Saving your money and earning one to two percent s not the way to build real wealth. To build real wealth, you must invest! But how and where?
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The Foundation For Building Wealth
The best way to build wealth is by investing. whether it's through stocks and bonds or real estate, investing your money in assets that appreciate over time is one of the best ways to build wealth!
Merely setting aside money into a savings account will yield one to two percent. To make your money grow you must invest in the stock and bond markets. You have the potential of your money growing between an average annual return of six to ten percent, depending on how and where you’re investing.
Over time, through compounding, this adds up to a nice nest egg! Investing is not some get-rich-quick scheme. And neither is it rocket science. It takes time and discipline but it’s the most tried and true way to build wealth over time.
That amount compounded over time is one of the most effective ways to build real wealth. As the chart above shows. Investing $10,000 generating 5% per year will grow to $11,576 over three years. Inflation is between two for four percent. Investing withstands the effects of inflation eating away at your money over time since the returns are higher.
How do you know where to invest?
Investing is one of the best ways to increase your net worth and achieve your goals. But where do you start? Where you invest is dependent on a few factors.
Jodi and Dan
Jodi left all financial decisions to her husband Rick. Rick hired Tim, his high school friend, who happened to be a stockbroker, to manage their assets.
Rick was a realtor and both him and Tom had a high tolerance for risk. The investments were for their retirement after all, which was not for another 20 years. Tim invested a high proportion of their savings in hi-tech companies. Things were looking good.
This was in the late 1990s. But the hi-tech bubble burst. The value of their portfolio dropped by fifty percent. As a result of over eighty percent of it being held in high-tech stocks
Unfortunately, at that time Jodi discovered Rick was having an affair and left him. They had to divide their assets as part of their divorce settlement, The forty percent drop in the value of their investments shocked Jodi.
It would not have been as bad if Jodi could have left the investments to recover. But she needed the money. How Tim invested Jody’s investments did not align with her objectives.
The Nuts and Bolts of Investing
How do you invest your money? Where do you start? This is the process of asset allocation. It is the strategy of allocating your assets into different asset classes.
There are four main investment asset classes
1. Cash and Cash equivalents. 2. Fixed Income — bonds. 3. Equities — stocks and shares. 4. Alternative Investments — precious metals, art, bitcoin.
Cash or Cash Equivalents
Bank accounts short-term deposits and money market funds are examples of cash and cash equivalents. Highly liquid, they convert to cash with no significant risk of change in value. You may earn some interest in the course of having your money in them — usually between 0.1 to 2%.
Fixed Income
Fixed income investments give you a fixed amount of interest on a fixed schedule. Bonds are a popular type of fixed income. The issuer has to pay interest at a fixed rate at least once a year and repay the principal amount when the bond matures.
The issuer may be the government — as in the case of federal or municipal government bonds. Or corporations — as in the case of corporate bonds.
If kept to maturity, you get the principal amount back while collecting interest at least once a year. Bonds can be safe if you keep them to maturity. With many bonds, the value of the bond may fluctuate before maturity. Corporate bonds are more volatile and riskier.
Equities/Stocks
The third asset class is equities. Equities/stocks are shares of a company. When you buy stocks or shares of a company, you’re purchasing ownership in a company.
Of the three asset classes, equities generally have the greatest potential for growth. They are riskier than the first two. Equities are long-term investments for long-term goals providing an excellent hedge against inflation.
Even within equities, there is a wide range of investments. Blue-chip bank stocks are less volatile than mining stocks. International Equities are generally more volatile and more ‘risky’ than domestic stocks. Because they have the added dimension of currency risk.
Small-Cap stocks (stocks of smaller companies) are riskier than large-cap stocks. Large-cap stocks.
If you do invest in equities, you must be willing to tolerate fluctuations in your principal. With a long-term goal like retirement, you can afford to take some risks.
A substantial portion of public and employer pensions are invested in equities to ensure that money contributed is going to grow to meet the needs of the huge number of pensioners that retire each and every year.
A conservative portfolio has more cash and fixed-income investments. An aggressive portfolio will comprise more equities. A balanced portfolio has all asset classes in it. With an almost equal amount of fixed income to equities.
Alternative Investments
These include bitcoin, derivatives, gold, and silver, and even art. These assets are not as liquid as the others mentioned above. They are also the riskiest. Investing is not an exact science and does leave room for individual interpretation.
Why do you need to invest in all four?
This is the basis of diversification. Not all four asset classes respond to economic conditions the same way. The different asset classes do not all move in the same direction at any one time. When there is news of uncertainty, then the stock market may correct. This may cause investors to move their investments out of equities and into fixed income for safety.
You need all four asset classes so that if there is downward pressure on one of the classes, the others may act as a buffer on your portfolio and prevent it from falling too far.
Where you invest depends on:
your values
the objectives for your life.
the time in which you want to achieve your goals (Your Time Horizon for the investments)
your tolerance for risk.
Your Time Horizon:
Your time horizon is how long you are willing to let your money remain invested before needing to use it. Short-term goals are those you hope to achieve within 3 years. Medium-term goals are those slated for between three to ten years. And long term goals are those you hope to achieve in another ten years or more.
Investments to achieve short-term goals are different from those you are expecting to achieve over the long term. You should invest in cash and cash equivalents to achieve your short-term goals.
Invest in more equities (stocks) to achieve long-term goals like retirement.
One of the biggest “mistakes” people make is by investing in short-term vehicles for long-term goals. And investing in investments meant for the long term to achieve short-term goals.
Invest in more equities to achieve long-term goals such as building a retirement fund.
One of the biggest “mistakes” people make is by investing in short-term vehicles for long-term goals. And investing in investments meant for the long term to achieve short-term goals.
Your Tolerance For Risk
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What is “risk”?
When clients think of “risk” they think of losing their money. That would be their ultimate risk. From a financial planning perspective, risk has different meanings. For one, it is the degree of fluctuations (volatility) overtime on your money invested.
High-risk investments cause your principal to fluctuate more than low-risk investments.
Like everything else there are trade-offs. An investment with no risk has a very small return.
Then there is “inflation risk” — will the growth of your investments keep up with inflation? Inflation averages about 3% per year. You need an investment that provides a return of over 3% to stay ahead of inflation.
Your tolerance for risk is your willingness to see your principal fluctuate in value without getting into a panic.
If seeing your principal drop by more than five percent leaves you feeling anxious, then you are likely a conservative investor. You should restrict yourself to cash equivalents and fixed income.
A portfolio made up largely of term deposits and government bonds. If you are not comfortable with your money fluctuating in value then you need to be comfortable with seeing minimal growth in your investments.
If you are an experienced investor and are willing to see your portfolio drop by thirty percent knowing that it is temporary, then you are likely you would be comfortable with an aggressive portfolio. One with a high portion of equities and even some alternative investments like commodities, bitcoin, and precious metals.
Your Values
Now, more than ever, where you put your money speaks volumes for what you value. The money going into Social Responsible Investments (SRI) has grown exponentially over the last ten to fifteen years! And it’;’s women and millennials who are leading the way in this space. Socially responsible investing is the practice of investing in companies that have positive social impacts such as renewable sources of energy.
Your Overall Financial Situation
If you have a high tolerance for risk but have no other sources of income, you should still avoid putting the bulk of your portfolio into high-risk investments.
If you had a financial emergency and need to use your investments, you do not want to be forced to sell off your investment if there was a prolonged downturn in the stock markets.
Back to Rick and Jodi and some important lessons from this story:
It seemed at first that they had a long-term time horizon for their investments. Because of their separation. Jodi needed the money sooner than planned.
The investments reflected Rick and his broker’s tolerance for risk rather than Jodi’s. Did Tim even ask her what was important to her?
Did he do a risk tolerance assessment with her or was it just based on her husband?
Rick was a realtor with unpredictable income. It would have been better to have a lower risk portfolio to balance the uncertainty of Rick’s income
Was there an emergency fund created to deal with life’s unplanned events?
The portfolio dropped by 40%. It was an aggressive portfolio. Unless you are certain you will not need the money for a long time and have other liquid assets as a backup, you should not be in an aggressive portfolio.
Bringing It Altogether
Investing is one of the best ways to increase your net worth and achieve your goals. You need growth if you have a long-term time horizon. If you are concerned about risk, ask yourself, “can you afford NOT to take any risks?”
Taking a risk does not always translate into a high return. But in general, equities have, on average, a better rate of return than cash equivalents. You need to take some risks if you hope to achieve your long-term goals. Work with an advisor who is aware of your objectives for your money and your tolerance for risk. One who can help you create a portfolio that aligns with your needs.
Additional Resources
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This article was written by Jennifer Thompson
This post contains affiliate links. I may receive a commission (at no additional cost to you) if you choose to purchase the products and services I recommend. Through coaching, webinars and public speaking Jennifer helps people and businesses discover how to achieve success on their terms. She has written numerous books on money: Women and Money: 7 Principles Every Woman Needs to Know to Be Financially Prepared in Any Economy and Growing Up With Money: Raising Financially Resilient Kids in an Age of Uncertainty.
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