I have a philosophy which probably comes through in some of my early posts about no-nonsense investing, risk versus volatility, and how to think about “crises.” I also cover some tips for investing in your 401(k). But I’ve never really defined the basic concepts or explained exactly how to get started on your own investing journey.
So, my friends, brace yourselves for a series of posts related to the fundamentals of investing. This month, I’m going to define some key investment terms to lay a foundation for you.
1. Saving versus Investing: This has to come first, because you need to know what investing is to start doing it with intention. Fundamentally, the differences between saving and investing are about timeframe and purpose. When you’re saving, you’re storing or collecting money for shorter-term purposes, like emergency reserve or expenses you will have within the next few years. When you’re investing, you’re focusing on growing your money to meet your long-term goals, like financial independence. You’ll have different strategies for saving versus investing, which you’ll see as we move along.
2. Assets: This seems like a good segue to defining assets. An asset is, very simply, something that has value. Assets make up your universe of potential investment options, and they include things like personal property, real estate, stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), and even intangible property like book copyrights and patents. In a later post, I’ll go over the most common asset classes (types of assets) you might invest in.
3. Compounding: At its most basic level, compounding is reinvesting what an asset earns to generate even higher earnings over time. For example, if you were getting a 5% return on a $10,000 investment every year, you’d earn $500 the first year and you’d have $10,500 at the end of that year. If you kept the $500 invested, you would earn 5% on $10,500 ($525) in the second year and have a total of $11,025. The amount of money you'd earn would continue to increase each year because of this compounding effect. This means the earlier you get started, the more your account value will grow over time. Imagine what will happen if you keep contributing, too!
4. Rule of 72: I can’t mention compounding without telling you about the Rule of 72. It’s an equation you can use to figure out how long it will take to double your money at a certain rate of return. Let’s run through an example: if you’re earning 5% on an investment, how long will it take to double your money? The # of Years to Double = 72/The Expected Rate of Return (%), so 72/5 = 14.4 years. It will take 14.4 years to double your money if you're earning a 5% return.
You can also do the reverse and calculate the rate of return you need to double your money in a specific amount of time. The Expected Rate of Return (%) = 72/The # of Years to Double, so if you want to double your money in 10 years, 72/10 = 7.2%, and 7.2% is the rate of return you need to get.
These equations apply to anything which grows at a compounded rate, like investments, investment fees, interest on loans, and inflation. They can help you understand the long-term impact of different rates of return and how much fees, interest, and inflation can cost you over time.
5. Inflation: This is an important concept when you start thinking about the rate of return you need to get on your investments. Inflation refers to the increase in prices for goods and services in our economy over time. For example, the rate of inflation in the US was 5% for the year ending in March 2023, which means prices went up 5% during that time. The key point is that (in the US, at least) the rate of inflation consistently goes up over time. This means prices continue to increase over time, and thus erode the buying power of your dollars as time passes. So, if you have a dollar today it will be worth a lot less 10 years from now; it will buy you less than it does now.
This is why you want investments which beat the rate of inflation over the long haul. If you’re getting 0.5% interest on a money market account or 4% on a CD, you’re probably not going to keep up with inflation. This is a good reason to invest in stocks; they have beaten inflation by quite a bit over the long term.
6. Owning versus Loaning: This is one way of thinking about investments. Some investments involve loaning money to others, like earning interest on a savings account. You’re technically loaning your deposits to your bank, and they pay you interest in return. Other investments, like stocks, involve owning an asset. When you buy shares in a company (i.e., stocks), you literally become a part-owner of that company. When the company grows in value over time, you can get dividends in return and the value of your shares can increase, too.
In general, loaning money to others tends to produce lower returns over time than owning assets. When you’re investing (i.e., holding assets over the long term), focusing on stocks and other ownership-type assets will generally deliver the higher returns you need to beat inflation. This doesn’t mean you shouldn’t have interest-bearing accounts or other loan-type investments, but ownership will drive the returns you need to outpace inflation.
7. Diversification: This term can refer to your investment portfolio (your total set of investments) or a specific type of assets like stocks. When you diversify your portfolio, it means you’ve invested in a range of different asset types, like stocks, bonds, commodities, real estate, and so forth. When you diversify your stocks, it means you’ve invested in a lot of different types of stock, like those from different companies, countries, organization sizes, and economic sectors or industries.
Diversification means that if stock values are going down, such as when inflation is high, you have other investments that will typically be going up in value (like bonds). And if you own stock in 350 companies, even if one goes out of business and you lose what you invested in their stock, you still have 349 companies to help balance that out. You’re more likely to meet your investment goals if you haven’t put all of your eggs in one proverbial basket.
8. Risk versus Volatility: Almost everywhere you read about investing, you’ll see people writing about investment risk. To get a higher return, they say you have to take on more “risk.” But “risk” is a complete misnomer; when people talk about “risk” they mean the risk that you’ll lose all the money you put in. If you have a diversified portfolio (see #7), the risk of actually losing every cent you invested is quite low. Sure, a complete meltdown of all world financial markets is possible, but the likelihood of that catastrophe is low relative to the likelihood that inflation will erase every bit of return you get on your cash or gold or whatever “safe” asset you hold instead. The real risk is that the growth of your investment doesn’t keep up with inflation and you don’t end up with enough money to cover your expenses for the rest of your life.
What’s more, you don’t truly lose anything unless you sell your investment. Unless you put ALL your money in one company and that company goes out of business, a diversified portfolio will rebound after a downturn. Even when the value of your portfolio goes down temporarily, it will come back if you don’t panic and sell while values are down. Since no one knows when a downturn or rebound will happen (despite what the snake oil hawkers might say), you just have to hang tight.
Volatility is NOT the same as risk; volatility is just the average amount of price fluctuation an asset experiences. Volatility is positively correlated with returns and is your friend. The less the value of an investment fluctuates, the lower the return. The value of cash in the US doesn’t fluctuate much, so you won’t earn much money if you invest in dollars or loan them out to banks. You need a stomach for price fluctuations to earn an inflation-battling return, but that’s not the same as risking all of your money. You’re allowing volatility, not risking everything, as long as you stick to that diversified portfolio and don’t panic.
9. Dollar Cost Averaging (DCA): This is a strategy for investing in which you buy investments at consistent, set intervals and with the same amount of money. This helps you take some of the anxiety out of investing, like when you worry you’re buying at the wrong time. If you buy $500 worth of stocks every month on the same day, sometimes that will seem like a great time to invest and other times it won’t. And that’s OK; the key is to NOT wait around for the right time. It’s important to just get started and stay consistent over time. 401(k)s are a good example of dollar cost averaging. If you put a certain percentage of your money into your 401(k) every time you get paid, that’s what you’re doing!
Just keep in mind that DCA and diversification are partners. You can’t just invest $500 a month in one company and expect to meet your financial goals. Your fortunes are completely tied up with the success of one company in this case, so DCA won’t work unless your investments are also diversified.
I hope this gives you an understanding of some basic investment concepts. Stay tuned for a discussion of all the different types of assets (asset classes) you can invest in, and some tips for creating an investment portfolio.
And a final note: congratulations for making it to the end of this post! I realize that investments probably sound about as fun as a swimming pool full of tar on a hot day in Alabama. For some people, the thought of investing provokes anxiety, or thoughts like, “I’m not good at this,” or “I can’t learn this.” Trust me, friends, you CAN learn this and you ARE smart enough to take care of your investments. You don’t have to do it on your own if you don’t want to, but you do need to know enough to be a smart investor. That’s where we’re headed. Thanks for joining me.