Setting goals is a vital step you need to take to ensure a financially healthy life. But when an investment company asks, “what’s your retirement number?” it’s hard for many people to answer. How much do you need to retire? How about, “As much as humanly possible”?
So instead of obsessing about a random number, you should first take a good look at who you are and what your needs are. Once you do that, you’re going to learn what kind of investments you should make and how much risk you should take on. Only then can you even begin to set goals.
So, let’s first look at you and begin with your investment objectives.
Objectives may sound like the same thing as goals, but they are slightly different. Your objective should be a general idea of what you want to get out of your investments. Do you want to generate income that you can use to live off? Or do you want to grow your saving for later use? Do you want to grow as quick as you can? Or do you want to make sure don’t lose any value to your investments? These general objectives will guide your investment decisions.
Next, evaluate how much risk you are willing to take on. If you will lose sleep when any of your investments lose value, then you probably have a low tolerance for risk. If you want fast growth and can tolerate the prospect of sometimes losing money, you probably have a high tolerance for risk.
Your objectives and risk tolerance can sometimes run counter to each other. If, for example, you want high returns, but you’re scared to death of losing money, then you need to move away from making high growth investing your objective. The strategy would be too risky and would be beyond what your risk tolerance could handle, and so make sure your objectives and risk tolerance match.
Next, let’s look at where you are in life. Life-related self-assessments must be taken into consideration when setting your goals. To do this, you should ask yourself a few key questions. In fact, every registered investment advisor is mandated to do the same for every client.
First question is your experience level. This one is straightforward. If you’ve never invested before, you should start off slowly and not take on too much risk.
Next, look at your time horizon. This one is not as straightforward. There is a lot of debate about how much risk you should take as you get older. Conventional wisdom says that you should take on less risk as you get older because you have less time left to correct mistakes. Which makes sense.
But there is now a lot of evidence to show that keeping a higher level of risk can pay off substantially when you’re older because you’ll have so much more money to invest.
In the end, a middle ground probably makes sense. Keeping some level of risk doesn’t mean you have to be reckless. It just means you don’t have to eliminate risk altogether as you get older.
Here is a good way to think about risk:
- Take on as much risk as you can tolerate when you’re young because you have more time to make up for mistakes.
- When you near retirement, maintain as much risk as you can tolerate. Retirement doesn’t mean you stop investing.
- But if the risk of losing money gives you anxiety, lower your risk level.
Another question to consider is your financial situation. If you have some debt and only a little bit of savings, you should not take on much risk. You literally cannot afford to lose money. On the other hand, if you have little or no debt and some savings, you can take on more risk.
Finally, your family situation should also influence how much risk you take on. If you are married with kids, you need to be more conservative to protect the savings you have, especially for things like health care and education.
So now let’s look back at your objectives. Again, you need to modify your objectives to match your self-assessment. If you are inexperienced, have some debt and have a family, you need to be very conservative with your investments to protect your savings. If are young, without kids, have trading experience, have little debt and a sizable disposable income, you can take on a considerable amount of risk.
In the meanwhile, here’s a goal for you: Save as much money as possible! But make sure you keep that goal within the bounds of your objectives and tolerance for risk.
Also keep in mind the bigger picture of savings. You should be thinking about budgeting and debt reduction so that you have more money to invest.
In the end, your objectives will get you on a road to savings and growth. Over time, this will help will buy you options in life. You’ll suddenly have to opportunity to go back to school, or take time off to take care of your kids, or buy a house… You don’t know where you’ll be in the future, but if you invest and grow your savings, in the future you will have options. And your future you will thank you for that.
It’s no secret - investing can be risky. You can lose money. And the greater the risk, the more amount of money you can lose.
To protect yourself from loss, you need to fully understand what risk is, and which investments have the highest risk.
So let’s start by looking at what risk is.
Risk refers to the possibility that your investments can lose value. On the rare extreme, some investments have the potential to lose all of their value. Even taking on moderate risk can expose you to a loss that can make your investment lose money. Risk is real, and when it hits you, the loss can be painful.
But risk also has a positive implication. There is a direct relationship between risk and the potential for positive returns. By taking on risk, not only is there the potential for loss, but there is also the potential for a positive return. This is called the ‘risk premium’. The market can reward those investors that take a risk. And the greater the risk, the greater the potential return.
For super-sophisticated financial products like options and shorts, the risk is so great that there is the possibility that you can lose more than 100% of what you invested. But people invest in these products because the potential upside can be just as massive.
On the other end of the risk scale are US Government bonds. They have statistically zero percent chance of losing value (the US government guarantees that the interest and principal will be paid). But for that guarantee of return, you have to give up all of your risk premium and get only a tiny return on your investment.
So the adage, “nothing risked, nothing gained” is an absolute truth in investing.
So here is the risk / reward scale – which ranges from:
Lowest risk with lowest potential loss / lowest potential return to
Greatest risk with highest potential return / highest potential loss
- US government bonds. These are the least risky investments available. They are backed by the US government, and have never failed to pay their principal or stated return. The risk is almost zero, and with the small risk comes a very small return.
- Investment grade corporate bonds. Many large companies issue bonds to fund development or expansion. Third parties will evaluate these bonds and the top rated bonds will be deemed “investment grade”. These bonds rarely collapse, so your principal is well protected. And while it is possible for interest payments to stop, it happens very rarely with these bonds. So you have slightly higher risk with moderately higher returns
- Stocks. The risk associated with common stock can vary widely. But one thing is true: Because the value of stocks fluctuate, the value of your investment CAN go down. For large, strong, ‘blue chip’ companies, the fluctuations are generally smaller, and the risks can be lower. For smaller, less known stocks, fluctuations can be severe and risk is much higher.
- Junk bonds. These are bonds that are rated below investment grade. They are usually issued by companies who are finding it hard to find financing. These bonds usually pay high interest. But because the underlying companies are often in a risky business or have weak financials, the risk of loss of principal and interest payments is real.
- Options, derivatives, short selling. These are all high-risk investments and should be avoided unless you are a super-sophisticated investor. The risk to your principal is so great that you can lose more than what you invested. But when they work, the potential return can be very large.
So now you know that risk equals potential loss as well as potential return. And the higher the risk, the higher the potential gain and the higher the potential loss.
And if someone tells you that an investment is low risk with high returns? A “sure thing”? Run the other way!
Your next steps are to look at how much risk you personally should take on. Spend some time learning about your own ‘risk tolerance’ - that will help you assess how much risk is right for you.
You probably know this already, but it can’t hurt to repeat it: Investing can be risky. This means that your investments can lose value. And when this happens, it can not only be painful, it can also impact your economic wellbeing.
But risk can also be your friend. Without taking on some risk, it is almost impossible to get good returns. The key is finding an appropriate level of risk that you are comfortable with. An educated risk is what you’re after, and that balance will reward you in the long run
In order to sort out how much risk you should take on, it is a good idea to take an overt look at where you are as an investor. Every investor should do this, and every investment advisor is mandated to do this. It’s called a ‘know your client’ (KYC) assessment, which gauges how much risk an investor should take on.
Generally, you should take on less risk if you are
- An inexperienced investor
- Have a family to support
- Want to protect your savings
- Are saving very little
- Have a lot of debt
- Are close to retirement
If you fall into a category that qualifies you as a low risk investor, it means you should take on more low-risk investments and less higher risk investments. This means your portfolio should hold a greater weight of government bonds and investment grade bonds and a lower weight of individual stocks. And if you do hold stocks, they should be large, strong blue chip stocks.
If you qualify to take on more risk, then you can lower the weight of bonds and hold more stocks. And those stocks can be smaller, more growth focused companies.
What about funds? Where do they fit into this mix? A fund can be made up of just about anything: bonds, large stocks, small cap stocks. So their risk is dependent on what is inside the fund. So bond funds can replace bonds and equity funds can replace individual funds in a portfolio.
Index funds, on the other hand, track the overall market. This means that when the overall market goes up, your investments increase in value, and when it goes down, you lose value. You will never do better or worse than the market. Index funds have the same risk as the overall market and sit right in the middle in terms of risk.
But this is all a very objective exercise. What about you and what you want? What if you are the type of person that likes to jump out of airplanes? Maybe you can tolerate more risk?
As part of any KYC, an advisor needs to ask an investor how much risk they believe that they can tolerate. Maybe a conservative portfolio is still too risky for someone who has little appetite for risk? Or maybe a low-risk portfolio has too little potential up side for someone who can tolerate more risk.
This self-assessment needs to take into consideration not only how much potential loss an investor can handle, but also how much potential return they are interested in.
In the end, a personal risk assessment should only change an investor’s risk profile a few degrees. An investor who should take on only a little bit of risk is not served well with a portfolio of volatile stocks. The risk assessment should still focus on what is appropriate for the investor and adjust it slightly for his or her own preferences.
Also consider that your risk profile is something that evolves over time as you gain confidence, experience, knowledge and assets. So don’t rush into risk. It is something that you will learn to manage and you should give yourself time to understand it.
In the end, the only time you will know your true tolerance for risk is when you are risking real money. Only when you actually feel the impact of a loss will you truly know if you can manage it. If the loss impacts you so much that it affects your quality of life, you need to lower the amount of risk you’ve taken on.
So do your best to make sure you understand how much risk you can take on. And reassess where you are at least once a year.
Nobody likes bad news. And that is especially true for investors. Bad news about a company can lower its stock price and wipe out billions of dollars of investor’s money.
Unfortunately bad news is hard to avoid. Often investors don’t see it coming. It could be news of a criminal investigation, an outbreak of a virus at a restaurant chain, a drop in oil prices, restated earnings, a lawsuit, new regulations, a product recall… These are risks that are hard to predict and even harder to avoid.
These risks are called ‘non-systemic risks’. They are things that hit individual companies or isolated pockets of the market more than the rest of the overall market.
Although you can’t entirely avoid non-systemic risks, there are ways to minimize their impact. This is done through diversification. By putting your eggs in different baskets, you are diversifying your investments and lowering your overall risk.
You can do this in three ways: diversify by asset class, geography or industry
Asset Class
The most important area of diversification is by asset class. When you invest, you can hold different asset classes, namely stocks, bonds, funds and cash. It is always a good idea to have a mix of all of these.
Stocks tend to be more volatile and risky and have more exposure to non-systemic risk. Bonds tend to be much less volatile, more stable and less risky. Stocks and bonds also tend to move in opposite cycles.
Funds can function like either bonds or funds, depending on what they hold. And cash is held as protection against a falling market (cash will not lose value like a stock).
By holding a mix of these four asset classes, it allows you spread your risk so that bad news will not hit all of your holdings at once. And by reducing your exposure to stocks, you can lower your exposure to non-systemic risk.
Geography
You can also diversify by geography by buying stocks and or bonds from different parts of the world. You can spread your investments across the US, Europe, Asia and the developing world. By segmenting your investments this way, the drop in the Russian Ruble or a meltdown in Asia will impact only a portion of your portfolio.
Industry
Finally, you can diversify by industry. Many industries run in different cycles, so by diversifying by industry you will make sure your entire portfolio doesn’t hit a down-cycle at the exact same time. For example, by investing in both miners and manufactures, you will protect yourself from falling commodity prices because low commodity prices will hurt mining but benefit manufacturers.
You should try to make sure your holdings are not concentrated in a single industry like technology or retail. Companies in these segments are popular and easy to understand, so make sure your portfolio isn’t biased towards these industries.
Simple Diversification
It should be noted here that Exchange Traded Funds (ETFs) can be an excellent, low cost way to diversify your portfolio. You can find ETFs that are diversified by geography, industry or asset class. A single fund can do a ton of diversification work for you, especially when you are building your first portfolio.
So that’s diversification. It’s easier than it looks. Start by diversifying between stocks, bonds, funds and cash. Use ETFs to do some easy diversification for you. Aim to diversify even further by industry or geography if you can. If you do it well, you can reduce some of the bumpiness of the overall market and lower your exposure to the impact of bad news.
Managing risk is one of the most important jobs you have when you are investing. The key way to do this is to spread your risk among different investments. By putting your eggs in different baskets, you are “balancing your portfolio” and spreading your overall risk.
As you know, markets go up and down. But these ups and downs are uneven and unpredictable. When one part of the market goes up, others can go down. When stocks go ups, bonds often go down. Even on the same news, the impact can be different.
This volatility can be managed to some degree. Events like drops in commodity prices, bad management decisions, product recalls, and changes in regulations hit individual companies, industries and countries differently. These are called non-systemic risks, and these risks are what you try to manage though balance.
The tool that is used to balance non-systemic risk is diversification. By diversifying your portfolio, you can manage some of your risk. You can do this in three ways: diversifying by asset class, geography or industry.
Most of the heavy lifting of diversification happens by diversifying by asset class. When you invest, you can buy stocks, bonds and funds, or just hold cash. Each of these asset classes behaves in its own way. Stocks tend to be more volatile and risky. Bonds tend to be much less volatile and more stable. Stocks and bonds also tend to move in opposite cycles. And cash keeps its value even in market downturns.
So by spreading your portfolio among these asset classes, your portfolio can be somewhat insulated from different types of market forces. Something that hits stocks hard may be a benefit to bonds and something that hurts bonds can sometimes help stocks. So by mixing your asset holdings, your portfolio can weather many kinds of market storms.
You can also diversify your portfolio geographically. If your portfolio holds lots of US stocks, it would be a good idea to diversify by buying European or Asian investments. By spreading your money this way, a downturn in the US will only impact part of your portfolio.
Finally, you can diversify by industry. Different industries run in different cycles. A downturn in oil prices for example may be devastating to oil companies, but lower fuel prices are a boon to transportation. By buying into different industries you will make sure that a down-cycle in one part of your portfolio will not spread to your whole portfolio. If you start with broad categories such as primary industries, manufacturers and services, you can branch out into more specific categories once you get the hang of it.
Also note that Exchange Traded Funds (ETF), can be an simple, low cost way to instantly diversify your portfolio. You can find ETFs that are diversified by geography, industry or asset class. A single fund can do a ton of diversification work for you, especially when you are just starting out.
Now that you know how to balance your portfolio, we need to look at the most important part of balance: you! No matter how you balance your portfolio, you need to take into account your own risk tolerance. If you don’t have much of an appetite for risk, or really cannot afford to lose money, then your portfolio should be balanced towards more conservative products.
The most effective way to manage risk is through asset allocation, specifically the proportion of stock, bonds and cash you hold. If you have a conservative risk profile, it would be good to hold more bonds and cash and a lower proportion of stock. If you can accommodate a lot of risk, you can hold a greater proportion of stock.
As a guideline, this is a sample of what a balanced portfolio should look like: A conservative investor can have a mix of 70% bonds, 20% stocks and 10% cash. For an aggressive investor, the holdings are inverse, 70% stocks, 20% bonds and 10% cash.
If you don’t have an appetite for risk, choose a bond fund at the core of your portfolio and take only a small proportion of stock. If you have a higher tolerance for risk, maybe take a more aggressive fund as your core, and take a larger proportion of stock.
One last thing, it’s always good to go back and revisit your balance every three months. The value of your holdings will change over time, so your balance will change. Make sure you check to see if you’re comfortable with your new balance. If you’re not, rebalance by selling some of the asset where you’re overweight, putting the proceeds into the assets where you’re underweight.
So that’s balance. It’s easier than it looks. Start by diversifying between stocks, bonds, funds and cash. Use ETFs to do some easy diversification for you. Aim to diversify even further by industry or geography if you can. But make sure you’ve taken your own risk tolerance into consideration. If you do this well, even if one part of the market hits the rocks, your overall portfolio won’t be impacted severely. And that’s the goal of balance: making sure a downturn in one part of the market doesn’t ruin your whole portfolio.
Just like when you exercise your regular muscles, your money muscles can be strengthened over time with practice and training.
Your money muscles are just an analogy for your risk tolerance. But your risk tolerance sounds so abstract that we are going to stick with muscles. Think of going to the gym for the first time. You generally feel fine… until the next day when everything hurts. The pain comes from the tiny tears in your muscles as they repair themselves and get stronger. Over time, by exercising again and again, your body gets used to the work, and you get to know what your body can tolerate.
Like with exercising, one of the hardest things with investing is taking the first steps. The most frightening investment is always the first. And the biggest high is always the first sale for a gain. Over time you learn what it feels like to have small gains and big gains; as well as small losses, and big losses. If the pleasure of your bigger gains is stronger than the pain of your bigger losses, it means that you are open to risk. If the pain of losing money is very difficult, then maybe less risk is more appropriate.
You can only build your money muscles over time through practice. Some of the best investors started out very risk averse (even saying they preferred to keep money in their mattresses!), but learned that they could get over their risk aversion by making small investments, or even virtual ones. So seeing that one week your $1,000 is worth $1,200 and the next it’s $900 and the week after it’s $1,100… you start to realize that your holdings will fluctuate. And the key is that over time, an amazing thing happens. As your investments change in value, your ability to TOLERATE those swings becomes easier and easier. That is your money muscles at work.
So what can you do to help build your money muscles?
The most important thing to do is to practice. Using virtual money in a practice portfolio is a terrific way to build your money muscles. You won’t get the same anxiety about risking your own money, or the excitement of making a profit. But by investing virtual dollars you’ll get a good feel for the market. You will get an understanding of how the value of your virtual portfolio fluctuates, when to buy and sell, how to ride though the dips, how to manage your risk and how much attention to pay to your portfolio. These are all critical skills that you can learn through practice in a virtual portfolio.
It will also help to learn what an appropriate level of risk is for you. If you feel nauseous when you your portfolio is down, then maybe a little less risk is appropriate. If you can ride out the ups and downs without anxiety, then you should be fine with risk.
Once you’re comfortable and have a feel for how the market works, then it will be time to open a trading account and invest your own money. The added emotion of real risk adds a new dimension to investing. It’s like the difference between running in the gym and running a race. You’re still basically doing the same thing, but a race adds an emotional difference that needs to be managed.
In investing, risking your savings can add a level of anxiety or a level of excitement that can make you misinterpret the risks in front of you. But if you have some confidence from practicing, and your money muscles are ready, you can manage your emotions and become a successful investor. Just make sure you monitor yourself as you manage your portfolio. If you feel too much anxiety, make sure you ratchet down the risk in your portfolio. And if you feel super-exited, make sure adrenaline isn’t making rash decisions for you, making you take on too much risk.
So that’s money muscles. Practice to gain your confidence. Watch yourself to understand your risk tolerance and remember that investing is a lifelong journey. Your muscles will grow over time if you use them!
So you have money to invest. You have a plan. You know your goals. You know your risk profile. You know what you want to invest in. Maybe you’ve already begun the journey and invested your hard-earned money already. Now what? How will you know how well you’re doing? How do you measure success?
First of all, it is super-important to go back to your objectives. Did you want to be cautious and preserve the money you had, or did you want to go all out and generate huge returns? The performance of your portfolio needs to be seen in comparison to those objectives.
You also need to look at what you’ve invested in. If you invested in conservative government bonds, you should not expect outsized gains. Your performance needs to be compared to the kinds of investments you’ve bought.
So let’s start by measuring gains. First of all there is a big difference between realized gains and unrealized gains. Realized gains are investments that you have sold, for a profit. The gain, called a capital gain, is taxed. Until you sell, there is no “real” gain and no tax. It also means you can’t really brag about all the huge gains you’ve made until you actually realize them by selling!
To figure out your gain, start with what you paid for the stock, including fees. This is called your costs basis. Now subtract this from the sum total of what you sold the stock for (the amount you got from the stock sale, minus any fees). This is your gain.
If you want to know the percentage gain, take your gain and divide it by your cost basis and multiply that by 100. That will give you your percentage gain. So if you bought a stock for $1,000 and sold it for $1,200, your gain would be 200 divided by 1,000, or 20%.
To better understand this percentage gain, you have to take note of how long it took you to earn it. A 10% might look great on paper, but if it took you 5 years to earn that gain, it really is only a 2% gain per year. So dividing your gain by the number of years you held the investment, will give you a good overall picture of your gain.
As a side note, if you sell for a gain outside of a tax advantaged retirement account (IRA or 401K), make sure you keep some of the money aside to pay taxes on your gain. If you held the stock for more than a year, you get a preferential capital gains rate that ranges from 0% to 20%. If you held it for less than a year, you will be taxed at your normal income tax rate.
To keep track of day-to-day changes, you should track unrealized gains. Keep track of each individual investment’s cost basis, and its current value. Also keep track of any fees as they come up and add them to the cost basis. This may be difficult to do for funds that charge fees over time. But it is super-important to do this. You need to see how of your gains are eaten by fees.
By adding up all your unrealized gain and losses, you will get a good sense of how well your overall portfolio is doing. Most brokers allow you to track this fairly easily.
So now that you know how to measure gains and losses, how do you judge those gains and losses? Is a 10% gain good? Is 5% terrible? How can you tell how well you’re doing?
Strangely enough, in order to know how well you’re doing, you need to compare yourself to how everyone else is doing.
If your stocks went up 5% last year, that sounds good. But what if the overall economy was in full gear and the overall stock market went up 20%? It means your stocks didn’t leverage the high-flying economy very well, and your stocks lagged the average. On the other hand, that 5% would be terrific if the overall market went down 5%. So context is important. Compare your gains to average stock market performance to see how well you’re doing.
The S&P 500 is considered the best proxy for the overall stock market, so compare your stock returns to that index.
The final thing to watch is deciding when to sell. Watching the performance of your stocks should give you sell information. If you’ve made terrific gains, on a stock, you should consider selling some of it to lock in the gain, or get out entirely. Don’t be too greedy! Also if a company’s stock drops because something fundamentally is wrong with the company such as restated earnings, lawsuits, plummeting sales, it may be time to bite the bullet and sell at a loss. Always have an exit strategy.
So that’s how you measure progress. You should look at it as often as you can, and as carefully as you can, making sure you incorporate all costs. By watching your progress, you’ll close the loop in your investing journey, giving you feedback to help you make good investing decisions.
How much is your money worth right now? The balance you see on your ATM receipt only tells part of the story. Your money also has another story, which speaks of it’s potential to do things in the future.
Money holds tremendous opportunity. Maybe the money you have saved will be able to pay for a boat in 5 years? Maybe it will be the deposit on a house in 10 years? What if you want to pay for $10,000 in tuition in 5 years, will the $7,500 you have right now pay for it?
These are all great questions and ones we can actually figure out.
These are called Present Value calculations and with it, you can figure out if you have enough today to do something important in the future.
To make the calculation, you need to know 3 things
- The price of the thing you want in the future (Future Value, FV)
- The length of time in until that point in the future (In years, Y)
- The rate of return you would get if you invest that money (Return, r)
You can go online to find present value calculators, but to do it manually, here’s the formula:
PV = FV / (1 + r)Y
It looks a little complicated, but it is fairly simple.
Let’s look at the above tuition example. If you need $10,000 in 5 years, you have two of the inputs figured out, FV, which is $10,000 and Y, which is 5 years.
The last thing you need is the rate of return. To be conservative, let’s assume you put that money into the stock market, buying an index Exchange Traded Fund. Let’s say you buy SPY, an ETF that tracks the S&P 500, and is super low cost. Its 10-year average return is around 7% per year. So let’s assume that SPY will return the same 7% for the next 5 years (a big assumption yes, but we have to put our feet somewhere).
In Excel the formula would be =10000/(1+.07)^5
When you plug the numbers into the formula you get a present value of $7,130, which means that you would need to invest $7,130 today in order to have $10,000 in five years. So the answer to the question is yes, our friend with $7,500 in the bank today should be able to invest her money and pay her tuition in 5 years (and still have money left over for some books!).
But, you may have noticed that the weakness of the present value calculation is the rate of return. As we said, you have to put your feet down and make an assumption about the rate of return you’ll get. But in reality, it is hard to predict what kind of return you will get, or even what risks you will tolerate to get it. So present value calculations have to be used with an eye to your own situation.
If instead you want to know the rate of return you require to grow your current savings into your goal amount, the present value calculation can be flipped around to tell you that rate of return. In order to calculate this, you would use this formula:
r = (FV / PV)1/y - 1
Let’s look at our tuition example again. If you want to grow your $7,500 savings into your $10,000 tuition in 5 years, you need to figure out what kind of annual return you need to earn in order to get to your goal.
In Excel, the calculation would be =((10000/7500)^(1/5))-1
So in this example, you would need a compounded annual growth rate of 5.92% in order to get to your $10,000 tuition goal.
Present value calculations are a great way to help you get your head around investment goals and targeted returns. The formulas get more complicated as your situations get more complex. There are lots of terrific calculators on-line to help you make these calculations. Go here for a very simple present value calculator. Or look to Calculator Soup or Financial-Calculators.comfor more sophisticated present value calculators.
People invest their money in the hope that it will increase in value over time. Without this reward, people would not take on the risk of investing. Growth is a fundamental prerequisite for almost any investment.
But how do you predict growth? Or even measure it? How do you figure out how much your investment will be worth in the future? Well, guess what? There is a way to figure this out! Roll up your sleeves and dig into the concept of ‘future value’.
Future value (FV) is the idea that a current investment will have a predictable value in the future, given an assumed rate of growth over time. So if you want to look at the future and see how much your investments might be worth, try a future value calculation.
There are online calculators that will do the work for you – but it’s important to understand the underlying idea.
We’ll start with an easy example: An interest bearing savings account. Let’s also assume that you don’t add any money to the account along the way and the interest rate you get does not change. Let’s say you put $5,000 in a savings account. We’ll call that ‘present value’ (PV). Now let’s say that the account pays 3% interest. We’ll call that the ‘rate of return’ (r). Finally, let’s also assume that you put the money away for 5 years. We’ll use 5 as the ‘number of periods’ (n). So now, if you want to know how much your money will be worth after 5 years, you use this ‘future value’ (FV) calculation
FV = PV (1 + r)n
If we plug in the numbers into Excel, it looks like this:
=5000*(1+.03)^5
Which gives you the result $5,796. So there you go, your money grew! Sweet!
Now lets assume that instead earning interest once per year, you get interest once per month. Nothing else changes, you still get 3% interest, but it gets paid as 0.25% every month. Let’s see what happens.
So now your (r) is .0025 (3% per year divided into 12 months) and your (n) is 60 (5 years times 12 months). If we plug these numbers into Excel, it looks like this:
=5000*(1+.0025)^60
By changing the frequency of your interest payments, your money grew faster, to $5,808 after 5 years. So the frequency of your compounding makes a difference! By spreading out your interest payments, you will earn interest on your already accumulating interest, thereby amplifying the effects of compounding, even at the same interest rate.
Future value calculations are a great way to compare potential investments, extrapolate savings into retirement or to see if you’ll have enough money to put your kids through college.
The only weakness to future value calculations is having to select an appropriate rate of return. It is impossible to look into the future, so there is no way to know precisely what rate of return you will actually get on your investments. So it’s a good idea, with any future value calculation, to use a range of inputs. The historical rate of return for US stock markets is around 7%, so it would be good to look at returns above and below that rate. If you are a conservative investor who avoids risk, focus on rates of return that are below 5%.
Finally, it is important to note that future value can be super-amplified by adding to your investments over time. The examples we’ve used here assume you put your money away and don’t add to it. If you instead added $10 every month to your investment, it would be worth $6,455 at the end of five years. Even adding a small amount regularly to your investments can make a huge difference.
Try out this more sophisticated future value calculator to see how adding deposits over time impacts the growth of your investments.
Get familiar with future value by trying out different rates of return, different starting values and different durations for your investments. When you do this, you will get a good idea how much you need to be putting away and what sort of return you will need to get for various future goals.
Future value is a vital concept to understand if you are setting any sort of savings goal for yourself. Savings goals become much more reasonable when you plug them into a future value calculator. It may seem like a boring proposition, but an hour spent experimenting with future value will go a long way to helping you realize your investment goals.
You’ve certainly heard the expression ‘time is money’. It’s usually applied to time wasted when you could be earning or doing something productive. But it’s even more applicable when it comes to investing.
Time is super-important to investing and every investor has to be mindful of it. Let’s start with the idea of compound interest – which is basically the way that money you invest grows exponentially vs in a straight line. Exponential growth means that you earn money on the money you earn.
To put it in real terms – with compound interest a thousand dollars invested today, assuming a conservative 4% return will grow to $1,480 in 10 years, $2,190 in 20 and $3,243 in 30 years.
Awesome right?
Not so fast, you also have to consider inflation.
In 1985, a loaf of bread used to cost 74 cents. In 2016, the price had risen to $2.45. So what has happened? In essence, the price of all goods and services in the US rose between 1985 and 2016. This general rise of overall prices in an economy is inflation.
The impact of inflation is real. If you put money under your mattress in 1985 to buy bread in 2016, you’re going to get a whole lot less bread for your dollar!
So let’s play it forward – will the cost of a loaf of bread triple again in 30 years? Maybe. The important thing to remember – your money, in pure terms, will probably be worth less in the future.
So – what does that mean to you? If you’re using a bank account to save, every dollar you save today that isn’t paying interest higher than the rate of inflation will be worth less in the future. By seeking out higher returns you can look to reduce the impact of inflation in the future.
Let’s go back to your thousand dollars. Today it will buy 408 loaves of bread. If you put the $1,000 under your mattress, in 30 years it will buy you something like 130 loaves. Now look at the outcome of investing. If you invest your thousand dollars, in 30 years you may be able to buy as many as 450 loaves of bread. Investing keeps you ahead of the effects of inflation.
Two more sophisticated concepts are buried in the bread story: ‘present value’ & ‘future value’. These are two different ways to think about the time/money relationship.
Present value is the calculation of what you need today, to get you to a specific future goal. Let’s say I have a goal of someday buying a beautiful boat. You estimate that the boat is going to cost you $500,000. First, give that ‘some day’ a date. Let’s say in 15 years time. Then assume an annual return – historical stock market returns have averaged 8% a year, but being conservative is always good – so let’s say 4%.
The present value of the money that I need invest today in order to buy that boat is $277,000. So with $277,000 and 15 years of investing – I should be able to afford my $500,000 boat.
Good way to think of it, right? Seems a little more affordable now.
Let’s look at it a different way. Let’s say I did have $277,000 lying around. The Future Value of that money, at 4% return is $500K in 15 years. However, the future value of that $277,000 if I don’t invest it, is $277,000. And remember that inflation will also have an effect on what I can afford. So that $277,000 in 15 years will buy a lot less of a boat than it can buy today.
It can be hard to get out of the cycle of living paycheck to paycheck. But the ideas around compound interest, inflation, present and future value of money can help you think beyond where you are today, and look to a more financially secure future where your money works as hard as you do.
Remember, if you’re just starting out on your investment journey, and you have many years ahead of you, then you have something that the most successful established investors do not: Time. And the sooner you start, the better.
Investing is risky. There is always a chance that your investments will lose value. You may have bought stock in an oil company that gets hit by lower oil prices. Or maybe your restaurant chain is hit by an E.coli outbreak (yes you Chipotle!). Or maybe your investment is in an older company that gets crushed by innovative competitors. There is always a chance that a stock or bond will lose value, and some of your hard earned money will vanish.
But the reason that people invest is that there is also a chance that your investment will increase in value. And that’s what why people take risks in investing; the search for profits.
If you want to avoid risk, there is actually something called the risk-free rate of return. For investors, this is the 3-month US Treasury bill. The government of the United States backs the payment on this bond, and it has never defaulted on it. So it is as close to a guaranteed return as you can find. But it is also one of the lowest returns available. Right now it returns a fraction of a percent a year. Your return is guaranteed, but your return is miniscule.
And there’s the rub. If you want higher returns, you need to take on more risk. The higher the risk you take, the higher your potential reward, and the higher the chance you will lose money.
So how do you measure risk? For bonds, it’s easy to measure. A third party (either Standard & Poors or Moody’s) rates every bond, and tells you what the risks are (either from not paying the stated interest payments or from not paying back your principal). So for bonds, investors can look at their ratings and easily gauge risk.
For stocks and funds, it is much harder to gauge risk. The current value of any stock is determined minute by minute by buyers and sellers in a market. That means that at any moment, the current price only reflects what the current risks are.
But the real problem of gauging risk is trying to do it into the future. As with anything predictive, it is extremely difficult to know all the things that could go wrong. And with risks, they are often invisible until they actually rear their heads.
There are analysts who rate stocks, and some are good at gauging risk. But for any single stock there will be dozens of different opinions about risk, so it is difficult to figure who has the assessment right.
Added to this are risks that you can’t avoid. These are called systemic risks or market risks, which impact entire markets. These are usually large events, like financial meltdowns or acts of war, which tend to hit all markets hard. These are unavoidable, but if you can hold on through these downturns, stock markets have always rebounded. Just hold your breath!
As a side note, systemic risks are great for bargain hunters. During the last downturn, Apple stock got cut in half, even though their sales are profits were increasing. Systemic downturns hit all stocks, even if they don’t deserve it. And those battered stocks are tremendously undervalued in those instances.
To manage your risk you need to do several things. First is to do your research. Know what you are buying. And do your best to gauge underlying risk in whatever you invest in.
Also, you need to know how much risk you personally should take on. Because stocks are riskier than bonds, the general rule of thumb is that the younger you are, and the more experience you have, the greater the proportion of stocks you can hold. Should stocks experience a downturn, you will have the time and experience to ride it out.
Unfortunately, there are risks that will pop up that you will not be able to avoid, a product recall maybe, or a lawsuit: Things that surprise all investors. And these are painful. Just make sure you reassess the company and decide whether this event shows a fundamental flaw with the company, which should make you sell your holding. Or maybe it’s just a bump in the road that time will rectify, and you should hold on to the stock and ride it out.
Risk can be both your friend and your enemy in investing. Without taking on some risk, it is impossible to get good returns. The important thing is to understand the risk involved and being secure in the level of risk you’ve taken on. Risk in itself is not bad. An educated risk is what you’re after, and it will reward you in the long run.
