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Introduction

There are plenty of grown adults out there who really seem to believe that America's stock markets are somehow magical, and that under it's magic anyone who invests in the market will always come out rich. It's easy to be enticed into investing by the success stories seen all over the newspapers, advertisements, magazines, and television. It is important to realize, however, that there is no gain without any potential loss in investing. That means you can lose part, or even all of your money in the markets.

Hopefully this writeup will help you to put your goals and expectations into perspective. In order to be a successful investor, you must be realistic about your expectations.

If you're a beginning investor, it's extremely important to realize the risks and rewards involved in investing, and consider taking it slow, especially if you're investing for the long haul.

"Investing should be boring, boring, boring." says Jane Bryant Quinn, syndicated personal finance columnist and author.

Taking it slow may be boring, but it's safe and you'll always come out a winner. Just ask the tortoise.

Risk versus reward

As I mentioned before, without risk there is no reward. You can't keep inflation at bay and prosper financially if you don't take some risks with your portfolio. Rewards and risks are thus closely related to each other. The greater your potential for reward, the greater your potential for risk and loss. The stock that went up 100% percent last quarter is most likely the same stock that will fall like a rock the next couple of months. The same applies to any other kind of investment - the more profitable the venture, the more costly the potential risk will be.

Your Best-Case Scenario

Depending on the type of investment you choose, your best-case scenario is different. Some investments are secure, fairly predictable, and stable, such as savings accounts and certificates of deposit (CDs). You can easily figure out your return (your investment's performance over time) on these investments. Other investments, however, are more dependent on market conditions and are more volatile, such as stocks, bonds, and mutual funds. There is no way to accurately predict your returns from such investments.

What you can do is a little research on your investments - there are plenty of resources available out there for you to research, for example, how the investment has performed in recent history. If you look at the history behind your potential investments, you can understand why they go up or down.

Consider the following example: In 1998, the stock for an internet bookseller named Amazon.com gave investors returns of 966%. That means if you had invested $1,000 in the last quarter of 1997, your money would be worth $10,664 by the last quarter of 1998. That's an impressive return for any investor in the stock market - much more than the average investor should expect.

Let's take a look at a few more examples in 1998. The 24 best performing stocks under Amazon.com gave investors returns between 164% and 896%, and the best performing mutual funds returned an average over 70%. On the contrary, the best corporate bonds received a return of little more than 15%.

Keep in mind, however, that these are best-case returns, and under normal conditions, stocks, bonds, and mutual funds don't give investors these kinds of returns.

Worst-Case Scenario

In contrast to the best-case scenarios, let's take a look at a few of the worst-case scenarios from recent history. In 1998, the worst performing stock cost investors 83%. That means an investment of $1,000 would have whittled away to a mere $170 by the end of the year.

Keep in mind - you will certainly lose all of your money in an investment if a company declares bankruptcy.

Realistic goals

"Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket." - Miguel de Cervantes, Don Quixote de la Mancha

It's necessary to choose your investments carefully, and have a diverse portfolio with different kinds of investments, not just high growth investments, and not just low risk investments. Take this example:

Which of the following portfolios do you think is historically more volatile?

A.) A portfolio with 100 per cent invested in bonds
B.) A portfolio with 60 per cent invested in bonds, and 40 per cent invested in stocks

The correct answer was A. In the past fifty years, a portfolio devoted totally to bonds is actually riskier than one with a healthy amount of stocks in it. Ideally, you should be able to offset your losses in one investment by the successes of another investment. By having a diverse portfoilo, you can reduce your risk.

As the adage goes, "don't venture all your eggs into one basket." If you put them all into one basket, and the basket falls, they all break, and you'll have a mess everywhere. Basically, by putting all of your money into one investment, you risk losing all of it at once. If you put all of your eggs into separate baskets, if one of them falls, you still have the others intact; if you diversify your investments, if one fails, you still have the other investments to rely upon.

Just putting your money into diverse investments is not going to make your money grow - you also have to choose these investments carefully, and that means that you have to have realisitic expectations on the risks and rewards for such investments as well. Since the 1930s, stocks have yielded an average yearly return of 10%, so returns of 15% to 20% are probably unrealistic. Same goes with corporate bonds, which returned about 6% in the same time frame, so 10% to 15% annual return is probably unrealistic.

Compounding Interest

In school, you might remember the kid who always smugly did his or her work early - always had the essay or paper done way before it's due, while you might just wait till the last minute and start furiously typing your paper the night before. Maybe you felt vindicated when the papers come back and you both got an A on the paper anyway. However, it doesn't work that way in the financial world.

In the financial world, the early birds always win. It's those who invest early that'll be retiring early and happily while everyone else is wondering how. So how is it possible?

The answer is simple - and you don't have to be a mathematics genius to understand it either. The earlier you start, the more compound interest you can begin to receive. Compound interest is the interest that you can earn on your interest. Let's take a simple example:

Let's say you've invested $10,000 and the next year you earned 10% interest in the next year, your interest income would be $1000. Now, if you earned 10% the following year, the $100 that you earned off the $1000 (the interest you gained the previous year) is called compound interest.

Take a look at the chart below to see how compounding can really make a difference over the long run:

$100 saved every month - Growth through compounding
% Return   5 years  10 years  15 years  20 years  30 years 
   0%      $6,000   $12,800   $18,000   $24,000   $36,000 
   5%      $6,829   $15,592   $26,840   $41,275   $83,573 
   8%      $7,397   $18,417   $34,835   $59,295   $150,030 
   10%     $7,808   $20,655   $41,792   $76,570   $227,933 
   12%     $8,247   $23,334   $50,458   $99,915   $352,992 
    

As you can see, compounding is a very convincing reason to start early in investing. If you're investing for retirement, perhaps you should take a look at this chart below:

Monthly investment for a $500,000 retirement by age 65 
   Age    At 8% return   At 10% return 
   35      $333           $219 
   40      $522           $374 
   45      $843           $653 
   50      $1,435         $1,196 
   55      $2,715         $2,421 

For information on how to calculate the compound interest, see other users' writeups on compound interest and the Rule of 72.

Getting Started

Before you begin in investing, it's suggested that you do a few things to ensure you are ready to dive in.

  1. First of all, you need to make sure you cover your risks. That means that you should acquire all the necessary insurance - health insurance to pay off your medical bills when you get in an accident or become ill, disability insurance to protect your income if you can't work, property and liability insurance to protect what you have, and of course, life insurance if you have dependents who count on your income.

  2. You also should contribute to your 401(k) all the way up to your company match, as soon as you can. Many mutual fund companies offer automatic withdrawal methods where the company extracts a certain amount of money from your checking account every month automatically. Your 401 (k) plan could automatically extract a percentage of your paycheck into a retirement fund. One of the key points of these plans is that the contributions are tax-deferred - taken out of your salary before taxes. Also the funds grow tax-free until withdrawn. But you do get taxed when you withdraw it from the plan. Also there are penalties if you don't meet the withdraw requirements (you are 59 1/2, or using the money to buy a home, or some other things). You should definitely invest as much as your employer and the government allows. That means if your employer provides a 401(k) retirement plan, you are allowed to contribute money to it before you pay taxes on it, which saves you current tax dollars, and all the earnings on the money compound tax-free until you pull it out. Matching is when your employer match a portion of what you contribute, normally about 50 cents on the dollar up to 6% of pay. You're missing out on this money if you don't contribute, so funding your 401(k) is extremely important. So before you invest, make sure you research your 401(k) plan, and see if it's a good idea to start contributing to it.

  3. It is extremely important to make sure your credit card debt it paid off. The reasons for this is that you have to make sure that you can't get an investment return anywhere near what you have to spend investing into your debt. Another reason why is that you have more investing flexibility and security.

  4. It is also suggested that you set up an emergency fund that contains at least three months' worth of living expenses, such as rent, food, mortgage, insurance, car payments, everything that you'd need for three months. This emergency fund will help you in times for example, when you are threatened with unemployment, or need to pay off something important like car repair or medical bills.

  5. Last of all, you have to make sure that you have a plan - you need to make sure that you are aware of what your financial goals are and what you need to do to get there, and also how much time you need to get to that point.

Every cent of your money counts. Everybody knows that bills can easily reduce even the largest paychecks to spare change. Even for good causes - your education, a babysitter, lawn trimmers, the plumber.... the money is easily taken away by anything.

The simple way to make sure that you have money to make sure you start investing is to save money. One way to do that is set aside a certain percentage or amount from your paycheck for your investments. .

Imagine how much you can save by bring carrot sticks and tuna salad every day to work instead of spending $6 a day on lunch. By investing those $6 daily for 30 years, (and assuming it earns 9% per year), you can end up with well over $200,000!

So, just taking it slow, going for the long run, and being just plain conservative with your money will make sure you are able to reach your financial goals.

Further Reading - Other Nodes

alex.tan has written some great writeups about investing that you might want to check out - Rules of investing in the 'New Era' and how to get rich trading on the stock market include basic rules you should follow when investing.

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