Returns Compound
Investing scares a lot of people. Their reasoning is simple. Their money would be at risk. There are no guarantees for most investments like stocks and bonds, unlike a bank certificate of deposit (CD).
However, the return rate on a bank CD is often very low. Although recently some CDs have paid over 4% for a limited period.
Left alone in an investment vehicle, your capital (the amount you invest) could generate a return that could be re-invested.
That re-investing of returns (earnings) is the basis for compounded earnings. That means your earnings will be able to generate more earnings! Thus, returns will compound.
“Rule of Thumb” for Compounding
The Rule of 72 is a simple formula to help you determine how long it will take to double your money.
Compounding is a great process to understand. But when you are looking toward the future, including retirement, you have a chance to realize a brighter future with bigger returns.
The Rule of 72 formula helps you evaluate the investments you want to pursue based on potential returns. Some have limited time options, and some have a longer range of time considerations, like stocks.
Though the choices will vary, your goal is always to grow your investment.
Below are the formula and three examples with return rates of 4%, 6%, and 10%:
Formula: Rule of 72 = 72/Rate of Return (%) = Time to double your money
At 4% = 72/4% = 18 years to double.
At 6% = 72/6% = 12 years to double.
At 10% = 72/10% = 7.2 years to double.
When you are looking at investments for retirement, the percentage on returns begins to loom large in your retirement plans.
Most 401(k) plans will reflect the return percentage on your annual statements. One big concern for many are those years when the market cycles down. Thus, you must be sure to review your investments with your plan advisor, at least annually.
Offset the Market Swings
The second “Rule of Thumb” for investing is to Dollar Cost Average.
This one is hard for many people, especially those who are chasing investments with high returns. The problem with investments with high returns potential, like some stocks, tends to reflect big dips when the market goes down.
The “Rule of Thumb” called Dollar Cost Averaging is a tactic to help you stay calm about the effects of the business cycle. That is, the swings in the market, both up and down.
Dollar Cost Averaging is simply investing your money in equal portions, at regular intervals, regardless of the ups and downs in the market. Over a long period of time the gains and losses average out, hopefully for a good return.
Know Before You Go
Before I address the third “Rule of Thumb” for investing, I want you to consider your comfort with money, which includes your ability to earn more money, your ability to save money, and your willingness to put your savings at risk for investment.
Your ability to earn money can be affected by your age, your education, and your work experience.
If you are consistent with saving, then you have learned to live below your income and have given saving a priority in your money management.
Your comfort level with investing will be affected by your earning power and your saving disciplines.
Savings are your investment capital. Be sure to pay off debt before risking too much with investments.
Make investing a reason to study. Know all you can to get comfortable about the level of risk you are about to take on. Some risk depends on your focus, and some risk relates to market volatility for that type of investment.
Your research should educate you on potential risk and return.
Returns are important, as you have seen with the Rule of 72. But risk is a factor to be aware of. You want to get your capital plus a return at some point.
Not all investments will be winners. That is why you must try to diversify. When you diversify, you invest in a variety of industries and company sizes. Each type of investment carries its own level of risk. And history has proven many of those risk levels. With that thought, I will move on to the third “Rule of Thumb” in investing.
The Risk Tolerance “Rule of Thumb”
The “Rule of Thumb” formula for risk tolerance is:
100 – Your Age = % of High-Risk Investment Tolerance
This formula is a reasonable guide for money managers and financial advisors to use based on what it is reasonable to put at high risk based on your age.
Of course, there are other factors that affect this calculation. They include your willingness versus your ability to absorb risk, your emotional tolerance for risk, and other needs in your financial planning.
Risk comes with different levels that must be considered for tolerance. First, aggressive risk tolerance means you accept significant short-term losses for higher long-term growth, such as having a high percentage in stocks.
Second, moderate risk tolerance means you seek a balance between growth and stability, often using a 60/40 portfolio (60% stocks and 40% bonds).
Third, a conservative risk tolerance prioritizes capital preservation and stability, preferring bonds and cash over high-risk, volatile assets.
The risk comfort “Rule of Thumb” formula reflects the primary factor of your time horizon. The older you get the greater your need is to keep your assets safe. You will have less time to recover from losses.
Your financial position is a factor. Steady income and stable financial status can absorb losses better than an unstable income situation.
Some of your goals may demand priority for funding and require less risk tolerance.
Act But Don’t Overreact
This blog about investing is to help you build a better mindset for money. You will need money when you retire. And, since I hope you live a long time, you may need more money than you think for your retirement dreams.
According to published research, there are only 56% of the population in the United States that have a retirement account. And 30% of those have less than $100,000 in their account.
If you are not a part of that 56%, I suggest you find a way to start a retirement account, such as a 401(k) or an IRA, as soon as possible!
If you have a retirement account started, be sure to maximize your contributions and monitor your returns. And consult with an advisor to determine your risk tolerance.
Pensions are disappearing. The government was good enough to give us options for funding our retirement with tax-deferred or after-tax fund options, such as the Roth IRA.
Your knowledge and research on the best investment funds or other vehicles for investment will greatly enhance your chances for compounded earnings and the growth that can come from paying attention to returns.
Being consistent with contributions, with the understanding that Dollar Cost Averaging will mitigate the volatility in the market, will help you feel more confident over time.
Then, you will be less likely to overreact when returns go down and be thankful that you have the courage to act.
By taking a calculated risk in investing, you can reap the benefits of the Rule of 72!