2 Investing Concepts Everyone Should Know

by Matt Bell on 16 May 2013 4 comments

Investing is arguably the most complicated and intimidating topic within personal finance. Understanding (and making use of) two key investing concepts will go a long way toward demystifying the process while dialing down the fear factor. Let's get started! (See also: The 10-Step Staircase to a Comfortable Retirement)

Compound Interest

At first glance, this one seems like no big deal. Compound interest is simply interest earning interest. For example, if you invest $100 and are able to earn 10% on that money, in a year it will have turned into $110. The next year, assuming you are still able to earn 10%, it isn’t just the initial $100 that earns interest, but the interest you earned last year will earn interest as well. So, you won’t end up with $120 at the end of year two; you’ll end up with $121.

Okay, so it’s not that impressive. But wait. Let’s put more money to work and give it more time.

Imagine investing $200 per month for your retirement beginning at age 20. And let’s assume you can get a 7% return on that money. By age 30, you will have invested $24,000. That’s $200 per month for 10 years. However, because of the 7% return, your $24,000 will actually be worth $34,617. Not bad, right? You racked up more than 10 grand in interest in just 10 years!

Don't Stop Believing

But wait. The longer you give it, the better it gets. Let’s run this all the way out to age 70, which, let’s face it, will probably be considered "early retirement" by then.

The $200 you’ve been dutifully tucking into your 401(k) plan all that time adds up to $120,000, an impressive amount unto itself. But because of the power of compound interest, that sizeable sum has become much, much more sizeable. In fact, it’s now worth more than a million bucks. Now that’s impressive. You’ve earned about $970,000 in interest through the power of compound interest.

This is why Albert Einstein reportedly called compound interest "the eighth wonder of the world." Even if he didn’t say that, it doesn’t take a Nobel prize-winning scientist to understand that compound interest is a relatively powerful concept.

Speaking of Einstein, there's a complicated looking formula for calculating compound interest. It's actually pretty straightforward once you understand the terms.

Even better, here's an online tool that calcualtes it for you.

On a side note, this is exactly why it takes so long to get out of debt. Debt takes the strong wind of compound interest and flies it in your face. Keep the wind at your back by investing.

“Fair enough,” you say, “but where can I get a 7% return?”

Asset Allocation

Pick up any personal finance magazine and you’re likely to see breathless headlines about the latest mutual fund to rack up impressive returns. But you’re not fooled. You realize that last month’s hot performer might be tomorrow’s dog. So which fund will do well next month?

Surprisingly enough, generating a respectable return on your investments isn’t so much about the specific investments you choose. It’s how you spread your investment dollars around. This is known as asset allocation. It may have a boring name, but asset allocation has been found to account for about 90% of investment returns.

Choosing Between Stocks and Bonds

The key asset allocation decision is what percentage of your investment dollars to put in stocks and what percentage to devote to bonds (or stock-based and bond-based mutual funds). Stocks are riskier than bonds, but they have the potential to earn a higher return. In general, the younger you are, the more your investment mix should tilt toward stock-based investments, but your risk tolerance matters as well. You can find lots of free asset allocation calculators online.

The calculators will typically suggest something a bit more detailed than stocks vs. bonds; they may recommend that you devote different percentages of your money to large-cap stocks (the stocks of large companies), small-cap stocks, foreign stocks, and bonds. Most brokerage houses, such as Fidelity, Vanguard, Schwab, and others, offer index mutual funds in these categories, which can provide a low-cost, relatively simple way to invest in those categories.

So, those are two key steps toward becoming a knowledgeable, successful investor. First, make use of the power of compound interest by getting started with investing as early as possible (although it’s best to wait until you’re out from under any credit card or vehicle debt and have a base of savings totaling three to six months’ worth of essential living expenses). And second, base your investment decisions on an intentional asset allocation plan that’s tailored to your age and risk tolerance.

What are your key investment concepts?

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Guest's picture

Investing is really great despite of the risk involved in it. Long term investments are the best way to go when you start to invest. Just like what you said, compounded interest is very helpful on this. I just want to say that everybody should learn to invest as early as possible to maximize his earnings and help him or her have a better financial life before he or she retires.

Guest's picture

It's amazing how powerful these two simple concepts are. It's important for people to start saving as soon as possible to get the most out of compound interest.

As savers age, they should transition their money into mostly bonds, to protect their earnings. Young savers have time to bounce back from a market dip, but older ones might not.

Guest's picture
Kat H

The concept of compounding interest is huge. It seems like this generation has no patience. We want things and we want them NOW. But, investing in something, whether it's stocks, bonds, or savings has the benefit of a long term payoff.

There's a new piece that shows the returns if a consumer invested in a company instead of a product by that company. It's pretty incredible to see that a $520 investment in starbucks in the early nineties would amount to almost $50K in profits today. That's the kind of long term payout worth waiting for!

Article here for reference: http://bit.ly/12f8438

Guest's picture
DivHut

Compound interest/dividends is amazing. When investing in dividend growth stocks you not only generate a future income for yourself but also allow the magic of compounding to do its thing. Investing and re-investing those growing dividends year after year for several decades will no doubt ensure a steady stream of income for retirement.