Anybody with common sense understands that saving money is important. Whether we’re talking about financing your future or investing capital for a higher return, you’d need the money to do it. The start of it all is savings.
With long-term financial goals, such as planning for retirement, there are two main factors to your success: your savings rate and your rate of return. If you have a short term goal, your savings rate is the most important factor; however, as you start moving towards a longer term perspective, the rate of return becomes increasingly important.
Let’s look at a basic example. Say you want to purchase a home in five years, and you estimate that you will need $50,000 for a down payment. Between now and five years from now, the amount of money you save is much more important than the return on that money. This is mainly because of the lack of time for compounding interest to have a large effect.
Now consider another example: say that you will need $2 million for retirement 30 years from now. While saving and contributing money towards retirement is important, especially in the beginning, the rate of return has a much bigger impact on your success.
The following chart demonstrates the power of your rate of return over a time span of 30 years. As you can see, even if you save less each month, after 30 years you will still have saved more, thanks to a higher rate of return:
You can experiment with the numbers more, using Bankrate.com’s Simple savings calculator.
Increasing Your Return
Now that we’ve demonstrated what a difference the rate of return can make down the road, let’s talk about increasing it.
Someone who gets paid to provide financial advice may like you to believe that you’re not smart enough to invest successfully on your own. Buying into this idea is exactly what keeps these folks in business.
And it’s important to understand that I’m not recommending that you try to time the market, engage in day trading, or spend every free moment you have analyzing financial statements of obscure companies.
I am, however, suggesting that if we’re cautious and diligent, we can begin to learn sound investment strategies and, over time, work towards an incrementally higher rate of return than you could ever get through, say, simply keeping your savin gs in the bank. As we’ve already shown, even an increase in a single percentage point of return can make you much wealthier over time.
Becoming an active investor is intimidating for many people since most of our experience with the stock market is through a passive investment vehicle like a 401(k) plan. There are ways, however, that we can move towards becoming more active in the stock market — with caution.
How To Ease Into Active Investing
With the rise of Exchange Traded Funds (ETFs), we can buy or sell investments representing a broader share of the global economy as opposed to a single company’s stock.
ETFs can be a less intimidating way for new investors to get active in the market. For example, you can buy an ETF that represents a group of large energy companies. Or, you can buy an ETF that represents the Chinese stock market. Or maybe you just want to buy an Index ETF that represents the S&P 500.
ETFs are bought and sold just like stocks, so you will still get the valuable experience of buying and selling positions — without exposure to the risk of a single company imploding.
Secondly, I would strongly encourage new investors to move in and out of positions in chunks. To do this, first determine the total amount of money you wish to allocate towards a specific ETF or stock. Instead of allocating the total amount into the position at one time, split the amount into halves or thirds. Move the chunks of money into the position over time in multiple transactions. By doing this, you will be at less risk of buying (or selling) at an improper time. It is a more cautious, conservative approach — also known as dollar cost averaging — and one that is wise for new investors.
Lastly, consider sticking to large-cap, well known companies (or, in this case, ETFs that track them). Take a look at the companies on the Dow Jones Industrial Average list. Don’t attempt to trade smaller companies and avoid from penny stocks.
I encourage you to stick to liquid stocks for well known, well established businesses. I would also recommend companies with a high dividend yield as the dividend income can help offset any potential losses you might incur with share price depreciation.
How much you save — or your savings rate — is important when you’re looking at a short-term goal. But with long-term investing goals such as retirement, your rate of return has a much bigger impact. The good news is that, if you have decades of investing ahead of you, you can afford to be patient with learning how to invest (as long as you keep those retirement-fund contributions coming, of course). Ultimately, a few years of slow learning may have an enormously positive impact on the size of your portfolio.
Kevin Duffey blogs about personal finance at 20smoney.com.