Do you have investing beliefs and an ultimate purpose?
Many investors have not asked themselves this question and the lack of answer has clouded their judgement.
Several times over the last hundreds years, we have seen market crashes, declines in interest rates, lower oil prices, and staggering precious metal prices.
When these things happened, investors panicked and started looking for gurus.
When all things are going wrong, many investors believe that there is someone out there who can predict when businesses will be good, when stock markets will fall, when interest rates will rise, and so on.
They end up following the herd or taking advice from people who have very little credibility and it is not unusual that they lose all of their lifetime’s savings.
So far, many people have not learned from the stock market crash of 1978, the dot com bubble in 1999, and the real estate bubble in 2008.
If there is really such a person who can make the right decision for your money, it is you and no one else. In this book, we will share basic principles about investing, why it is important to invest, and tips how you, the individual investor, can make sound decisions about your money.
The Miracle of Compound Interest
You may have heard or read what Sir Albert Einstein said about compounding: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Too many people do not realize how compound interest adds to their burden of debt. This is especially so for those who purchase on credit and fail to pay their bills on time. But what exactly is compounding and how is it calculated?
Compounding is a type of calculation in which the accumulated interests are added to the principal to calculate the current increase in interest. In a simple interest arrangement, you only pay the interest plus the principal.
In addition, the number of years that a principal and its interests are compounded substantially affects the end value.
Supposed you borrow $100 with a 10% interest on a simple interest arrangement, you only owe $110 in total. This you will divide by the number of years you have to pay, say 10 years, which results to $11 per year amortization.
In compound interest, you add the 10% on top of the $110 for the following year, which results to an additional of $11. This totals to $121. The next year, take 10% of $121 and add that to $121 and that is the total you owe.
This usually happens when you pay late on your bills. Your remaining balance, including interests accumulated, will be multiplied to the current interest rate and will be summed up to get the final amount of what you owe.
If you reverse this situation and you are on the receiving end of the equation, you will financially prosper provided you have enough patience to wait.
This is the power of compounded interest that one earns when investing long term. The longer you allow your money to compound, the greater the return.
If you save $10,000 today and it earns 10% interest per year, your total money would be $11,000 by the end of year one.
By the end of year two, your money will earn another $1100 ($11,000 x 10%). This gives you a total of $12,100 in only two years. By the end of the tenth year, your money will be worth $25,937!
To further understand its power, please see the table below demonstrating the difference between simple and compound interest investments.
As you can see, a simple interest only doubled your money in ten years. But the compounding increased your money by more than 150%
How to Determine Your Risk Tolerance
Peter Lynch, one of the most renowned investors and fund managers in the world, once said that you should never invest money that you cannot afford to lose for at least 10 years.
This is based on the reality that all investments have the likelihood to default or be lost. All investments have accompanying risks, albeit they vary in gravity.
Some are low risk like deposit accounts and government treasury bonds; some are medium risk like corporate bonds, and some are high risk like stocks and futures.
Identifying your risk tolerance will allow you to make an informed decision on which type of investment vehicle to take. It allows you to view worst-case scenarios and prepares you how you would react to them.
Determine Your Time Frame
The first question to answer is how much time do you have to invest? Better yet, how long is your horizon to invest?
Younger individuals have longer periods ahead of them and can take high risk investments. People who are nearing retirement do not have a decade to invest and are much better off in low to medium risk investment platforms.
To answer this better, determine how soon you will need the money. If the money you have now is something you need to use within five years, your risk tolerance is relatively short and you are best suited for conservative investment portfolios.
If you do not need the money for at least ten years, an aggressive portfolio will fit you nicely.
Determine Your Risk Capital
Before you can answer this, you need to understand your net worth. Simply put, this is your personal equity. Your equity is calculated as your total assets minus your total liabilities.
Risk capital, on the other hand, is the amount of money you are initially investing. This money is something you do not need at the moment.
Think of it as money that will not be available in the near future. Consider it gone, if you will. This means that you should never invest emergency funds and money you need to pay for the rent or education.
If you have a high net worth, then it is also safe to assume that you can increase your risk capital and vice versa.
The problem is that those who have low risk capital and low net worth are usually lured into riskier investment programs because they want to earn bigger and quicker. It is unfortunate that it is the same people who usually lose.
Determine Your Financial Objectives
Although many think that the obvious answer is to earn money, there is much to be said than this. You need to have a specific purpose other than earning.
Are you saving for your children’s college education, a house, a car, or for retirement? Having a conclusive response to this will help you gain insight on your investment horizon and risk capital.
The assumption is that the money you are investing now is supposedly the money you are saving for the purpose mentioned above.
For example, let us assume you are trying to save $200,000 for a house and you want to reach this in 10 years. Ask yourself, how much of that money are you willing to risk now? Ten thousand? Twenty thousand?
The key here is to fully understand that the money you invest is what you should consider as disposable income. It may disappear. So if you cannot bear to imagine losing ten grand, your risk tolerance is low and this will guide you in deciding whether to take low, medium, or high risk investment portfolios.
How and Why Automate Investment Contributions
It has always been said that successful savers are those who pay themselves first. This is easier said than done.
The common mindset of many people is to pay bills first, enjoy second, and whatever is left is the savings, which usually is none.
To invest successfully, you need a shift in your mindset. You need to start believing that every payday, the first thing you need to chuck off your check is your investment requirement. Then you live off if whatever is left. Below are the benefits of an automated investment contribution.
Dollar Cost Averaging Defined
It is the mindful and meticulous method of studying stocks and bonds and other investment vehicles that puts investors at high risk.
Time and time again, professionals have proven that there is no way you can time the market. In addition, changing decisions every so often is very likely to distract you from your original goals.
Dollar cost averaging can save you this agony by setting up an automatic payment arrangement with the financial institution who facilitates your investment.
Every payday, a fixed amount is taken off your salary and this is added to your portfolio, regardless of the condition of the economy, the market, or the interest rates of bonds.
The benefit of dollar cost averaging is that it disciplines you to contribute regularly, thus removing self-sabotage from the picture. It also reduces your risk by allowing your money to buy shares of mutual funds at a lower cost when the market is down.
How to Automate Your Investments
If your employer offers 401K, this is a good start. Money is taken off your paycheck on a regular basis. If there is none, you can choose to open a Roth IRA and contribute every payday.
Another set-up is to enrol in mutual funds. There are many companies that offer low capital funds with low monthly subscription rates.
These companies will invest money on your behalf and as the time progresses, the value of your investment will also grow. Some banks can set-up an auto-debit process tied up to your checking or savings account.
You can also use digital products like eTORO. The wonderful thing about this account is that you can actually copy the trades of people who are successful in the stock market.
With eTORO, can see how much these people have earned, and you can create a portfolio that is based on their choices.
Essentially, they will do the thinking for you. All you have to do is to invest money. Now, if they lose, you lose. If they make huge amounts of money, you will also do.
The Most Popular Investment Options
Investment is probably one of those terms that is overused and misused. Today, people refer to their luxuries as investments, such as cars and expensive home theatre systems.
Investments are those that appreciate in value. These are things that generate money and anything that does not produce both is considered an asset but not an investments. Below we will discuss the most popular form of investments available to retail investors.
The first type of an ownership investment is stocks. A stock is tangible certificate that you own a portion of a company. When a corporation or a business needs money basically splits its ownership into shares.
Let us say that a business needs $1000 in capital, it may split its shares into 1000 pieces, each costing $1. You as an investor buy these stocks in the premise that the company will do well and become profitable.
If you buy 100 shares in the previous example, you own 10% of the company and this entitles you to 10% for every penny earned, also called dividend.
You can own stocks or shares in a private or public company but it is a lot easier to acquire stocks in publicly listed companies.
These companies are those who needed to raise billions of dollars to either expand, fund research, or pay off debt. Publicly listed companies are found in the stock market and purchasing their shares is done through registered brokers.
The benefit of buying publicly traded stocks is its liquidity. You can buy these shares today and sell them tomorrow. Private stocks are less liquid because you need to find somebody who is interested to buy your shares. The stock market, however, has millions of potential buyers and potential sellers at any given time.
The way you earn through stock is through capital appreciation or dividends. Dividends are usually paid annually when the company had a good year.
The downside in this is if the company incurred losses, you will not be paid anything. Capital appreciation happens when people are interested to buy shares from you at a higher price than what you bought it for.
This happens when the company has performed significantly well and is financially strong. Stocks have outperformed many investment portfolios in the history of time. This is also the riskiest of all investments because prices fluctuate every second.
A bond is a debt. Bonds are issued by investors either to the government or private entities who need money but do not want to borrow from the bank due to high interests.
In essence, you are acting as the lender. Since you are not likely to have $500 million to lend, you issue bonds in denominations along with retail investors.
All the money is pooled until enough is accumulated to lend to a specific entity. In return, companies pay an annual interest to you until such time that the date of bond maturity is reached and you are paid in full.
There is still a risk involved here because some companies may go bankrupt and default on their debts. It is widely believed that government bonds are the safest because the government is not likely to go bankrupt.
All it has to do is to print more money. Compared to stocks, bonds are less risky because corporations are graded based on their credit worthiness.
This means that you have full confidence in lending a corporation based on its history of paying its debts.
Bonds are ideal for individuals nearing retirement so the individual can live off a fixed income—through interest of the bond. This is also an ideal investment vehicle for those who do not have a long-term horizon for investing. Typically, bonds are issued with maturity dates of up to five years.
The counterpart of bonds in stocks is mutual funds in which investor money is pooled to buy large blocks of stocks in the market.
Certificate of Deposits
Pretty much, this is your regular savings accounts with a twist. Also called as CD or time deposit, you cannot withdraw your money for a specific period of time. In return, the bank will pay you a higher interest rate.
Gold, Precious Metals
Gold is one of those metals that the earth cannot produce. Whatever gold we have on earth right now is the only gold we will ever have. This rarity is what makes it so expensive. Add to that the costs of labor and processing. In the same lines with gold are silver and copper.
REITS or Real Investment Trust Funds
This is a combination of stocks and real estate. In this form of investment, you do not buy your own real estate property.
What you buy are shares of companies who have real estate properties that they are renting out. So essentially, you are buying a part of the property which will appreciate in value overtime.
Venture Capital and Lending
Being a venture capitalist simply means being a financier. You are funding projects or businesses and in return, you get a share of the profit. In most cases, venture capitalists become partners of the business they funded.
Lending, on the other hand, is giving your money to people on credit and interest. This is different from bonds because in most cases, you do not really assess the borrower’s capacity to pay.
In bonds, the companies borrowing money are rated by third party credit rating agencies. Today, there are peer to peer organizations like Lending Club and Prosper who accept money for lending on behalf of investors.
These organizations pool investors’ money to lend to people and interests are paid out once the borrowers pay their obligation.
How to Determine the Right Investment Options
By this time, we would assume that you are done assessing your risk tolerance and you understand the different risks associated with each type of investment.
To sum up the previous two chapters, if your risk tolerance is higher and your investing horizon is longer, you are best suited for stocks and equities.
On the other hand, if your risk tolerance is lower and you have a short time horizon for investing, you are better off with bonds.
The next step is to determine whether you are a conservative or an aggressive investor. Look at the high level definitions below and determine where you belong. It is possible to be in between.
Has shorter time horizon Has longer time horizon
Has lower risk tolerance Has higher risk tolerance
Financially unstable Financially stable
Now that you have indentified which bracket you belong to, look at the recommendations below on how you will allocate your funds.
If you rated yourself as very conservative, the recommended portfolio for you is to allocate:
- 20% in domestic stocks
- 50% bonds
- 30% short term investments
This type of mix allows you to enjoy stable and steadier performance of your investment with a little room for growth.
This is ideal if you are not very conservative but somehow on the way to aggressive. This balanced portfolio is perfect if you are looking for opportunities for growth and you can tolerate minor fluctuations in your investment.
- 45% domestic stocks
- 5% foreign stocks
- 40% bonds
- 10% short term investments
This is a type of portfolio recommended for individuals who are not that aggressive but as not as conservative either. These are individual who have a minimum of 10 years to invest and have moderate risk capital.
They are financially stable and the money they invest now are not needed near term. This is appropriate if you prefer growth and if you can tolerate significant volatility in your portfolio.
- 60% domestic stocks
- 10% foreign stocks
- 25% bonds
- 5% short term investments
Aggressive Growth Mix
This is most appropriate if you have a long term horizon and a huge amount of money to risk. An aggressive portfolio is designed for those who have very strong inclination for growth and can tolerate huge and sudden movements in their portfolio.
- 70% domestic stocks
- 15% foreign stocks
- 15% bonds
Remember, you need to assess yourself carefully, most especially your time horizon and risk capital, before picking the type of portfolio for you. A mistake in your self-assessment can prove to be very financially devastating move.
How to Take Advantage of P2P Lending
In the previous chapters, we touched on peer to peer lending as a type of investment. Here we will dabble a little bit into it to understand how it works and we will compare two of the leading peer to peer lending companies in existence today.
Peer-to-peer lending or P2P lending is basically a crowd funding activity, supported by unrelated people, called peers, the aim of which is to lend money to those in need without going through the traditional lending companies or banks. The lending typically takes place online after applicants have passed credit checks.
The main advantage to the borrower is lower interest rates. Banks and financial institutions typically charge 10% while P2Ps charge below that.
From a lender’s perspective, the returns are higher than bonds but this is also riskier because the borrowers also have a likelihood of defaulting.
Today, there are two leading P2P Lending companies: LENDINGCLUB.COM and PROSPERITY.COM.
As an investor, you can utilize these companies to grow you money by lending your funds to them at an interest and allowing their fund managers to allocate the money to approved borrowers. Below is a comparison of the two.
Investment automation refers to investors’ capability to allow either P2P companies to invest on their behalf.
The investors will deposit money and the company will take care of distributing it to borrowers. Manual investing, on the other hand, refers to the investors’ capability to select a specific borrower based on his profile, credit rating, and interest rate.
TWO PASSIVE INCOME STREAMS
The last chapter of this book will provide two simple yet ignored ideas to generate passive income on top of your investments.
Many people believe that investing is a great way to earn passive income upon retirement. However, you have to realize that to raise $1000 in per month, you should have at least invested $250,000, assuming that it generates 5% annual return on a regular basis.
This is a feat to achieve so we are listing other ways for you to earn without any heavy involvement.
Perhaps this is the most profitable of all and the easiest to understand. All you have to do is to buy a property and rent it out. Just like any business, investing in real estate has its complications. You need to carefully assess and do the math if you can make a profit.
Calculate your mortgage and tax liabilities annually and check if the property can be rented higher than that amount. Add to this the expenses you will incur for repairs. The difference between this and what the tenant will pay annually is your take.
This is a type of marketing that requires a lot of hard work before it flies. You need to build a website and post contents that people will be reading and coming back to.
Later on, once you have built an audience, you can enrol in affiliate marketing services and add their links or banners to your site.
Whenever a person clicks on the link and makes a purchase, you are entitled to a commission. Average in the industry is 20% of the product cost.
You can learn more about affiliate marketing from my other posts as shown below:
While affiliate marketing is simple, it is not easy. Many people fail because they have false expectations. But if you just work hard enough, you can earn as much as $100,000 per month with little to no investment.
The truth is, many who have tried this failed because they did it without the guidance of a mentor. You will succeed if you invest in your affiliate marketing knowledge. Pay for a course and get support from the experts.
As you can see, there are many ways that you can invest money. A vast majority of these are passive, but they still require hard work. As far as I am concerned, affiliate marketing is the one that has the least risk.
Affiliate marketing requires very little capital, not more than $100, but it can yield more than $100,000 over time.
My second best recommendation is for people to copy what other successful traders are doing. With this approach, you can choose traders who have a long history of success in investing. To be able to do this, you need a free social media trading software, like eTORO.
Choose how you want to invest, and decide if you want an active participation or a passive one.