9) Investing 101: Conclusion

by · August 24, 2010

Let us go over some key points on what we’ve covered in the previous sections of this tutorial. Remember these as you prepare yourself in your journey into the world of investing.

  • Investing is making your money work for you.
  • Compounding is a “miracle of mathematics” and it lets you earn more than simple interest would.
  • As an investor, know your objectives and level of risk tolerance.
  • To be successful in investing, don’t just use one strategy.
  • There are many investment vehicles. Each has its own unique characteristics.
  • Diversify investments in your portfolio to help you manage the risks involved.

In the next part, we will illustrate how you can actually make money by taking advantage of compounding.

The Example

Joseph has no prior experience in investing. He wants to invest yet he isn’t sure what his next step should be. His knowledge of finances is good but he doesn’t want to spend his free time going over financial statements or worrying about his investments. After reading more about stocks, bonds and mutual funds, Joseph learns that there are two basic approaches to the market. One is through an active portfolio management and the other is passive portfolio management.

A good example of active portfolio management is when a mutual fund manager examines a company’s financial statements to see if the stock is appropriate for the fund. Active management is about selecting securities that will perform better than the overall market.

On the other hand, passive management believes that trying to beat the market is a futile exercise. The passive investor will instead use the history of the stock market to an advantage. For example, the purchase of an index fund that mirrors a benchmark used to track the performance of a market, suits a passive investor better.
Joseph likes the idea of passive investing. It suits his style better. He decides to put his money into S&P 500 index fund, which is a mutual fund indexed to the 500 largest companies in the U.S.

Of all the types of securities, why an index fund?

  • By purchasing an index fund, Joseph doesn’t have to worry about spending too much of his free time picking stocks. An index fund is passive investing.
  • The fund is already diversified with several kinds of stocks. Most index funds can be set up with  $1,000 or less, so Joseph doesn’t need a very large amount of money to start.
  • An index fund is cheaper than any other mutual fund most of the time. The fees are far lower, plus Joseph doesn’t have to pay an expensive MBA fund manager.

Joseph also uses an automatic payment plan to invest 10% of his paycheck every month instead of investing a large amount once a year. Any bank or fund company will let you invest with an automatic payment plan. The fixed monthly investment also makes use of dollar cost averaging. At times Joseph will be buying units of the fund at higher prices, and at other times at lower prices, which will average out in the end. What is really great about dollar cost averaging is that it let’s Joseph save every month.
The Concepts at Work
And that’s about all there is to it. It’s pretty simple stuff, actually. And despite the ease of setting up a strategy like this, it allows Melanie to follow all the principles we’ve been discussing:

This strategy in investing is really quite simple. It allows Joseph to follow the principles that have been discussed in the previous sections of this tutorial. Note that this is only an example and is not meant as a personal advice. The point here is to give you an idea on how an investor might carry out the ideas in this tutorial. Try to remember too that there is no one-size-fits-all approach when it comes to investing.

  • The money is being put to work by investing in an index fund of the 500 biggest companies in the U.S.
  • Joseph can reinvest the money paid out in dividends where compounding is being applied. He can also set up a retirement fund that will allow the investment to grow without being taxed immediately and also at a lower rate.
  • The investment style allows Joseph to have more liberty to do other things with his free time. This is one of the better strategies for beginners. Later on, Joseph can invest in stocks and more advanced strategies when he is ready for it.
  • This strategy can be customized so that it meets an investor’s objectives and asset allocation. Joseph has time on his side, so it is ok for him to be totally in equities. Otherwise, an investor can buy a bond index fund easily, that still offers the low costs of indexing.

Indexing doesn’t really do any damage in the long run. While it may be a good start for beginners in investing, it isn’t the only approach. Sooner or later, when you are more comfortable and knowledgeable in investing, you should consider trying advanced strategies or riskier investments that works according to your style. All with due caution, of course. But being too risk-averse is not good. If you are too cautious and always play it safe, your investments will not grow to its full potential. Whatever you may decide, always remember the basic principles and don’t stop learning.