Make Your Money Earn For You

Now that you’ve learned about budgeting and banking, it’s on to the fun stuff. Investing is the best way to earn substantial amounts of money. Here’s how you can earn money with your existing money.

Risk and Reward
Higher risk equals higher reward, right?

Nope.

Higher risk equals higher potential for reward, a big difference. The first (wrong) version assumes that if you invest in a risky venture, you will get higher rewards. This is very bad to think. The better way to think about it: If you invest in a biotech-startup, it’s risky: The stock may drop like a ton of bricks tomorrow. But if it really succeeds, the reward would be dramatic–a many-times-over overnight return on your money, something you’d never get from safer companies like GE or Wal-Mart.

What kinds of investments are risky? Well, every kind is risky to some degree. So…risky compared to what? Investing in a single stock is risky compared to investing in a lot of stocks (i.e., diversifying your portfolio). In general, stocks are riskier than bonds. And investing in an unproven startup or a company you haven’t researched in depth is really risky.

Risky investments aren’t good or bad–you just have to find a balance between your tolerance for risk and reward.

Huh?

If you’re in your twenties, you have an enormous tolerance for risk. Let’s take the worst case. Say that tomorrow, you lost your job and all your money in investments. It would be bad, thats for sure–but not catastrophic. You could still go home and live with mom and dad, look for another job, and be ok.

Things are different when you’re older. At 30, you have a spouse and kids. At 40, you have a mortgage. And at 60, you have retirement and hip surgery, you old bastard. Simply by virtue of your age and place in life, you become more conservative. You can’t afford a total wipeout when you need your Vioxx prescription filled next week.

The point is that, as young people, we can take risks now that we won’t be able to take later. And if you invest sensibly, that higher risk can translate to higher (dramatically higher) rewards.

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Investing for the Long Term
…is what smart people do. Please don’t be stupid!!

Friend: “Ramit, where should I invest my money?”
Me: “Well, when do you need the money again?”
Friend: “Next year.”
Me: (Sob) (Then bitter anger)

Investing for a 1-year outlook is almost impossible to guarantee good returns. 5 years is better; 30 years is best. If you’re reading this in your twenties, chances are you will be rich. A wise man once said that “compound interest is the greatest invention of man.” His name was Albert Einstein.

Check this scenario out: You start investing at age 25, investing $2,000 each year until age 35. Then you STOP–never touching that money again. Your dumb friend doesn’t start until age 35, but he invests $2,000 a year for 30 years (compared to your 10). Who has more by age 65?

You! Actually, you’ll have over $70,000 more than your friend. Here’s a cool simulation.

One more thing. Over time, investing for the long-term (aka “buy & hold”) always beats short-term investing. (See some basic information here & here. Once you invest your money, don’t plan to take it out for a year. 5 years is better, and 30 years is even better. Why? Any given year can be good or bad, but that volatility will be averaged out over a long period of time, with good companies providing you dramatic returns.

Here are the technical details of why long-term investing works and short-term investing sucks (skip this part if you’re not interested).

First, we’re very bad at timing the market. For example, if you buy a stock on Jan 1 and it goes up 20% by March, you might sell–only to miss the 200% climb next month. Or if your investment drops, you’re tempted to sell it to cut your losses–literally buying high and selling low. That is bad. (Read more about investor psychology).

Second, every time you sell a stock, you’re incurring trading fees and taxes. Over time, these dramatically reduce your returns. In fact, Warren Buffet (Snoop Dogg of investing) once proposed a 100% capital-gains tax on investments held less than a year.

Third, it’s a lot of work to constantly buy and sell like that. Avoid work when at all possible.

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“The Market”
You might have heard people saying “The market is up 2% today.” They’re usually talking about the S&P 500 index, a collection of 500 U.S. stocks. There are thousands of other indexes, most notably the NASDAQ (tech stocks) and the Dow Industrials, but we’ll use the S&P 500 (“the market”) for comparisons.

Now this is where it gets cool. “The market” is the benchmark for your investments. Over the past 70 years, it’s averaged an approximately 11% rate of return. Some years it went down a lot; others up). That means if you put $1.00 in, one average year later you’d have $1.11.

The Rule of 72: 72 divided by your return rate = the number of years it’ll take to double your money.

Woah. So 72/11 = 7 years to double your money. If you invested $10,000 directly into the market today, you’d likely have around $20,000 in 7 years. And that’s if you didn’t touch it at all–what if you added a little bit each month?

Anyway, use 11% as a benchmark. You should expect at least 11% from your investments because you can invest directly in the market itself. If, for example, you invested in a stock (higher risk because it’s just one stock, not 500), you’d expect a higher potential reward. So next time your friends are bragging about their stocks or mutual funds, ask them what their return rate was. “200%,” they’ll lie. Ask them what it was over 10 years, then snort. You could beat that by investing directly in the market.

Other typical rates for comparison
0.25% – typical bank savings account
2.89% – 2-year CD
9.4% – average annual mutual-fund return (with survivorship bias factored in)