In this new 6-part investment series, we will cover the basics of investing, review the different asset classes available, and detail the best way to start building an investment portfolio that suits you. No highfalutin investment terms or business Jargon, just straight forward advice to help you get started on your investment journey.
What Exactly is Investing?
Investing is the process of allocating resources with the expectation of generating income or profit in the future. From a strictly financial standpoint, the resource in question is money. This money is typically deployed across various asset classes such as stocks, bonds, and real estate in a bid to build wealth over time.
Savings vs Investing
Saving is what you do with the money you’re going to use to pay for short-term goals. For this reason, this money will need to be held in a highly liquid and easily accessible deposit account. Due to their risk-free and highly liquid nature, these savings accounts will offer little to no returns, leaving you with negative returns from an inflation-adjusted standpoint.
Investing is what you do with money earmarked for long-term goals like retirement. With a long time horizon, you can make growth, rather than liquidity, the priority, creating the opportunity to avail of positive returns over time.
Types of investments
Traditional asset classes
• Stocks: Partial ownership of a company
• Bonds: Interest generating loan to a government or company
• Cash Equivalents: Low risk, low return, highly liquid short-term investments such as Treasury bills and Certificates of Deposit
Alternative asset classes
• Real Estate: Direct property investing or a REIT type structure
• Private Equity: Investing directly in companies not available on public exchanges
• Commodities: Gold, oil, etc.
• Hedge Funds: Actively traded investment funds that trade relatively liquid assets and employ various investing strategies to earn a higher return
Various investment structures
• Mutual Funds: Managed portfolio, pooling money together with other investors to purchase a collection of stocks, bonds, or other securities
• Index fund: a type of passive mutual fund. Instead of paying a manager to pick investments, it matches the holdings of an Index fund such as the S&P 500
• ETF’s: Collection of securities, such as stocks, typically tracking an underlying index. ETF’s are different to index funds and mutual funds as they are traded on an exchange with price fluctuations throughout the day, while mutual funds and index funds are priced once a day at the end of each trading day
While historical performance is not a guarantee of future performance, it provides insight into how specific asset classes behave over time and their long-term return potential. Over the last 20 years for example, all asset classes have outperformed cash, despite two significant downturns during this 20-year period in the form of the dot com crash and the financial crisis.
20 Year Annualised returns 2000-2019
10 Year annualized returns 2010-2019
The wonders of compounding
Time exerts the greatest influence on your investment portfolio. Through the power of compounding, a small amount of money over time can grow into a substantial sum. Within financial circles, compounding is often referred to as ‘magic’ or ‘an investor’s best friend‘ while Alfred Einstein once described compound interest as the most powerful force in the universe.
Compounding is simply when the returns you earn on your investment start to make returns, creating exponential growth over time. We can sometimes struggle to comprehend the power of compounding as we tend to think of growth in arithmetic as opposed to geometric terms. Taking the below example tracking the return of a single $1,000 investment over 30 years, you can expect to earn nearly 20,000% more though your investment account.
The sheer power of compounding should add a sense of urgency to everyone’s investment plan regardless of your financial goals. If you wait just six years to get started and your assets grow at 12% annually, you will have half as much money when you retire compared to starting today. That’s a life-changing difference in net worth for just a little procrastination.
Even though investing can generate attractive returns, it is not without risk. The biggest risk with investing is that you may lose the money you invest. Unlike your savings account, which is typically guaranteed by the FDIC. That being said, there are simple steps you can put in place to mitigate these risks such as diversification and managing your time horizon (we will go into more detail on these approaches in the coming weeks).
Certain investments are less risky than others, but all investments carry some amount of risk. The returns that you earn are a direct result of the risks you take. For someone to take on a lot of risk, there must also be the possibility of great reward. Conversely, investments with less risk typically have lower returns. In today’s market, there are a plethora of investment opportunities across the risk spectrum, ensuring that even the most risk-averse investor can generate positive real returns.
Stocks are generally regarded as one of the riskier investments due to the frequent fluctuation in the price of a given stock over time. This price fluctuation is referred to as volatility.
Returns of the S&P 500 index from 1960 to end August 2020
The cyclical nature of the stock market ensures that there will always be periods of negative returns, as evidenced in the above graph. If you are willing to accept this volatility as a market function and invest with a longer-term focus, you stand to generate substantial returns in the process. As you can see from the above graph, the stock market has followed an upward trajectory over time, bouncing back from each downturn in history to go on to record new record highs.
Of course, it is not as easy as just throwing your money into the stock market and coming back in 20 years to collect your winnings; if it were, I’d be out of a job. But by taking steps to put a well thought out and diversified investment plan in place, you can mitigate much of your risk and expose yourself to stable returns that will continue to compound over time.
Many view investing as being ‘too risky’, choosing instead to play it safe by holding all their money in their savings account. The reality is, this ‘risk-off’ approach is akin to choosing the poison drip, slowly eroding your spending power over time. Cash has underperformed all other major asset classes and is the only asset class that has continuously generated negative real returns in recent history. Food for thought next time you choose to ‘play it safe’.
How to get started
Over the coming weeks, we will delve into how you can build an investment portfolio that suits you and outline simple steps to help you get started on your investment journey, so stay tuned.