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Investments

Investing for the Future

One of the defining traits of western societies is the expectation of financial independence, even from those whose families may have enough money to support seven future generations. For most of us, high school graduation marks the end of financial support from parents which could also be interpreted as their acknowledgement we are finally adults. Just like death and taxes, it is certain in life that we will always have expenses but one cannot say the same for the income aspect. Thus, we earn income not only to support our present but also future and like other important decisions, a little planning goes a long way towards ensuring a pleasant future. One is often tempted to make excuses for not investing money in the future because immediate gratification is always more satisfying than planning for a distant future but most of these excuses such as having little income or too much time to save for the future have little or no sound basis. This is why investing should be adopted as early as possible because not only it makes investing a less painful experience but this strategy also increases the probability of financial independence for life.

Albert Einstein declared ‘compounding’ to be the most powerful thing in the universe (Roth) and in doing so, he probably also offered the most compelling argument to start investing early no matter what the income level may be. Often examples help us understand a concept better than the actual idea. The beauty of compounding interest is that it addresses two excuses often made against investing early. For those who complain about having too little income or money, compounding demonstrates that little investments over a long period often beat huge investments over a short period. Thus, early investing helps an individual secures his financial future without diminishing the quality of life in the present. According to the rule of 72, someone who invests $100 at 9% at the age of 35 will have $400 by the age of 51. In contrast, an individual who invests $50 at 9% at the age of 19 will have $800 by the age of 51. This example tells us how investing earlier with even small amounts is preferable to investing later with larger amounts. Most individuals make the mistake of overestimating the importance of initial investment and underestimating the importance of time element. Similarly, someone who invests $100 at 5% per annum interest rate will have $162 after 10 years but $340 after 25 years (U.S. Securities and Exchange Commission). In other words, the deposit’s combined growth rate was 62 percent over 10 years but an astonishing 340 percent over 25 years.

Not all investments are created equally and the expected returns usually reflect the risks involved. This is why bonds usually have lower expected returns because they are deemed safer than bonds. While bonds are safer, allocating most investment funds to them is less desirable in the long term as opposed to the short term because longer time horizon affords an investor the luxury to take higher risks in pursuit of greater returns. This is why investment alternatives to bonds such as stocks are recommended to those starting early or who still have a long path left towards retirement.

It is also important to diversify as reflected by a famous saying ‘never put all of your eggs in one basket’. There is no single investment vehicle whose profit potential justifies the risk involved in relying on only one investment instrument. This is why one should divide investment funds or assets among different investment instruments such as bank CDS, money market funds, stocks, Treasuries, and real estate (Dunnan). Even those nearing the age of retirement may still hold on to a diversified portfolio though most of their assets may be relatively safer investments such as Treasuries and bonds. The risks in investing are mostly the product of events over which individuals or even the underlying companies may not have any control. Companies’ performance is not only determined by leadership and employees but also external factors such as the state of the economy, trends, and political/legal factors. This is why it is important to have a diversified investment portfolio so that a poor performance of any single investment instrument doesn’t threaten the entire future financial security.

Discipline is also extremely important in investment and numerous strategies could be adopted to ensure that one continues to grow his/her nest egg for the future. One strategy is to ‘pay yourself first’ or simply putting aside a portion of income aside for investment purpose before creating expenditure plans. Another strategy is to participate in employers’ 401(K) plans in which employers often match the employees’ contributions up to a certain level. Some of the greatest benefits include tax-free growth of funds, free money from the employer, and the deterrence against early withdrawals due to penalties (CNN Money). Discipline in investing also involves realization that active investment management doesn’t necessarily result in higher returns and in fact, passive investing works better for most people, especially those with limited investment funds. This is because passive investing such as index funds don’t charge as high fees as actively-managed funds and fees also don’t add up due to frequent buying and selling which only hurts the overall annual returns (DeFeo). Investment decisions can also be influenced by emotional factors such as buying frenzy or stock sell-offs which often lead to disastrous results. One should avoid temptations when it comes to investing and instead follow logical principles. In fact, going against the crowd is often a sound investment strategy according to Warren Buffet who advised investors during the recent financial crisis, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.” (Buffet). In other words, buying stocks rather than selling stocks is a better strategy during recession and the reverse is true during boom times. Buffet’s advice is best understood in the light of economic concept of supply and demand as most investors sell stocks during recession, making them cheaper in price and increasing the probability that buyers will get a great deal. Similarly, strong demand for stocks during boom times increases the probability of stocks being over-valued. Thus, discipline goes a long-way towards impressive long-term returns and Warren Buffett is perhaps the best example in modern times.

Even in investing, the concept of opportunity cost should not be ignored. Many people complete college with student loans and other debt obligations. Thus, there is a temptation to pay-off loans first before allocating funds to investing. But the decision should only be made after comparing the costs and benefits of first option which is to pay-off loans first before investing and the second option which involves dividing funds between loan payments and investing. If the average interest rate on loans is high such as 10 percent or more, it may make sense to completely pay-off loans before investing (DeFeo) otherwise one could divide funds between loan payments and investing activities.

People are often discouraged from investing early in their lives due to certain misconceptions such as the need for significant funds and in addition, they also severely understate the importance of time element. Compounding is a powerful tool which is why it pays to start investing as soon as possible. In addition, one should have a diverse investment portfolio in order to minimize the impact of poor performance by any single investing instrument. Investing early also allows the individuals to pursue higher-risk but also more profitable investment opportunities such as stocks. Discipline is also very important in investing and one should make investment decisions on the basis of sound and logical reasons rather than emotions which often drive the overall stock market trends.

References

Buffet, Warren E. Buy American. I Am. 16 October 2008. 9 April 2013 <http://www.nytimes.com/2008/10/17/opinion/17buffett.html>.

CNN Money. How to invest in a 401(k). 9 April 2013 <http://money.cnn.com/magazines/moneymag/money101/lesson23/index3.htm>.

DeFeo, John. How to Invest – Basic Investing Strategies. 31 October 2012. 9 April 2013 <http://www.thestreet.com/story/11748100/1/how-to-invest–ways-to-make-your-money-grow.html>.

Dunnan, Nancy. “Introduction.” Ed. 10. HarperBusiness, December 29, 2009. XV.

Roth, Allan. Compound Interest – The Most Powerful Force in the Universe? 7 June 2011. 9 April 2013 <http://www.cbsnews.com/8301-505123_162-37743513/compound-interest—the-most-powerful-force-in-the-universe/>.

U.S. Securities and Exchange Commission. Tips for Teaching Students About Saving and Investing. 9 April 2013 <http://www.sec.gov/investor/students/tips.htm>.