Part 8: Start Investing

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Investing some money in the stock market can be a great way to get your finances working for you long term, as you work towards building a portfolio to supply you without another income stream. If you’ve never invested before, this might sound like a scary new thing to learn, but these days you can invest in low-risk investments with even just small amounts of money, so as long as you only put in money you don’t need (and not your entire savings), investing MIGHT be an adequate way to build up your assets and net worth further.

Part 8: Start Investing

Generally speaking, there are two types of investments that make up most of the stock market: stocks and bonds. Stocks or shares represent a small part of the company. Whoever owns shares of a company essentially owns part of that company. Shares give shareholders dividend payments at specific intervals (for example yearly or biannually) based on profit results.

Bonds on the contrary represent loans taken out by a company. If you buy a bond you essentially lend money to a company. Throughout the lifespan of the bond you will be paid interest and at the end of it you will be returned the original amount of money that the bond was issued for.

Both stocks and bonds might with time go up in value, meaning that if you decided to sell these assets you could make a bit of money. Unfortunately the opposite might also be the case: they could go down in value in which case if you had to sell them after their value has gone down, you would lose money.

When it comes to investing your money in the market, there are three main ways of doing so:

  • You can pick and choose your own stocks and bonds to invest in. Handpicking your own investments gives you a lot of flexibility and means you’re in (almost) complete control of the process: which company to invest in, when to buy and when to sell. It does of course mean you need some knowledge as to how to make these decisions.
  • A second option is to invest in mutual funds where a fund manager makes all of those decisions for you. Mutual funds often have high associated costs and fees however and therefore aren’t always the most efficient way to make money on the market.
  • A third way to invest is via index funds which is a way to proportionally invest in all the companies of a specific index. This type of investing doesn’t require you to have specific knowledge and often has very low costs. 

None of the above options are without risk: investments can always go down in value and whilst you can make money on the stock market, it is just as easy to lose money.  That said, as long as you take calculated risks and invest in relatively safe investments, putting money into the market can be good opportunity to. build your wealth.

It’s worth finding some time today to check out the investing options that might be available to you, what their minimum monthly required contributions are and what their fees or costs are. This gives you a much better idea of what investing might look like to you.

Lastly, before ending this quick intro into investing, let’s look at an investing guideline that has become known as the 4% rule. This rule is based on extensive research done by Trinity University where researchers found that if you have an investment portfolio of a certain value, and take out no more than 4% annually, your portfolio will nearly always sustain itself due to market increases, meaning the increase in value balances out the money you take out. Practically speaking this means that if your investments are worth $60,000, you can take out $2.400 each year without your portfolio going down in value. Or if you build a portfolio worth $500,000, you can take out $20,000 each year! That might even be enough to live off without needing any further income? Unfortunately, whilst the 4% rule is a great initial guideline, it doesn’t always hold up, especially not in times of a recession, so before you think all you need to do is invest and then live off the proceeds, you’ll likely need a contingency plan for when there is an economic downfall scenario.

Investing can be a great way to build and maintain your wealth, but it is also complex and there can be great risks involved. This blogpost is just an introduction to the topic. Before you go off and invest all of your savings, please make sure to educate yourself further with blogs, books and / or podcasts on this so that you don’t take any unnecessary and irresponsible risks. 

The above is an adaptation of part 8 of the 10 parts in the guidebook to Financial Independence100 Steps to Financial Independence: The Definitive Roadmap to Achieving Your Financial Dreams where you can find more details as well as action plans and guidelines to each of the 10 parts. Available in both ebook and paperback format!

Get your FREE sample of the 100 Steps to Financial Independence Book here

Coming up next: Part 9 of the Journey to Financial Independence!

Day 21 / 31 Learn about Shares and Bonds

Day 21: Learn about Shares and Bonds

Day 21: Learn about Shares and Bonds
Day 21: Learn about Shares and Bonds

Today’s challenge will be a crash course on investing. Since there is a lot to go through and not much blog post length to use, let’s dive straight into this…

Shares

Any company is made up of shares and each share is essentially a very small part of a company. If you have a share, it means you own a part of that very business. The more shares you have, the bigger the part you own of that company.  Continue reading “Day 21 / 31 Learn about Shares and Bonds”

Step 73: Lifestyle Investing Option

Step 73 of the 100 steps mission to financial independence: Lifestyle investing option
Step 73: Lifestyle investing option

In the previous step we’ve looked at asset allocation and using the yearly rebalancing technique to keep the right balance between your various assets in your portfolio, even if some of your assets grew more than others, thereby taking up a bigger percentage of your portfolio. In step 73 we’ll look at how rebalancing your portfolio can also help to readjust your portfolio when you get closer to your goals. In the examples below I mainly use retirement as a goal, but it can of course be other goals too that you might have in mind for your investments, such as a college fund for a (grand)child, a down-payment for a house etc.

Lifestyle option

Let’s assume that you have a 70/30 shares / bonds allocation to start off with in your portfolio and that the main goal for that portfolio is to use it as (an addition to) your pension provision. With time when you start nearing retirement, you might become a little nervous about the possible volatility of this portfolio however. What happens if there is a sudden crash in the market and you lose a big chunk of the money in your portfolio right before or after you were planning to retire? It means you suddenly wouldn’t have the same amount of money available that you maybe planned to have, which would probably compromise some of your pension plans. Of course when you’re 30 or 40, having a portfolio with a bigger risk factor doesn’t matter as much as your portfolio still has time to recover after a possible crash before your retire. But when you’re close to retirement age, you don’t have the same luxury of time and you probably don’t want that same volatility anymore as when you were younger. Continue reading “Step 73: Lifestyle Investing Option”

Step 72: Rebalance your Portfolio

Step 72 of the 100 Steps Mission to Financial Independence: Rebalancing your Portfolio
Step 72: Rebalancing your Portfolio

This and the next step look at managing your assets in your portfolio on a long-term basis to ensure they remain aligned with your goals. With time some assets might grow faster than others, goals might change or you might want to change the risk level of your portfolio the closer you get to your goals. In all cases this can be dealt with by rebalancing your portfolio and re-allocation your assets. Similar to the investing principle of “buy when everybody else is selling”, which we discussed in step 54, the rebalancing of your portfolio is another investing concept which is easy to understand and execute logically, but can be difficult to implement psychologically.

Yearly rebalancing

The yearly rebalancing of your portfolio ensures that if one area of your portfolio does really well in one particular year, you don’t deviate too much from the original asset allocation that you had in mind for your portfolio. If one assets grows much more than another, it might make your portfolio too volatile or too safe for your goals and risk tolerance.

Let’s look at an example and assume that you want a 70% shares and 30% bonds allocation in your portfolio. You put in $10.000 and the moment you enter the market both bonds and shares happen to be $100 per unit. Ignoring costs for the sake of this example, that means you’d have $7.000 in shares and $3.000 in bonds. A year later the shares have far outperformed the bonds, and even though both have gone up in prices, your bonds are now worth $3150 (a 5% increase), whereas your shares are now worth $8050 (an increase of 15%). The stocks and bonds allocation is now no longer 70/30 but 72/28. Not a huge difference you might think but if the shares keep outperforming bonds by that much for a few years, you might end up with an 80/20 portfolio in just a few years. Continue reading “Step 72: Rebalance your Portfolio”

Step 51: Investing through Mutual Funds

Step 51 of the 100 steps mission to financial independence: Investing through Mutual Funds
Step 51: Investing through Mutual Funds

In the previous step we looked at the advantages and challenges of choosing the shares and bonds to invest in yourself. In this new step we look at an alternative which is designed to help you if you don’t want to choose your own investments, but rather rely on the opinion and experience of somebody else: Investing through collective or mutual funds.

As we’ll see, this type of investing has its own major positives and drawbacks so let’s get started with the details.

Mutual funds – an overview
In the case of collective or mutual funds, the money of small investors in pooled together in order to raise the total amount available to invest. A fund manager is appointed to manage these funds and he or she decides which shares and bonds to add to the portfolio, trying to make as much money as possible. This often means they buy and sell continuously, following the market, aiming to buy shares at a low price, sell them at a high price and rush selling if they see a fall in the market coming, to avoid their clients losing a lot of money. Sounds like a good tactic? On paper yes, but in reality there are two main problems with this type of investing. Continue reading “Step 51: Investing through Mutual Funds”

Step 49: The Difference between Shares and Bonds

Step 49 of the 100 steps to Financial Independence: The Difference between Shares and Bonds
Step 49: The Difference between Shares and Bonds

Stock markets have a vast selection of stocks and bonds that can be invested in and before deciding what to invest in, understanding the main differences between stocks and bonds well is absolutely key if you consider getting in the stock market. Investors can decide whether they want to invest in just shares, just bonds or whether to create their own mix of stocks and bonds. With time, many furthermore decide to slowly reallocate their investments, so even if you start with a certain percentage shares and bonds, this needn’t stay as such for the rest of your investment life.

Here we’ll look at the main differences between shares and bonds from an investor’s point of view and how they both offer different advantages and disadvantages.

Volatility

  • Share prices vary more day-to-day but also over long periods of time: their value can increase or decrease fast.
  • Bonds are generally more price solid and fluctuate less over time and at a much slower pace than shares.

Continue reading “Step 49: The Difference between Shares and Bonds”

Step 48: Understanding Bonds

Step 48 of the 100 steps to financial independence: Understanding Bonds
Step 48: Understanding Bonds

In step 47 we looked at an introduction of what shares are, but they are only part of the stock market, there is another major player to be found on the stock exchange, which are of course bonds. In this step we’ll look at bonds in greater detail and find out why they might be interesting to invest in.

What is a bond

A bond is in essence nothing more than an IOU that a government or company issues when they borrow money. In the case of a bond, the debtor (i.e the government or company that issued a bond and therefore borrows money) agrees to pay back the full amount of the original loan, along with interest.

A bond is traditionally an official paper to confirm the loan and when bonds are issued, they usually have the following information:

  • Value of the original loan, i.e. how much money the bond was for.
  • Interest rate that the company or government will pay back yearly.
  • Redemption date: this is the date when the issuer of the bond will pay back the original loan. This is usually anything between 5 and 30 years.

Like with stocks, companies and governments often issue many bonds at the time in order to raise a total amount of money they need for a new investment or expansion.

Why do bonds exist

So why do companies issues bonds and not just borrow money from the bank? The main reason to choose for bonds is that companies can often agree lower interest rates with investors than they can with banks. It also means that they don’t need to adhere to the restrictions that many banks impose on entities when they borrow money. By issuing bonds it guarantees that companies have more flexibility and freedom when it comes to chosing between reinvesting or loan repayments.

So why not issue shares then? A drawback of shares is that a company cannot just continue issuing more and more stocks without annoying their investors as the more shares are out, the more owners of the company there are, the more reduced the Earnings Per Share (EPS) are: the same profit has to be divided amongst more investors. With bonds, companies don’t have this problem as they can issue more so long they can find new investors willing to lend them money. Of course the disadvantage of bonds over stocks is that the full amount needs to pay back, which as we saw in step 47 is not the case when a company issues shares.

What do bonds give

Bonds give investors the possibility of making money in the following two ways:

  • Interest payment – as with any loan, a debtor agrees to pay interest on an outstanding loan, so if you lend somebody $100 at an interest rate of 5%, you can expect to get $5 every year until the redemption date, when the bond will be paid back in full.
  • Capital gains – similar to shares an investor can decide to sell their bond to somebody else, meaning the new investor takes over the loan. Since bonds are traded on the market, their prices can go up (or down). Bonds can be sold for more or less money than was originally lent to the company or than what the original investor paid, so as with shares, one can make and lose money on the buying and selling bonds.

What affects the price of bonds

The fluctuation of bonds prices is usually a result of the following three main factors:

1. Interest rates of the national and global economy

Investing in anything on the stock market always brings a risk as well as a cost with it. You pay fees somewhere along the line, be that to a stock broker or your brokerage account.. at some point you’ll pay. Added to that, bonds might cease to exist if the company or government goes bankrupt. So if you get 5% interest on a savings account with you bank, you’d be silly to buy bonds at 4%, as not only will you get less money on it, you will also run a higher risk of losing your money and you haven’t even paid for any costs at this stage. When interest rates of the economy go up, bonds have to offer more interest, otherwise people will invest their money in their own savings accounts. Add in inflation rates being high or low and you can imagine that it might be more interesting to put your money in stocks instead of in a low-interest bond.

2. Risks associated with the bonds

Every bond issuer is different and is either more or less likely to actually pay back the loan. If the entity goes bust, you simply won’t get any money back. Safer bond issuers might be more interesting as they are less likely to go bankrupt, although returns (i.e. interest rates) are generally lower than on bonds from more risky entities. To indicate how safe a bond is, there is a credit quality rating or bond rating, which ranges from AAA (highest level of safety) to AA, then A, BBB, BB and B and continues with CCC, CC and finally C, which indicates a low quality bond. During different economic times, people are willing to take more or less risk.

3. The remaining life span of the bond

Bonds that have a long life span have a higher risk of a payment default (the issuer not being able to pay) or a change in their credit rating. A company might be very healthy at the moment, but what will they look like in 30 years’ time? Because of the associated risk, longterm bonds usually have a higher interest rate to correct for the increased risk or insecurity. Bonds getting closer to their redemption date can go up in prices as they become more interesting to have as the chance of payment default or bankruptcy of the company goes down.

Two last warnings

  • Remember that if you bought a bond of $100 for $110 (thinking you’d either get enough interest on it to counter for the $10 difference, or would be able to re-sell at an even higher price), since the bond was originally issued for $100 at the end of the its date, you will only be given $100 by the issuer! If on the other hand you purchased it for $90, you will make $10 on the bond by its expiry date.
  • If a company has issued both bonds and stocks, then their bondholders must be paid interest before any profit can be given to the share holders. At the same time when you buy a bond, you won’t be given any part of the profit.

Step 48 – Understanding bonds – in detail

Like in the previous step, we are for now just finding out about bonds and how they behave on the market.

  • Type in bond prices + a company to find out more about the characteristics of bonds, such as their interest rates, maturity date / redemption date, and current prices. See how this evolves over time. Don’t worry about the actual details or number, just try to get an idea of how bonds trade on the market.
  • It’s harder to find information on bonds in the news, as news items tend to focus more on shares since they sound more exciting due to their prices fluctuating more. Try and see if you can find some information on bond prices, defaults and other information on bonds.

And that ladies and gentlemen is the introduction to bonds. Does the whole stocks-and-bonds-story still sound little confusing? Good, as the next step is completely focussed on comparing the two in greater detail.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.