Why bother for a few extra percent per year?
Here’s a good answer to that sensible question: Over many years, a few extra percent per year will increase your nest egg dramatically. The more years you have to invest, the greater the difference a few percent makes in your returns (see Table 2-3).
These numbers are simply amazing! Start first with the 25-year column in Table 2-3. For every $1,000 invested over 25 years, you’ll have $1,282 at a 1 percent annual return. At a 9 percent return, you’ll have $8,623, or nearly seven times as much!
TABLE 2-3 How Compounding Grows Your Investment Dollars
| For Every $1,000 Invested at This Return | In 25 Years | In 40 Years |
|---|---|---|
| 1% | $1,282 | $1,489 |
| 2% | $1,641 | $2,208 |
| 3% | $2,094 | $3,262 |
| 4% | $2,666 | $4,801 |
| 5% | $3,386 | $7,040 |
| 6% | $4,292 | $10,286 |
| 7% | $5,427 | $14,974 |
| 8% | $6,848 | $21,725 |
| 9% | $8,623 | $31,409 |
Now look at what happens over 40 years. At a 9 percent investment return, you’ll have more than 21 times as much money versus what you’d have with a 1 percent annual investment return.
Here’s a practical example to show you what a dramatic difference earning a few extra percent can make in accomplishing your financial goals. Consider a 30-year-old investor who’s saving toward financial independence/retirement on a $60,000 annual salary. Suppose that their goal is to retire by age 67 with about $45,000 per year to live on (in today’s dollars), which would be about 75 percent of the investor’s working salary.
If this person begins saving at age 30, they need to save about $690 per month if you assume that they earn an average return on investments of about 5 percent per year. That’s a big chunk to save each year (about $8,300) — amounting to about 14 percent of gross (pretax) salary.
But what if this investor can earn an average return of just a few percent more per year — 8 percent instead of just 5 percent? In that case, the same goal could be accomplished by saving just half as much: $345 per month (or $4,150 per year)!
Considering your goals
How much do you need or want to earn on your investments?
You have to balance your goals with how you feel about risk. Some people can’t handle higher-risk investments. Although investing in stocks, real estate, or small business can produce high long-term returns, investing in these vehicles comes with greater risk, especially over the short term.
Others are at a time in their lives when they can’t afford to take great risk. If you’re still in school, if you’ve lost your job, or if you’re starting a family, your portfolio and nerves may not be able to wait a decade for your riskier investments to recover after a major stumble.
If you work for a living, odds are that you need and want to make your investments grow at a healthy clip. Should your investments grow slowly, you may fall short of your goals of owning a home or retiring or changing careers. All this is to say that you should take the time to contemplate and prioritize your personal and financial goals.
Chapter 3
The Workings of Stock and Bond Markets
IN THIS CHAPTER
To buy and enjoy using a computer or smartphone, you don’t need to know the intricacies of how each device is put together and how it works. The same holds true for investing in stocks and bonds. However, spending some time understanding how and why the financial markets function may make you more comfortable with investing and make you a better investor.
This chapter explains the ways that companies raise capital, and you get a brief primer on financial markets and economics so you can understand and be comfortable with investing in the financial markets.
How Companies Raise Money through the Financial Markets
All businesses start small — whether they begin in a garage, a spare bedroom, or a rented office. As companies begin to grow, they often need more money (known as capital in the financial world) to expand and afford their growing needs, such as hiring more employees, buying computer systems, and purchasing other equipment.
Many smaller companies rely on banks to lend them money, but growing and successful firms have other options, too, in the financial markets. Companies can choose between two major money-raising options when they go into the financial markets: issuing stocks and issuing bonds.
Deciding whether to issue stocks or bonds
Bonds are loans that a company must pay back. Instead of borrowing money from a bank, many companies elect to sell bonds, which are IOUs to investors. The primary disadvantage of issuing bonds compared with issuing stock, from a company’s perspective, is that the company must repay this money with interest. On the other hand, the business founders/owners don’t reduce or relinquish ownership when they borrow money. Companies are also more likely to issue bonds when interest rates are relatively low and/or if the stock market is depressed, meaning that companies can’t fetch as much for their stock.
Stocks are shares of ownership in a company. Some companies choose to issue stock to raise money. Unlike bonds, the money that the company raises through a stock offering isn’t paid back because it’s not a loan. When the investing public buys stock, these outside investors continue to hold and trade it. (Although companies occasionally buy their own stock back, usually because they think it’s a good investment, they’re under no obligation to do so.)Issuing stock