Time to Read (using avg wpm): 14 mins
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
~Robert G. Allen
Let’s break the ice and get familiar with the 2 most important concepts for the average stock market investor:
- Long Term Investing
- Compound Interest (Compounding)
Were going to see how much realistic potential the stock market can have, even for a brand new, average investor.
The stock market has been increasing in value at about 10% per year on average. It has it’s years where it grows 30% and it’s years where it drops 30%, but on average, since at least 1928, it has been increasing at a 10-11% per year rate.
So say you could invest $100 in an index fund of the entire stock market, 60 years ago.
More simply: what if you got 10% yearly compounded interest on $100 for 60 years?
Okay so after the first year you add your 10% to your principle, which is $100, giving you $110. Then, the next year you add your 10% and you have $120 right?
No. That’s what’s so cool about compounding;
you take 10% of your new principle, $110 and add 10% of that; giving you $121.
Well hey, that’s only 1 more dollar Luke. Yeah but watch this as we go through each year:
Ha! Pretty cool huh? 60 years of investing at 10% growth and you have 300x your money.
And that’s without ever adding to your principle. What about when you add another $100 to your principle every year?
At the end of the the 60 years, when you have put $6000 total into your fund, you will have amassed $364,277.97.
Btw $100 a year is nothing. That’s $8 and some change every month. I bet you could do much more too. Maybe $100 a month? $200? $550?
At $100 a month, $1200 a year, after 50 years at 10% a year, you will have a balance of $1,677,228.28. If you wait another 10 and make it 60 years you will have $4,371,335.61.
Okay, just one more I promise– here’s 10% a year at the maximum monthly deposit in an IRA, $550. At the end of 50 years you will have $9,224,755.55. Make it 60 years and it’s $24,042,345.85.
Okay but how is all that compound interest and the long 60 year term relevant?
Well that’s exactly what the stock market is. I mentioned before that the market has been growing at a 10% rate on average every year, in the long term, so long term investors, in theory, should be able to do exactly what was described above with certain investment vehicles.
Well no-one is going to invest for 60 years unless they start at age 15. And it’s impossible to say for sure what the stock market is going to do.
And the stock market isn’t compounding annually it’s compounding continuously at a changing rate determined by market value and algorithms calculating 100x over in the time-span of a mouse click.
Plus that’s all before taxes and who knows what the capital gains tax will be in 60 years.
And then there’s diversification and other market tactics to consider.
So yeah I guess it’s not as simple as free money and you may have to do some homework– but it’s certainly going to be better than growing your money at 0.06% in a savings account.
At 0.06%, the average savings account rate, after 60 years compounding annually on $100 you will have $103.66 (lol)– compared to compounding annually at 10% and ending with $30,448.16.
So now that our blood is pumping and our brains are itching for some stock market knowledge bombs, lets get it going:
- Getting Fancy
- Brokerage Firms
Investment vehicles are the different ways available to purchase assets and make money in the stock market.
These are what you drive to the financial freedom plaza. The top 3 most popular vehicles are bonds, stocks and mutual funds.
These vehicles are your tanks.
Very slow growing but safe. This is the vehicle you put some money into to assure some growth without worrying too much about fluctuation and volatility.
A bond is a loan. If you buy a bond then you are the lender and the government or a company is the borrower. The borrower pays you interest on the loan until the bond “matures” and then they give you the original money back.
A nice and safe way to drive to the financial freedom plaza– faster than a savings account but still going to take a little while.
The small ones are your flaming drag racing motorcycles and homemade bottle rockets strapped to a skateboard.
These can take you to the financial freedom plaza quickly– but they can just as well explode in flames.
The big ones are like armored vehicles; a little faster than a tank with a little less armor.
A stock is a share of a company. If a company puts out 4 shares and you buy 1 share, you own 25% of the company.
The value of your stock will be proportional to the value of the company. In the example above, say you bought your share at $100. The value of the company is then $400. Say the next day the company is worth $600, that makes the value of your share $150. Woo!
Now let’s imagine the other way, say the company’s value goes down to $200; now your share is worth $50. *Thumbs down*
If a company does well, your stock does well and vice versa.
“Yeah, I know how stocks work jerk,” you say.
Great. Let’s move on.
This is like a Honda Civic. A nice, clean car with good handling– but there’s a catch. You can’t drive it. It is driven by the first person you see; could be a race car driver or a tiny baby.
Mutual funds are a compilation of stocks, usually industry or strategy focused, with a professional manager.
This vehicle is generally more safe, diversified and easy– but it can still be funky.
- Mutual Funds are managed by professionals.
- They are diversified
- Super easy to pick and throw money at
- They put the “fun” in “funds.”
- Mutual Funds are managed by “professionals”– that get paid even if they mess up.
- Fees can take away from your returns and absolutely demolish your potential long-term compounding.
- Can sometimes have a high minimum investment requirement, such as $200,000.
- They put the “FU” in “funds.”
Their cousin, the ETF (exchange traded fund), is a better alternative in my opinion– and we will be getting to those in the Getting Fancy section.
What a concept.
The name of the game?
That delayed gratification.
My future me will be thankful.
Cash money millionaire.
Chew toys galore.
K9 IRA, a butterfly cinquian by Doug
End of intermission.
Advanced tactics and vehicles:
These are the tactics that if you forced them into the same vehicle metaphor here these would be the bat-mobile.
It can do exactly what you want it to do, but if you try to drive it without knowing all the levers, you will probably activate the driver side ejector seat…
If you have never taken calculus, you are brand new to this word and have an open and excited mind.
If you have taken calculus– stop shaking– this is different.
These types of investments are descendant from an original asset and can include futures, options and swaps.
There are 7 types of derivatives (according to Wikipedia). These are more complicated and really for people that are surrounded and engaged in stock market investing; not recommended for us plebeians (at least not without professional advice).
The only derivative that I think is worth mentioning is a future, or future contract, which is agreeing to buy an amount of stock at a predetermined amount at a specific time in the future. The only time you would do this would be if you speculated that the price of the stock would increase in the future and set yourself up to buy it cheaper than it will be. This can bite you too if the price drops and you still have to buy it at your agreed upon price.
Investopedia has a good article on derivatives if you want further explanation.
This is a way to capitalize on a hunch that a company is not doing well and you think their price will drop.
You borrow 10 shares at $3 and sell them.
Now you hold a “short position.” If the stock value drops to $2 and you close your short position, you buy the 10 shares back at the lower price and give the shares to the original lender.
So you get $30 for the original sale and spend $20 getting the shares in the first place. It may seem confusing but essentially you make $10 through this process.
Although it can work the other way and if you borrow the shares at $3 and the price increases to $5 and you close on it (to protect yourself from losing even more) then you will lose $20 through the process.
If you want to learn more about short selling, check out this short selling tutorial on Investopedia.
These are the Teslas. The less popular– but better (in my opinion) vehicles.
Exchange traded funds; the David to the mutual fund’s Goliath.
An ETF is a mutual fund without all the drawbacks. It’s a collection of assets, stocks, bonds, etc…, that are set to model after an index, commodity, industry or strategy. Essentially they are an easy way to diversify while focusing on what you want your portfolio to include.
Much better for long term strategy because of it’s diversification, low to no fees and concentration.
We will get into these more in the strategy part of this post but one random word to the wise I have been warned about is to avoid synthetic ETFs because they don’t model an index or commodity as closely as they should.
Real estate investment trusts
A sweet, liquid, alternative way for any investor to get into the real estate market.
Since their conception, REITs have done better than the top 3 U.S. stock market indices, the S&P 500, the NASDAQ and the Dow Jones.
As with all vehicle types, you will need to do your homework before you get into this but I would recommend having at least one REIT in your portfolio.
There are 3 kinds of REITs you can get into:
Mortgage REITs– These are REITs you buy into where you are introducing your money into a big pot of other investor’s monies that help provide loans and backing to mortgages for residential or commercial properties. The income you get from this type will be interest earned on the mortgages.
Equity REITs– In this type you pool your money with other investors to be part owner of a commercial property like a hotel, warehouse, office, etc… You make your money from this one in the form of rent from the entity using your property.
Hybrib REITs– a combination of the two types.
These types of income above are paid out to you in the form of dividends (which you pay taxes on) and, if you are interested in long term investing, I would reinvest the dividends right back into your REIT. Some REITs offer the option to enroll in a DRIP or DRP (dividend reinvestment plan), that will re-invest the dividends for you.
But not only do you get dividend income but you also get capital appreciation– that is, when the market price of your trust increases, the value of your holdings increase as well. But it works conversely as well and the real estate market can fluctuate pretty severely at times. But if you are long term– that’s no problem, plus you are getting the dividends.
For more info on REITs check out the NAREIT (national association of real estate investment trusts).
These are real, homogeneous things that you could hold in your hand like gold, silver, iron, or beef.
Gold is one of the most popular commodities.
Commodities can rise or fall in value based on those same old elementary school principles of supply and demand. Take silver for example:
There is a limited amount of silver in the world. When computers got popular, people were using a lot of silver for the circuit boards.
So that meant there was scarcity and demand. So the price went up. Those who had bought and held silver could now sell it at a higher price than they had bought it.
The commodity market… I only have heard it recommended as sort of an insurance policy in case something happens. Say currency as we know it changes and there is an ultra inflation and suddenly it costs $1,000 for a piece of bread. If you have a bunch of gold, you have money and financial value as a tangible element- instead of in a currency.
Which when you think about the name of it – ‘currency’ – it’s kind of scary. The whole word just means “at the moment it is this value but who knows what’s gonna happen…”
No real money is to be made if you are a beginner investor. 90% of investors actually lose money trading commodities. Just a sort of an “end of days” insurance policy- in my opinion.
End of Part 1
Alright there’s a lot more to this and this is getting pretty long, so I’ll cut it here and make a part 2.
In part 2 we will get to:
- Final Words
Thanks for reading, any questions or comments can be submitted in the comments section below!
There’s also a Terms segment of this topic. If you don’t know some of the terms, check it out by clicking that terms button.
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