Investing Basics: Getting Started

Why invest?

Welcome to Investing Basics! If you've found your way here, chances are you've either got some money socked away or you're planning to do so. What are you saving for? Retirement? College for the kids? A new speaker system complete with woofers and tweeters? An exotic animal menagerie complete with Chihuahuas (woofers) and canaries (tweeters)? A retirement villa in the sun-baked hills of Tuscany?

Say you take $2000 of your savings and put it into the stock market. If your money returned 11% a year (the S&P 500's historical average), two grand would be worth $53,416.19 after 30 years. You could buy that Tuscan retirement villa (or at least come up with the down payment) with that kind of money.

Maybe you don't have $2000 burning a hole in your bank account, but perhaps you can afford to invest your lunch money. Brown-bag your lunch and sock away just $4 a day, 250 days a year. It's not a lot, but if you're in your early 20s, you've got the investor's best ally on your side -- time. If you invest $1,000 once a year in an investment that averages an 11% annual return -- the annual stock market return since 1926 -- it'll grow to more than $1 million after 46 years, which is right around the time you'll be ready to retire.

Of course, as you get older and more financially stable, you should be able to put away more to invest. Upping the ante to just $166 a month (lunch money plus about what you pay for basic cable TV and a movie channel), would put you at the million-dollar mark in just 39 years.

Simply put, you want to invest in order to create wealth. It's relatively painless, and the rewards are plentiful. By investing in the stock market, you'll have a lot more money for things like retirement, education, recreation -- or you could pass on your riches to the next generation so that you become your family's Most Cherished Ancestor. Whether you're starting from scratch or have a few thousand dollars saved, Investing Basics will help get you going on the road to financial (and Foolish!) well-being.

The power of compounding

The table below shows you how a single investment of $100 will grow at various rates of return. Five percent is what you might get from a certificate of deposit (CD) or with a government bond, 10% is a little less than the historical average stock market return, and 15% is what you might get if you decide to learn how to pick your own stocks . (Click the link to go to the table)

Why is the difference between a few percentage points of return so massive after long periods of time? You are witnessing the miracle of compounding. When your investment gains (returns) begin to earn money, too, and those returns start to earn... small amounts of money can mushroom very quickly. Extend the time period or raise the rate of return, and your results increase exponentially. For instance, if you start young, say at 15 years of age, note how quickly a single $100 investment grows, especially in the later years.

Looking at it another way, let's compare two teenagers and their lifetime savings habits. Bianca baby-sits a lot and spends most of her spare time reading. She saves $1000 a year starting when she's 15 and invests it in the stock market for 10 years earning 12% per year on average. After 10 years, she comes out of her shell, stops adding money to her nest egg, and spends every penny she earns club hopping and on trips to Cancun. But she keeps her nest egg in the market.

Compare her account to that of her friend Patrice, who squandered her early paychecks on youthful indiscretions. At age 40 Patrice gets a wake-up call when her parents retire on nothing but Social Security. She starts vigorously socking away $10,000 every year for the next 25 years. Guess who has more at age 65? That's right, Bianca. (You figured it was a setup, didn't you?) Her 10 years of saving $1000 per year (just $10,000 total -- the same amount Patrice put away in just one year) netted her $1.6 million by age 65. Patrice, on the other hand, scrimped for 25 years to invest a quarter million dollars out of her own pocket and ended up with just under a million. Neither will be going to the poorhouse, but you see our point: Bianca's baby-sitting money grew for 50 years, twice as long as Patrice's, and Bianca barely missed it.

(It's almost not fair to mention this, but Bianca's money was in a Roth IRA. Patrice could only put 20% of her money in the Roth ($2000 per year). So Bianca's $1.6 million is tax-free, but Patrice will be paying capital gains taxes on most of her money.)Every day you are invested is a day that your money is working for you, helping to ensure a financially secure and stable future.

Financielle Note: I myself am a very cautious investor and stick to things like GICs. Good luck finding an investment that will give you a 15% return if you are willing to go into riskier investments than I am; you are much braver. For those like me who seek the more secure investor vehicles some institutions provide GICs that are linked to a diversified portfolio of stocks where you are guaranteed a certain percentage but can make more on top of that based on how that portfolio does. If you want to tread lightly into stocks something like that may be an option.