- Investing is first about allocating capital, then about where to invest.
- We’ll discuss how much you should allocate to savings for your age and expected market returns.
- This is the most important thing you should focus on when investing and thinking about your financial future.
Start With The Goal
We should start our investing adventure with the goal in mind. By having clear goals, it will be much easier to find ways to reach those goals.
The two most powerful factors related to investing are compounded interest and time, which allows for that interest to compound.
Let me give you a few examples of how this works in relation to investment returns and the investment horizon one could have. Of course, the longer the investing horizon, the less sacrifice is necessary now and vice versa. Also, the higher the return, the faster you get to where you want to get.
Let’s see how much should you invest daily to hit $1,000,000 in the next 10, 20, 30, or 40 years in relation to the possible return on investment achieved.
To become a millionaire in 10 years, you need to put a significant amount of money aside, between $150 and $227 a day depending on the achieved return. Given that valuations are extremely high, the realistic thing to do would be to take the 4%, perhaps the 8% return if there is a market crash.
But let’s see how adding just 10 years to the picture changes everything. This will show the importance of time when investing.
As you can see, if the investment horizon doubles, the required investments don’t halve, but are just a third to a fifth of what’s necessary in the 10 year period. This is thanks to the power of compounding where the interest starts earning interest on itself and this compounds over time. As Albert Einstein once said, “Compound interest is the 8th wonder of the world.”
If your investment horizon is 30 years, the required investments are again just a third of the 20-year example even though the time horizon only expanded 50%.
If we expand the horizon to 40 years, the daily contributions necessary to become a millionaire are between $3 and $30 depending on the return on investment. As I would expect a realistic return from stocks to be around 8% over the next 40 years, you can become a millionaire by investing just $10 a day easily over the next 40 years. Think about it.
So the longer the investment horizon, the easier it is to accumulate wealth. Further, a higher return on investment makes things even easier.
The key of all the above is to allocate a monthly amount to such an endeavor and in 20 or more years, you will find yourself with a nice nest egg. The problem is that few really do such a thing because it’s difficult to do for such a long time. However, there are some tricks that help.
#1: Make It Automatic
The best way to invest and stick to it is to automate it. Many funds offer the possibility to automatically invest and you can also set up an automatic transfer to your brokerage account if you prefer to buy stocks individually. This would also allow you to buy those stocks that have the potential to deliver extreme long term returns but are cheap in relation to the market now because the market is usually focused on the short term.
#2: Don’t Worry About The Return
You might have seen that there is a big difference in the required monthly savings in relation to the achieved return. Further, you know stocks are now expensive and you might think that higher returns than 4% are impossible to get. Well, the key return will be the one achieved over the whole investment period, not the one currently in place. If you start investing and stocks drop 80%, the return on the new investments will cover for any drops as if the return on stocks increases from the current 4% to 12%, your necessary monthly investment drops from $860 to $102.
Over the long term your returns will average out.
#3: Have Two Portfolios
If you have different goals, the best thing to do is to have two portfolios. The one where you save for the long term is the one that should never be touched even if you are tempted to use the money for some attractive short term investments. By having two portfolios, you can follow a more fun investment trading strategy while the long term wealth building vehicle works in your favor no matter what.
The key of today’s article is that above anything else, what will lead you to investment success is not the stock you pick, but the monthly investing habit you make and clear investing goal you have.