Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
One small step that everyone can take to improve their personal finances is to start investing. With extremely low interest rates on savings products for the last seven years, now- more than ever- it pays to be an investor. The goal of investing is to increase wealth and accumulate money for long-term goals such as retirement.
An important investment prerequisite is an “investor’s mindset.” This means being psychologically ready to accept the uncertainty that is part and parcel of investing (read: you can stomach losing some money). Instead of a predictable (albeit low) bank account or CD rate of return, investment returns can- and do- vary.
Below are six advantages of investing:
Attractive Returns - According to data compiled by Ibbotson, an investment research firm, between 1926 and 2013 (88 years), the compound annual return on various types of investments was as follows: 12.3% for small company stocks, 10.1% for large company stocks, 6.0% for government bonds, and 3.5% for Treasury bills. The inflation rate during this period averaged 3.0%. People with all of their money in cash assets barely would have kept up with inflation and probably had a negative return after subtracting both inflation and taxes.
The Magic of Compound Interest - Over time, compound interest magnifies the difference in the returns of asset classes. According to Ibbotson, an investment research firm, a dollar invested in large company stocks (measured by the performance of the Standard & Poor’s 500 index) and a dollar invested in bonds (measured by the performance of U.S. government bonds) differed by about a 29:1 ratio from 1926-2013, not a 3:1 or 2:1 ratio that many people would expect by simply looking at average annual return figures.
Long-Term Growth - Money grows faster over time in investments rather than savings products such as bank accounts and CDs. To figure out how fast money doubles, use the Rule of 72. Simply divide an investment’s return into 72 to determine the number of years that it takes for a sum of money to double. Of course, past performance is no indication of future results. Nevertheless, history is instructive. With a 10% return, money will double in about seven and a half years. With a 3.5% return, it would take 20 and a half years. Even worse, with today’s low rates on cash assets, it will take 72 years to double a sum of money with a 1% return.
Time Diversification - Time decreases the volatility, or ups and downs, of investments. This is especially true for stocks and mutual funds that invest in stocks. Investors should know the time frame for their financial goals and plan on investing at least five years to reduce the risk of loss associated with investing in stock for a short time period. Another way to diversify is to select diversified mutual funds or exchange-traded funds.
Tax-Free Investment Options - Several investments provide tax-free income, which is beneficial for high marginal tax bracket investors. Available options include state or local government municipal bonds and tax-exempt municipal bond funds. In addition, you can withdraw the earnings from a Roth IRA tax free if you have reached the age of 59½, and at least five years have passed since your Roth IRA account was opened.
Affordability - Many investments require only small dollar amounts to get started. Examples include stocks that offer direct purchase plans and mutual funds that open accounts for $1,000 or less. You can reduce the average cost of an investment over time by depositing a fixed amount at regular time intervals, a strategy called dollar-cost averaging (DCA). DCA won’t protect you from losses during market downturns but it does fit the way that most people receive money to invest: weekly, bi-weekly, or monthly, depending on how they get paid. If you are participating in an employer retirement savings plan, you are already practicing DCA.