Tuesday, May 10, 2011

Don't fear the stock market

Don't be afraid of the stock market. Be cautious, sure, don't be hasty or rash--that is a healthy and reasonable approach. But don't be afraid.

Also when someone like me starts telling you they're a stock market wizard you should walk away, or read on to humor them, but take your grain of salt along for the ride. Nobody can predict the future. You can only be a wizard in hindsight.

That said, pensions don't exist for most of us. Social security will be an echo of itself when we retire, if it exists at all.

For those born after 1960, the age for collecting full social security benefits has already been increased to age 67. (Source). As someone in her early 30s, that is a long way off. So why should I worry about it now?

Time. You should worry about it because you're wasting time.

There are two elements you need to learn right now if you don't know them:

  1. Dollar cost averaging
  2. The power of compound interest

Dollar cost averaging (DCA) is when you invest equal amounts of money into a portfolio over time so as the market goes up and down (which it will), your risk is more evened out--averaged out even. The reason this strategy works is you'd never take a lump sum and invest it into a single stock because then you have to magically pick the absolute best moment to invest, which is impossible. DCA helps you reduce risk by spreading out your exposure to price volatility.

The power of compound interest speaks to how much faster money can grow, the sooner you start saving.

"The most powerful force in the universe is compound interest."
-- Probably not Einstein

Although it's not clear if Einstein really said it, a number of financial gurus love this famous pseudo-quote attributed loosely to Albert Einstein.

Even if the quote isn't, the sentiment is genuine.

There's a little trick called the Rule of 72 that tells you know how long it will take your money (or debt) to double, ignoring taxes and fees.

Start with the number 72 then divide it by the interest rate. The result is how many years it takes your money to double.

Let's say you have $10,000 invested at 6%.

Divide 72 by 6 (interest rate) and you get 12. In 12 years you will double your money, no matter how much money you started with. In this example, after 12 years you will have $20,000.

If you take this a step further, you see that the sooner you start allowing your money to double, the more money you'll end up with. If you only have 12 years total to let your money ride, it doubles. Good, but not great. If you let your money ride for 36 years at 6%, what do you have?

This is where the power of compound interest shines. You can't just multiply what you get after the first 12 years by 3. If you did that you'd end up with only $60,000. In reality, you'd have $80,000.

Let's break it down:

  • After 12 years you have $20,000, still at 6%.

  • In another 12 years (72/6 is still 12) you double your money again, so now you have $40,000.

  • Since you still have another 12 years left, you can double your money one more time and end up with $80,000 after 36 years.

The Rule of 72 is just one way to see why compound interest is important. Retirement professionals usually show you a bar chart featuring a 25 year old versus a 50 year old which clearly lays out why time is on the 25 year old's side. Although it may be true, this chart is not targeted to people who are starting to save/invest later in life. It just makes them feel bad about not starting sooner.

So put it in the right perspective and start saving as soon as possible. Every little bit of time helps.

What does dollar cost averaging and compound interest have to do with the stock market and retirement?

You probably can't avoid the stock market if you want to retire someday. (Note: If you're already within 5-7 years of your retirement date, then other rules apply.) The stock market is currently your best hope for building the funds you need. However there is no magic investment that will get you there. Dollar cost averaging and compound interest are two tools you should know about, but there are more, such as index funds, knowing about fees, and contributing to a 401k matching plan through your employer. Start slow, educate yourself, and don't be afraid. Reading personal finance blogs, watching Suze Orman, or reading Dave Ramsey are all great places to start.

I am not a financial professional; I'm just an enthusiast. If what I say is interesting to you, please go out and do your own research and make your own decisions. Never follow anyone's advice blindly. Thanks.

2 comments:

GreenDragon said...

AHHHHH!!! MATH!!!! *runs away and hides*

Seriously though all this that you are taking about is very important, and I know this, but I have such a hard time wrapping my brain around it. So much of it is nebulous and foreign to me. I suppose I just need to pick a place to start and begin researching.

Christy said...

Both points restated without math:

1) Save $10 once a week.

2) Don't withdraw the money.

** Bonus Point ) Every couple of months, increase the amount you're saving by a dollar or two.

Later, when you start figuring out your strategy, you can do something with the money. The first step is just to save consistently. That's it. You may even already be doing it.

Using exactly the same principles you can work up to buying stock or investing in a Roth IRA. But you have to start somewhere.