Money 101Submitted by SharpMan Editorial Team on Sunday 10th October 2010
- Understanding your time horizon.
- How much risk can you tolerate?
- The beauty of compound interest.
You finally have a "real" job. You’re buying SharpToys galore, and like many Americans, you may be running up your credit card bills. Time to rethink your plan by getting out of credit card debt and investing some of your new-found cash. But before you plunge into the world of stocks, bonds and mutual funds, you really need to know a few things about your investment goals and the type of investor you are. Read on for some SharpWork basics:
"Investment," for What? Realize that an "investment" is nothing more than some amount of money you intend to save for a medium to long-term goal, such as a new car, a down payment on a house or retirement. It’s the equivalent of putting money in a piggy bank, with the added benefit of having the pig pay you for holding your money. This way your savings dollars grow more quickly.
Your Time Horizon.
The time horizon is how long you’ll have to wait to liquidate your investment and spend your money. The time horizon is one of the most important things you must know before picking a specific investment (such as a stock or mutual fund). In general, the longer your time horizon, the more aggressive you’ll want to be with your investment dollars.
Why? More aggressive investments, like stocks or stock mutual funds, tend to produce a greater return over time and tend to outpace inflation. In the short term, however, stock prices can vary widely; for example, you might experience a large short-term drop in value. (Do you know anyone who bought a lot of tech stocks in March?) This can cause major problems if you need the full value of your investment today.
While longer time horizons equal more aggressive investments, like stocks, short-term horizons equal more conservative investments. These investment options normally earn less, but preserve their value. Examples of less aggressive investments are money market funds and bank-based savings accounts.
Once you know your time horizon, remember to adjust it as you get closer to the day you’ll need the money.
Before plunking down a single dollar on your investment, you need to know your tolerance for investment risk. Sure, you may have a long time horizon (e.g., you are young and saving for retirement), but you might not have the stomach for aggressive investing. People who invest in long-term horizon vehicles like stocks who don’t tolerate investment risk very well are less likely to get the full amount out of a more aggressive investment.
Why? If you’re shaky about losing your money in the stock market, you’re more likely to sell when things go south — and they buy again when the market recovers. This is a strategy that will make your broker and the IRS happy, since they make money on the transactions, but is unlikely to pay off for you, since the taxes and commissions will eat away at the total dollar amount of your investment. On the other hand, investing in something more suited to your tolerance for risk will allow you to ride steady and collect a higher overall return.
SharpMan Tip: Studies find that most people overestimate their risk tolerance. To determine yours, ask yourself these questions:
- Do you panic when the market goes down 20% in a single day, and all of the talking heads are predicting doom and gloom?
- Do you find yourself glued to CNBC, or frantically checking your portfolio on your start page on an hourly basis?
- Does worrying about your investments and what might happen to them keep you awake at night?
If you answered "yes," your investment plan may be too aggressive. (Check out the SharpHealth article Beating Insomnia to help you cope.)
Compound interest works like this: say you put a chunk of money into an investment that earns 8% annually. At this rate, if you reinvest your earnings (i.e., keep investing the income from the initial amount you put in), you’ll have an 8% return the first year, a 47% return in five years, and 116% in ten years. Obviously, to take ultimate advantage of compound interest, you’ll want to start investing as early as possible. If you’re right out of college, all the better! But even more seasoned SharpMen can take advantage of compound interest if they start investing now.
Bear in mind that the magic of compound interest can work against you if you are in debt. The interest that compounds on your revolving credit card balance results in your paying far, far more than the purchase price of each item. Make every effort to pay credit card balances in full each month.This article last updated on Sunday 10th October 2010