Long Term Investing
Life goes by very quickly and it’s easy to defer investing until you feel more knowledgeable or have more money. However, I strongly encourage you to get started as soon as you can. You find good employment, you create a workable budget that builds in monthly savings and you participate in any company retirement plan available to begin your investment process.
I have mentioned several times to invest for long term growth. When you are young you can afford to be more aggressive in your investments, especially within a retirement plan. Remember too that the markets inevitably go down from time to time and this becomes a bonus for you as you continue to systematically and unemotionally invest even when prices are low. This strategy alone can create great wealth over time. One thing I have learned in my years of investing is that no one, not one person, has ever been able to consistently predict the future of the stock market. I know that the companies in the stock market are made up of people just like you and me. Those companies must run their business to make a profit and thrive over time or they will not survive. This is where the growth in your investment comes. Mutual fund managers are constantly on the lookout for the next Apple Computer or Starbucks Coffee. Companies like them have rewarded their shareholders very handsomely over many many years. There is no reason for you to stay on the sidelines and miss participating in that growth.
If I were to identify the greatest barrier to creating wealth over time it would be the emotion of fear. When we get scared we are often afraid or unable to take action of any kind. This paralysis certainly translates to the investment world and can be a serious detriment to your financial future. The flip side of fear is greed – this too can have a devastating impact on your long term financial well- being.
In 1999 technology companies were soaring in the stock market. The prevailing feeling was technology was going to be more and more a part of our lives (which was true) and one couldn’t lose by owning these types of investments. Greed caused people to flock to technology investments like lemmings marching mindlessly toward the precipice. In early 2000 the tables turned. Within a very short period of time the value of many of these companies decreased significantly. The prediction of ‘can’t lose with this’ was terribly wrong.
In 2006 the same mindset was demonstrated in the real estate markets. Low interest rates and lots of ‘eligible’ borrowers made the real estate market soar. Everyone wanted in just like the technology lemmings of 1999. The result of this ‘can’t lose’ mentality in the real estate markets mirrored that of the technology crash. Many people found their investments worthless or substantially reduced to the point they were ruined.
It gets back to our own psychology – we want in on the action but are compelled by our emotions to make terrible decisions. Each one of these periods of wealth decimation was followed by extreme fear and a ‘get me out at any price’ mentality. Recognize the greed to fear cycle and avoid it.
Investing for the long term takes away these emotional mistakes we all can make. Remember with dollar cost averaging we invest every month without regard to what the markets are doing today. We have our emergency fund set up, we budget closely, and we invest for the long term. Creating wealth is easy in many ways as long as you keep your emotions under control. Don’t do what everyone else is doing. Sure, buying tech stocks in 1999 provided a lot of short term ‘good feelings’ but in a very short period of time it was taken away. People who paid exorbitant prices for real estate in 2006 are now left holding properties that are well underwater in value. Smart investors did not change their process. In fact, a smart investor might even raise the level of investment as prices came under the siege of mass fear. Today, in 2013, real estate is now a much better value because of reduced prices.
One of the smartest investors of all time, Warren Buffett, is famous for investing in out of favor industries when everyone else is running for the door. This takes great courage and faith but is absolutely the best way to create wealth over time. The fact is no one knows the future. What is obvious though is when prices are cheap and when they are expensive. When everyone is flocking to a particular investment gains are usually limited and those investments are typically well advanced in price creating a much higher chance of loss. You see, we are built psychologically to want in on things that are working now – we love short term gratification. However, this can be terribly damaging to your financial well- being. Warren has made a fortune buying when no one else is willing and does not get caught up in ‘can’t lose’ fads.
Don’t Be Too Conservative
I find one of the greatest mistakes individuals make when investing is being too conservative. Again, in this case, our natural instincts for safety are something we have to fight. I’m not suggesting you speculate or even get too aggressive but most investors need growth of capital over time. There is this phenomenon called inflation which is truly the biggest enemy to any financial asset. Inflation is nothing more than seeing the prices of the goods we buy every day increase a bit every year. The long term average inflation rate is around 3% but at certain economic moments it’s been a lot more. All that means is that carton of milk you buy every week next year will cost 3% more than it does today if that is the current rate. For the past 5 years the inflation rate has been around 2%.
So let’s do the math. Let’s say you’re a very conservative investor and do not want to take any risk of capital. Your money is invested in things like CD’s (Certificates of Deposit, sometimes called Time Certificates) which are insured against loss by the U.S. Government. Unfortunately, there is a price you pay for this safety. Currently (2013) if you buy a CD that matures in one year it pays about 0.50% annually. If inflation is running 2% you are not keeping up. I like to use the phrase: ‘you are safely losing money every year.’ In this example you are actually going backwards by 1.50%, however, it is “safe”. (Inflation 2% - what you’re earning on the CD 0.50% = 1.50%)
Realistically most investors will need to earn between 7-9% to not only keep up with inflation but also grow their money. Retirement accounts in particular are an investment where you can afford to be more growth oriented. In addition, a home is an investment that has surpassed inflation fairly consistently. The point is playing it too safe can be harmful to your long term financial picture. Remember, stocks and real estate vary in price literally every day – their value depends on the current market for that investment. Both have had great long term returns for those investors with patience and a willingness to invest regularly.
- Invest long term by investing monthly – this reduces the chance for errors based on emotion
- Rejoice when particular markets are down in price – this becomes your opportunity to buy at excellent prices
- When everyone is doing something in the investment world do the opposite
Power of Compounding
I believe compound interest is the 8th Wonder of the World. This simple process has created a great deal of wealth over the years for many people. Essentially the concept is whatever interest or returns you create from an investment, your earnings, also begin to earn interest and returns. It’s a self- feeding process. A basic example: let’s say you have a $1,000 invested in an account that earns 5% interest annually. Over the course of one year you will have earned $50 in interest. The following year you start the year at $1,050 and earn another 5% on that money. At the end of the year you would have then earned $52.50 on the investment. Your money begins to compound or multiply on its own (multiplier effect). As time goes on this makes a larger and larger impact and is a primary factor in creating great wealth over the long term.
Compound Interest Table
Investors who are able to leave their initial investment alone (or add to it) over long periods of time can benefit greatly from compounding. The $1,000 investment mentioned above, if left untouched in a 5% interest bearing account, will be worth over $7,000 at the end of 40 years.
This next table shows the future value of a $1,000 investment over 20 and 40 years at various interest rates from 4% to 10%.
As you can see from the table the multiplier effect makes a significant and positive impact on your wealth over time.
- Investing long term allows your money to compound on itself
- Keep your money invested to take advantage of this power