Issue 3 of How to start investing
The first step to investing is to pay yourself first. In order to invest, you need to have the money to invest and to do so, we must change the way we manage our money. Typically, we get our pay check and take care of our expenses and hope that we have some money saved at the end. As a consequence, most people find that they don't have enough money to invest.
The first step to investing is therefore to pay yourself first. What this means is that when you receive your pay check, you set aside a certain percentage for your investment portfolio. The rest of the money is for you to pay bills and spend on other items. Lot of people fail to invest consistently because they miss this first step. Without paying yourself first, you are not adding money to your investment portfolio every month. This could make a huge difference in your investment portfolio.
Investing works due to the principle of compounding interest. Compounding interest means you earn interest on the interest earned! For example, let's say you start investing with $1,000. Historically, the average return of the stock market (using the US as an example) is 10%. So let's say for example you earned a 10% return in year 1 and hence now have $1,100. Now when you re-invest this sum and get another 10%, you are earning 10% of $1,100 which is $110. Hence, you now have $1,210. This process repeats and repeats until you have a larger and larger sum.
Now let's say that you decided to pay yourself first and added an extra $1,000 a year to your portfolio. Thus, you start with $1,000, earn a 10% return and have $1,100. But now you add another $1,000 so you have $2,100. A 10% return on this would be $210. Hence, at the end of year 2, you have $2,310. Now, you add another $1,000 again so you invest a total of $3,310.
Over a 10 year period, this would make such a vast difference. The person who invested $1,000 and didn't add anything afterwards, would have $2,593.74 after 10 years assuming an average annual return of 10%. However, the person who invested an additional $1,000 every year would have $18,531.17!!!
Having learned this, here is an exercise for today - determine the amount of money you will set aside every month for your investment portfolio. Multiply it by 12 to get the amount you will add to your investment portfolio at the end of each year. Though past performance is not indicative of future performance, let's assume that you are able to get a 10% return on investment per year on average. Take these figures and plug them into the compounding interest calculator found on this website.
Experiment with how much your investment portfolio will be worth at the end of a given number of years (e.g.) 5 years or 10 years.
Next, determine how much you need a year to survive - this includes money for rent, food etc.... Then, divided it by 10% (i.e.) divide it by 0.1. Use the compounding interest calculator to find out how many years it will take your investment portfolio to get to that figure. At that stage, the return on your investments can cover your living expenses without you having to withdraw any money from your investments!! Experiment with how sooner you can reach that goal if you saved some extra money every month to add to your investment portfolio.
To watch me demonstrate some live examples of using the compounding interest calculator, visit this website and look through the section entitled "Step 1: You yourself first" and "Step 2: Compound."
Legally required disclaimer: All information presented is for educational purposes only and is not a advice to buy/sell any stock or other investment instrument. Investors are solely responsible for their profits/losses. The instructor has taken care to ensure accuracy of the information presented but no guarantee of this is provided and the instructor shall not be held liable for any inaccuracies.