Introduction
Investing for retirement or your little one’s college fund can be scary and often fraught with information overload. Financial pundits and gurus tell you to try this, that, and the other only confusing you and/or your significant other even more. Financial influencers throw around terms like “diversify”, “portfolio”, and “risk averse”, but what do these terms mean?
In this post, I will define these big and, frankly, intimidating words and walk you through some concrete examples of how to reduce your risk and increase your income from investing. Disclaimer: This is not investment advice but merely information to add to your financial toolbox. Always consult a qualified financial advisor before making investment decisions. They are there to help you for a reason.
Risk and Reward
The first piece of knowledge to understand about investing is the concept of risk vs. reward. Risk can be thought of as the chance you could lose money. Reward (return) could be thought of as the profit you can gain from an investment. Everything in your investing toolkit will be based on the concept of risk vs. reward.
Watch the video below to understand risk vs. reward:
Most new investors want to reduce risk and maximize return. This is the goal of almost every type of investor including big companies and governments. However, the new investor is more risk-averse than the corporate giants. What does risk-averse mean? Simply put, you avoid risk.
Hey, don’t judge. Finance is simpler than you think.
Usually, investments such as US Treasury Bonds are relatively low risk. However, Treasury Bonds, or “T-Bills” as they are affectionately called by the finance geeks, produce returns in the 1-4% range. That means if you invest $100 in one of these mystical things at 4% returns, at the end of a year you will have $104. Obviously, your retirement cabin in the mountains is going to be a cardboard box fort at that rate. So what can you do to increase your returns?
Diversify.
Diversification and Compound Interest
What is diversification? Simply put, diversification is spreading risk across a wide assortment of investments. What you are looking for here is balance. If you have a high-risk investment, such as stocks, you can balance that out with something of a lower risk, such as bonds. The two risk levels will balance each other out, like pouring ice on a fire. The returns will also balance each other out, and the result is higher returns with reduced risk.
Okay, so we figured out how to mitigate risk and increase returns. That’s all there is to know, right? Wrong. There is one more tool in the savvy new investor’s toolbox, and that is compound interest. What is compound interest? The investor’s muse. I’m just kidding :P. However, compound interest is an extremely powerful tool.
Compound interest is a money multiplier. Over the course of time, with compound interest, your money will grow exponentially. If you’ve ever heard the saying “Multiplying like rabbits”, that is what your investment will do. A great tool to understand the power of compound interest is this tool from investor.gov. For example, if you put $100,000 at age 25 into an investment account that earns 10% compounding interest annually (or APY) and let it sit for 40 years, you could have roughly 4.5 million dollars by the time you are 65. Graduated from that cardboard box fort, haven’t we? 😉
Not too shabby, huh?