In the past, if people needed to borrow money, they would go to a bank. But peer to peer lending allows borrowers to borrow from other people at a better rate than they could get from a bank and with fewer and less strict requirements. The lenders make money on the interest the borrowers are charged.
  5. Retirement Investing: When you invest in a retirement vehicle like a 401k, Roth or Traditional IRA, the money is locked up until you reach retirement age, usually 59 ½. With some exceptions, you cannot withdraw the money before that age without paying the penalty. Retirement accounts often have certain tax advantages that other forms of investing don’t offer.
  6. Cash Equivalents: Cash equivalents can be actual cash like the money in your checking and savings accounts or money market accounts and certificates of deposit.

How to Start Investing

First of all, let us debunk the biggest myth that prevents people from investing. You do not need a lot of money to invest. Some investment platforms require no minimum at all. Sure, a 7% return on $100 isn’t going to be a huge amount. But remember, the longer you wait, the more you lose out on compounding interest.

1. Stock Investing

Starting small: Acorns has done a lot to open up investing to a wider audience. It is especially appealing to young, tech-savvy investors because everything can be done right from your phone.

You connect your debit and credit cards to the Acorns app. They round up each purchase you make on those cards to the nearest dollar and each time your spare change totals $5, they invest it for you in an ETF. The ETF is made up of a mix of stocks and bonds.

If you wish to invest more, you can schedule recurring deposits daily, weekly, or monthly to grow your investments even faster. There is a $1 per month fee if your account balance is $5,000 or less and a 0.25% management fee for accounts over $5,000.

Understanding Acorns the micro-investing app

And as a bonus, Acorns is giving Minority Mindset fans $5 to start investing today.

Stock Market Investing: When you’re ready to manage your own money, you can buy and invest in individual stocks. Individual stocks definitely have their place in a smart investor’s portfolio. It does take a little more effort though because you need to research which companies are worth investing in.

Some questions you may want to research are: is the company profitable, how long has it been making a profit, who runs the company, are they innovating for the future, how is the overall sector the company is in doing?

If you don’t know where to start, choose companies with products you believe in and use yourself.

You will need to open a brokerage account to buy and sell individual stock. You can do that with Ally Invest. You can make trades for $4.95 each with no account minimum and no minimum trade activity.

2. Real Estate Investing

Buying property: As we said earlier, there are many kinds of real estate. Essentially, you buy property and then rent it out to people who use or live in your property in exchange for rent. To fund your deals you will need access to capital or you will need to come up with a creative investing strategy.

Real Estate Crowdfunding: Like Acorns opened investing in the stock market to lots of people, Fundrise has done the same for real estate investing. When most of us think of investing in real estate, we think of being the landlord of a residential property, owning a house and renting it out or being some kind of big hotel or resort tycoon.

But Fundrise lets you become a real estate investor for as little as $500. Your money will be invested across a portfolio of real estate properties. In exchange, you will get your share of rental income, interest, and appreciation if there is any.

Understanding Fundrise the real estate investing softwareAnd the best part? No one will call you in the middle of the night to fix a clogged toilet!

You can see some of Fundrise’s historical returns for investors here.

3. Money Lending Investing

Be The Bank: Instead of letting your money sit in your bank account (where it loses value to inflation), you can do as the banks do and lend your money out.

You have a lot of options here. You can lend your money to real estate investors, you can lend it to startups, or you can lend it to people who need money to pay their bills.

Each lending option comes with its own share of risks.

In return, the people who who borrow your money will be entitled to pay you your money back with interest. And private money lenders tend to charge higher interest rates than banks.

You’re probably wondering, “but what the borrower doesn’t pay me?” Great point. This is why you want to add in protections.

Just like how the bank asks for collateral (like a lien on your house), you can get collateral for your loans. This way, if you don’t get paid, you can repossess your collateral and sell it to cover the loan.

There are a lot of laws and regulations on this, so please speak to an attorney in your area before you start lending.

Peer-to-Peer Lending: Just like Acorns and Fundrise, there are some peer-to-peer lending platforms that make the lending process easier. 

Retirement Investing

Retirement investing gets its own section so we can explain the three most common types of retirement investments. One of the most important differences between regular investments and retirement investments are the tax advantages retirement accounts have.

401k

For many people, this is their first experience of investing because it’s offered by their employer. Money is taken automatically from each paycheck pre-tax and invested in a mutual fund where it grows tax-free until you start taking withdrawals after age 59 ½.

Some employers offer 401k matching. Remember, matching is free money if you use it.

If you make $100,000 per year and your company offers a 3% match, that means if you invest $3,000 your company will also contribute $3,000 for you. That is $3,000 of free money!

We’re not going to get into all the pros and cons of a 401k in this article – this is just general information, however, this match can be very valuable and you should consider capitalizing on it.

Another advantage is that when you contribute to a 401k, you lower the amount of money you have to pay taxes on, always a good thing! If you make $100,000 and contribute $3,000, you only pay tax on $97,000 rather than the entire $100,000.

There are limits to how much you can contribute to a 401k each year, so be sure to do your own research.

Traditional IRA

This type of IRA is not taxed at the time the money is invested but when it’s withdrawn after age 59 ½. The money invested grows tax-free.

There is a limit to how much you can contribute per year, $5,500 for 2018. Contributing to a Traditional IRA lowers your taxable income the way contributing to a 401k does.

A Traditional IRA can contain a variety of investments including individual stocks, bonds, and mutual funds.

Roth IRA

This type of IRA is taxed when you invest the money but not when it’s withdrawn after age 59 ½. The money invested grows tax-free. The contribution limit is the same as the Traditional IRA.

Roth IRA contribution limits

via BeManaged

A Roth IRA contains the same variety of investments a Traditional IRA includes.

Which is better? If you think your tax rate will be lower during your retirement, the Traditional. If you think your tax rate will be higher during your retirement, than during your working years, then the Roth might be the right choice.

Again, do your own due diligence, we don’t know your personal financial situation.

Asset Allocation

One of the most important decisions to make when investing is asset allocation. How are you going to divide the money you invest among different types of investments?

When you have someone investing your money for you, you will mostly be deciding how to divide your investment between stocks and bonds.

For these asset allocations, stocks are considered a riskier investment than bonds, but this ‘risk’ is typically rewarded with higher returns. Generally, the younger you are, the higher your risk tolerance should be because your money has many years to ride out the ups and downs of investing.

A 30-year-old’s portfolio will look very different than an 80-year-old’s portfolio.

Some experts follow the rule of 100. You subtract your age from 100. That number is how much of your portfolio should be in stocks; the rest should be in bonds.

Asset allocation between stocks and bonds

via Motif Investing

The rule of 100 is just a guideline that some people follow. You should use your own level of risk tolerance to help guide you further. Plus, it doesn’t account for real estate investing which can be extremely lucrative.

Young investors should not have cash equivalents beyond their emergency fund. Cash equivalents are low risk and get no returns. Keeping lots of cash on hand is better suited for investors close to or in retirement.

Diversification

Diversification is a fancy way of saying, “Don’t put all of your eggs in one basket.” When you have a diversified portfolio, you theoretically reduce your risk.

But, diversification reduces your profit potential as well.

Let’s say you had $100,000 and you invested your money evenly, $20,000 each, across 5 stocks: A, B, C, D, and E.

After one year: A went up 2%. B went up 5%. C went down 1%. D went up 4%. And E went down 7%.

That means:

Your $20,000 investment in A went up to $20,400;

Your $20,000 investment in B went up to $21,000;

Your $20,000 investment in C went down to $19,800;

Your $20,000 investment in D went up to $20,800; and

Your $20,000 investment in E came down to $18,600

Overall, your $100,000 grew to $100,600 which is a profit. However, if you invested all of that money in either stock A, B, or D you would’ve had a better return.

As Warren Buffett says, “diversification makes little sense if you know what you’re doing.”  So, you should understand the pros and cons to diversifying your money within one market (e.g. the stock market).

Diversifying across different markets, like owning real estate and investing in the stock market, will provide you with better diversification.

Your Time Horizon

Another important thing to consider when choosing investments is your time horizon, how long you plan to leave that money invested.

The longer your time horizon, the riskier your investments can be. This is why younger investors are encouraged to be more heavily weighted towards stocks than bonds.

A short time horizon is five years or less. This might be money you want to save to buy a home or take a vacation.

A medium time horizon is five to ten years. This could be money to buy a rental property or to send a child to college.

A long time horizon is ten years or more. This is typically money you are saving for retirement.

Manage your investments accordingly. You can sell a stock pretty quickly, but selling an apartment complex can take months.

Should You Invest or Pay Off Debt?

Great, you’re convinced; you can’t wait to start investing! But what if you have debt?

The question can largely be answered by the kind of debt you have. If you have low-interest debt like student loans or a mortgage, you can continue to pay off the debt while investing at the same time.

The average interest rate on a student loan is between 4.45-7% (which you might be able to reduce by refinancing your student loan). The average historical return for the stock market is 7% a year.

So it makes more sense to devote some of your money to investing when you have low-interest debt because you can make more money than you are paying out in interest.

If you have high-interest debt like credit card debt, that must be your priority. The average interest rate on credit card debt ranges from the mid-teens to the mid twenties.

You can see that it doesn’t make sense to get a 7% return on your money when you are paying 24% interest on your credit card debt.

There is one exception to this. If your employer offers 401k matching, contribute the minimum required to be eligible for the match. That is free money which doesn’t come around very often!

Again, these are general ideas. We don’t know your personal financial story and we don’t know the investments you are considering so do your own due diligence.  

What About the Risk?

We showed you that you don’t need a lot of money to start investing so what’s still holding you back? Oh, the risk. Yes, we understand.

If you don’t follow the financial news closely, all you hear is the really scary stuff.

You’ve heard about the 1920 stock market crash and great depression when bankers were jumping out of their office windows on Wall Street because of the financial turmoil that was happening.

You probably saw the 2008 financial crisis, or its aftermath, when the subprime mortgage market collapsed, Lehman Brothers failed, and we were plunged into the worst financial crisis since the Great Depression.

Oh, and don’t forget about Bernie Madoff, the investment advisor who swindled people out of billions and left them with nothing.

But if you study these economic cycles and you stay patient, you should be able to profit off of other people’s emotional investing.

Us Economy Economic Cycles

via Drop Dead Monkey

Plus, if you thought your money was safe & would at least hold its value in your savings account, you’re wrong.

How much interest does that money make?

Most banks pay far less than 1% interest a year. At the same time, the average inflation rate is about 3%.

So your money is actually losing value by sitting in the bank. Inflation chips away at your money’s buying power. If a cup of coffee costs $1 now, on average it should cost around $1.03 next year.

But the money in your checking account only earned 1%. That means your $1 in the bank will only grow to $1.01. So, you’ll be two cents short for that cup of coffee after one year.

Why? Because your money just lost value in the bank.

Now, you could take two pennies out of your pocket to pay for the coffee but calculate this loss of value with many more dollars over many more years, and your retirement could look pretty grim.

If you kept $1,000,000 sitting in the bank, after one year, that million dollars would lose around $20,000 worth of buying power due to inflation.

For all of those scary things we mentioned above, investing can make you money over the long term.

Don’t take our word for it. These are the average annual returns of the stock market for each decade from 1950-2015.

Even accounting for the down years, the overall average is still 7%.

Proper asset allocation and diversification are how you mitigate the risk of investing. The real risk is not investing your money.

This Sounds Like a Lot of Work!

There is work involved, but the good news is, most of it is at the front end. Once you choose your investments, you can mostly leave them alone to do their thing.

You will need to tweak things like your asset allocation as you get older but you don’t need to adjust it every year.

You may also need to make changes as major life events happen. If you decide to start saving for a home, you might lower the amount you are investing every month and divert some money into a savings account, depending on your time horizon.

If you have children, you may want to divert some of your investment money into a 529 College Savings Plan to help pay for their college education.

If You Want to Grow Your Wealth…

Investing is one of the best ways to grow your wealth and secure your future. The longer you wait to get started, the harder it is to catch up. Investing can help give you the financial freedom we all want.

Knowing that you have a growing nest egg allows you to do things like start your own business, switch careers, go back to school, or retire early.

Plus, investing will help insulate you from the coming impact of automation. It’s coming, and it’s coming soon. It’s estimated that within just fifteen years, 38% of American jobs will be lost to automation.

Automation is Taking Over

via Big Think

So stop waiting and start investing.

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