One Easy And Safe Way To Grow Your Money (Money Mindset Series III)
December 5, 2007
(Photo by saibotregeel )
One common challenge that I hear about developing additional sources of income is: “I don’t have the time to work for another source of income.” It is obvious that underlying this is the old school money thinking . I can certainly understand the mindset behind this as I once belong to this category of people - thinking that labor is the only way to generate income. This is not true; besides active labor, there are other ways of generating income.
In part 2 of the Money Mindset Series , we have debunked the traditional mindset that hard work alone is no longer the currency of the 21st century. We need to move away from working hard, to working smart. At the same time, I’ve highlighted that to enjoy better job security and life balance - we need to develop additional sources of income.
In this part of the Money Mindset Series , I like to elaborate on one way to generate passive income through wise investments of your money. At the same time, I like to challenge some traditional money mindset related to investing:
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The savings account is the best investment as it has the lowest risk.
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Investing is gambling.
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You need to take high risk to enjoy high returns.
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I need lots of money to make money (or invest).
When I was young, I remember hearing horror stories from my parent about relatives being burned at shares trading and lost their entire fortune overnight. For those of you whose parents have lived through the Great Depression, I’m sure you will find such stories very familiar. For me, I grew up connoting investing to high risk speculations that I should never ever touch. Much later in my life, I realized what a costly mindset that was! I had lost so much time and opportunities to grow my money.
WHY THE SAVINGS ACCOUNT IS THE WORST CHOICE TO GROW YOUR MONEY
Let’s start off with our best friend for growing money - the savings account. I used to think that the savings account is the safest way to grow your money, it’s not. In fact, it’s the worst.
(Source: Fatwallet.com)
The savings account seems like a safe investment tool because unlike other investments, there is no risk of losing your capital. In exchange for this capital protection, savings account has relatively low returns or interest rate.
The table above shows some banks’ savings rate that I found. Based on this sample data, it shows that the savings interest rate from Jan 2005 till May 2006 ranges between 2.35% (ING Direct - Jan 2005) to 4.8% (HSBC - May 2006). Even though it’s not much, many people are still happy to live with this low rates for the benefits of capital protection.
Let’s introduce the enemy of the savings account - inflation . For the benefits of those who do not know, prices of goods and services generally rise over time due to demand and supply forces - this phenomenon is termed inflation. As such, goods and services generally become more expensive over time. According to InflationData.com, the average annual inflation rate (USA) since 1914 is 3.42%.
Obviously with inflation in the picture, the savings interest rates no longer looks as attractive. In the best case, the real growth of your money in a savings account is 1.38% (HSBC interest rate 4.8% - inflation 3.42%). In the worst case, your money is in fact shrinking at a rate of -1.07% (ING Direct 2.35% - inflation 3.42%) -your money’s growth is slower than the increase in prices of goods and services ; you’re better off by spending that money in the first place!
THE TRULY LOW RISK WAY TO INVEST
I have learned that the savings account is not a good investment instruments. As such, I turned to mutual funds and shares. However, my initial concern is the high risk of losing money using these types of instruments.
(Source: MSN Money )
The above chart shows the 2 major US stock indices: the S&P500 and DJIA. These indices are frequent-used benchmarks for the US general market performance. The charts shows a 50-years period from Jan 1957 till Jan 2007. As you can see, the indices has only one general direction during this period - UP. For the last 50 years, the S&P500 has grown 2400%, and Dow Jones Industrial Average has grown 3000%. This means that if you had bought $1000 of a mutual fund based on these indices 50 years ago, you would have at least $2.4 million now!
So why do people lose money in their investments? There are many reasons and each is different for its own set of circumstances, but I like to share 3 general observations to this:
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Not knowing enough about financial markets- referring to the above chart again, you will see that there are many short intervals during the 50-years period where there are drops in market performance. Essentially, the market fluctuates up and down in the short term, but over the long-term, it’s general movement is up. So if you hang on to your investments for long enough, you have very good chances of making a gain.
One key reason for losing money is because non-savvy investors buy into the market during a peak and start selling when the prices drop. For these uneducated investors, any drastic drop in price is a very scary affair, as they do not understand the underlying reason for the drop or if it will ever recover. As such, they sell their investments at a lose.
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Investing with money that they need - To prevent selling at a lose, you need to hang on to your investment during bad times when prices are low. This means in order to enjoy low risk investment, you must invest for the long term. To be able to hang on, you must make sure have another bucket of emergency funds to use during rainy days, so that you are not forced by unexpected circumstances to sell your investments to generate cash.
If you are interested in savings up an emergency funds, check out One Simple Surefire Way to Save Money (And Not Spend It) .
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Putting all their eggs in one basket - another common reason for losing a fortune is because people bet their entire savings into one hot favorite stock which turned out to be a loser. It is very difficult to be able to accurately predict the performance of single companies, even for expert analyst. However, buying into market trends is more predictable as history has already proven with the above chart.
Based on the above, investment is in fact low risk when you take the correct approach to it:
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Invest for the long term - short term fluctuates are inconsequential when you look at investments in the longer term of years. I’ve had my days when my investments are making a (paper) lose. I simply hang on to them and wait for the prices to recover. Unless there is another event like The Great Depression, most investments do recover over the long term.
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Invest with spare money - I only invest with my spare money, and I also maintain an emergency fund to prepare for rainy days. In this way, I never had to sell at a lose, and I can hang on to my investments for as long as I wanted to.
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Diversify - This is especially true for new investors as you still lack the knowledge and experience. As such, it is recommended to spread your risk and minimize the impact of one judgment error. One easy way to diversify is to buy mutual funds, which is a bucket of shares from different companies. Some mutual funds are based on market indices like Dow Jones Industrial Average and they follow the general market performance. These are very safe places to start from.
If you know what you are doing and get yourself equipped with the proper financial knowledge, investments in mutual funds can be a low risk affair with tremendous potential for greater gains than savings account.
AN EASIER WAY TO MAKE MONEY BY USING MONEY.
One common mindset with investment is that you need a huge capital. I hope the following hypothetical story will help you see otherwise:
Assuming Peter started a yearly investment of $1000 at age 25 for 10 years, at a rate of return of 6 per cent. When Peter reached 35, he stopped his annual inputs of $1000 but allowed his investments to continue growing at 6% from age 35 to 62. By age 62, his investment would be worth $71,420.00! This is very good returns for a capital of only $10,000.
The above shows a simplified calculation of compounding interest using only $1000 as capital of investment. Notice that the same 6% growth every year is actually increasing in absolute gain (rightmost column). It’s because you are reinvesting the gains from previous year into the new year. As such, the compounding effect that results in the huge growth from a relatively small capital is possible over time.
I hope you see the following points:
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You don’t need huge capitals to start investing - with compounding, small amount of money can grow tremendously over long periods of time.
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You don’t need to work very hard to make money - the best money generator is in fact money itself. Again, some time is required to see significant gains. So you need to be in for the long haul and not hoping to make a quick buck. When you consistently invest small amounts of money and allow them to compound, it’ll work for you and make more money in return.
Hopefully, the message is clear by now: investment over the long term is a safe strategy to generate large amounts of returns . This means you need to start as early as possible. As Peter’s example shows, even with only $1000 per year (less than $100 per month), you can have tremendous gains over time.
In my opinion, such a long-term strategy to making money is definitely more secure than only slogging away at your work to earn a flat salary, and hoping for a promotion.
MY EXPERIENCES WITH INVESTING IN MUTUAL FUNDS
I started actively investing some years back. I also started off with only a few thousand dollars in mutual funds as that is a good place to start for beginners.
Through active savings and investing, I was able to finance my wedding, honeymoon and new home renovation without having to take any loans. The gains from some of my investments and savings certainly helped a lot to offset major expenses like these. I’m glad today that I’m debt-free and I intend to stay this way.
After these few years, the compounding effect is starting to show and there is financial stability as I have a tidy sum put aside to cushion any mishaps in my life. I remember that I used to worry about money a lot and a certain sense of lack. Thankfully, those days are gone, and I seldom have to worry about money issues anymore. Living a simple life helps and investing to build a healthy financial nest helps even more. I believe everyone should live this way and through this article, it is also my hope for you.
Academically, I’ve come from a software development background. It took me a lot of upfront efforts to learn about finance, economics and different investing instruments. However, these knowledge has paid off well for me and I have not regretted this move.
Now that the upfront effort is over, the rest of the ongoing effort is really minimum. I only have to stay abreast of major world events, financial news and review my portfolio quarterly. There isn’t really much work needed to maintain the investments on a day-to-day basis, and I simply go about my job as usual. The rest of the work to generate money is really done by money itself. It’s really quite easy, now that things have gone on track.
CLOSING REMARKS
I like to qualify that this article is NOT a how-to guide for investment. There is simply too much about financial education to be covered in a single article.
My takeaway for you is this - investment in mutual funds is one of the easier ways to start generating additional income streams . Investment risks can be mitigated if you know what you are doing through proper financial education.
If your mindset about investing has always been negative, I also hope this article will trigger you to re-evaluate your thinking and start considering the possibilities out there. You may have more to lose by not trying than trying.
For the sake of your life balance, spend some time and effort to get some financial education and start investing wisely. I recommend that if you are first starting off, start with mutual funds or exchange traded funds. It is a simple investment tool with good diversification which provides relatively low risk for good returns. It is easy to learn and will give you a good grounding for more complicated investment tools later on.
To have money to invest, a proper spending lifestyle and saving also play a big part. In next part of the Money Mindset Series, I will be covering consumer spending and the mindset behind it to address this issue.
FURTHER READINGS AND REFERENCES FOR INVESTMENTS
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Investopedia.com - has great articles and tutorials for beginners to start learning about investment. Even has a simulator to practice stock-trading without using real money.
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MSN Money - a great money portal covering banking, investment information with real-time and historical stock quotes and market movements.
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MorningStar - another great investment portal and you can signup for a trading account.
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Great article, Lawrence. This gave me a kick in the behind - I’ve been “meaning to” get started on my own investment portfolio, now that I’m totally out of debt. This perspective is giving me the last bit of incentive I need, thanks!
Blessings,
Andrea
Haha Andrea,
Glad this ‘kick’ is working. It’s time to get cracking and kick your money to work more for you. Let me know if you need to exchange pointers.
Yeah, savings accounts are not the way to go. I prefer mutual funds for long-term savings/investments.
Good post with data support. Careful pick of mutual fund investment reaps far better returns than plain savings in the bank. That is why most banks are also offering mutual fund and bank investments to their clients today.
I wrote a paper on investment before I was accepted as an intern with an international investment company in Washington D.C. I also gave speeches in class on investment. Investment is a topic which I feel everyone should have an interest and do something about it to plan for their retirement or future.
Thanks for sharing.
Hi Jesie,
Thanks for your kind words. Really appreciate it.
I notice you are from finance background. How about sharing some investment tips on your blog?
I’m really enjoying this series Lawrence. As I said, this will be a fantastic series, one of the pillars for your blog in the future. I’m sure people will be referring to it a lot in times to come.
Cheers,
Albert | UrbanMonk.Net
Modern personal development, entwined with ancient spirituality.
Thanks for the advice Albert.
It seems like you have read my thoughts.
I do intend to follow up with 2 other series, one on Work and Passion, and the other on Relationships. Each series will cover one pillar of this blog. So stay tuned, and look out for them!
[…] part III of The Money Mindset Series , I highlighted the need to invest and grow your money to facilitate living a balanced life. In […]
Hi Lawrence,
I love spreadsheets that show the power of compounding interest!
Something a little extra that is worth mentioning is the type of mutual funds. There is a difference between actively managed mutual funds and passively managed mutual funds.
Actively managed mutual funds are ones that have a manager who picks stocks according to how he thinks they will do. Passively managed funds have a pre-set formula and they let it run and only make adjustments to keep the distribution between the different picks equal.
Passively managed funds is more like what you were talking about with focusing on the long run. An example of a passively managed fund is SPY, which mimics the S&P 500, which means you’ll get similar returns to the S&P 500. As an added bonus, passively managed funds typically have lower taxes, since the funds are sold at a lower rate than actively managed fund. Passively managed funds also have lower management fees, since the manager needs to do less. This can generate an extra 1%-2% real gains per year.
Also along the lines of focusing for the long term, I read an article on investor psychology, which states that when investors sell a stock and purchase a new one, they typically make less than if they would have just stuck with the first one.
Hi DS,
Thanks for sharing these wonderful information about active and passive mutual funds. These are really relevant and useful information.
So it looks like you’re quite a savvy investor yourself?
Hi Lawrence,
I am learning investing, but I would hardly say I’m a savvy investor. I actually lost about 20% of my portfolio recently when the market took a series of unexpected moves that I wasn’t prepared for. I’m taking off the rest of this month so I don’t get into “revenge trading” (people tend to become riskier when they lose than when they gain, which further reinforces the importance of money, which I don’t want)
Something that I also forgot to mention is that passive funds have historically outperformed 80% of actively managed funds. On top of that, most of the 20% that do better do not do so consistently, meaning that most probably just got lucky that year.
Looking at the way stock market is moving, I guess timings is also very important in investing. If you got in at beginning of the years, I guess the paper value will at least 50% less and it will take a very long time to recover.
I find here good way to Grow Your Money tips.It is a nice post with have a good info….keep it up…