Before reading this blog post, consider reading my full guide to the Road to Retirement in Seven Steps first. I created it to explain how to understand your personal finances and get you on the road to financial freedom. I highly recommend completing the activities in the post before reading this one as it has key information on how to get started with your finances. Additionally, this guide will go over the necessary steps to gain control, strategically and dynamically, over your personal financial life. It goes over debt, income, and ways to find money to invest into the stock market. Finally, it also makes a recommendation on a financial app called Personal Capital to help you understand and monitor your finances. You can also read my review on Personal Capital here.
Ok – thanks for reading. Now, on to this blog post on the basics of the stock market and how to invest.
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Financial literacy is an ongoing problem facing Americans, especially for millennials, and for some reason, it doesn’t get the attention it deserves. At a time when millennials should be investing due to their still-ample time in the market, only 24% of millennials show signs of at least basic financial literacy. But the problem is not only with this age group. In 2020, only 55% of adults in the United States invested in the stock market. The statistics continue to get worse with 64% of Americans retiring with less than $10,000 and 70% of U.S. households not having a long-term financial plan.
Lack of knowledge about how to invest and manage their money prevents people from making choices to take more control of their lives. As a result, people work way into their retirement years. What if there was another way – what if you could even retire early? Would you?
Investing in the stock market is one of the best ways to build wealth, especially for retirement, and yet not everyone takes full advantage of what it has to offer. Unfortunately, many people are not comfortable with the key elements of how to invest. As a result, we are not investing or don’t invest enough, thereby losing out on one of the most valuable investing components: time!
Sure, investing in the stock market can be intimidating AND it has risks. But if you know some of the wheels and the levers, we can all take part!
“The beginning is the most important part of the work.” – Plato
In this blog post, we are going to go over some of the building blocks of the stock market, how it grows, and where to invest money. To be up front, the answer is investing in stock market indexes long term.
We are going to keep it simple to get you headed in the right direction – we don’t want to boil the ocean, as the saying goes. The point here is that stock market investing can be overly complicated, but it doesn’t have to be.
Read on to learn the six things to get you started on the right path toward investing and gaining more control of your life!
Key Components of Investing in the Stock Market
1. What is a stock and what does invest in a stock mean?
A stock is a share of a company – a piece of a company or corporation. By owning a stock, you are a shareholder; you own a piece of the company. The number of shares you hold in proportion to the overall total number of shares will tell you the percentage of the ownership you hold in that company.
If a company has one million shares and you own 200,000 shares, you will have a 20% ownership of the company. A company could have millions or even billions of shares.
For our purposes, when we are discussing investments in stocks, it is over the long term. This post is not about day trading; this is about how to increase your wealth through long-term investments to retire or even retire early. Several studies have shown that investing in the stock market over extended periods will generate favorable returns. A return is the money made or lost in the stock market. However, a favorable return occurs from either capital gains or dividends.
When the value of the stock is higher than the original price you paid when you sell it, you have a capital gain. A dividend is when the company you own shares in provides you with a share of the profit. What they pay you is a dividend, and those are paid at frequencies determined by each company, but typically it happens quarterly.
A bond is a loan that a company takes out and is paid by investors. You make money from bonds when the company pays interest. You can also sell bonds at a higher price. Bonds are considered less risky than stocks.
Over time, one of the ways to reduce your risk on your investments is to change the percentage of stocks and bonds. As you get older and want to have less risk because you no longer have time to let the market reset, you would consider changing it to have 60% stocks and 40% bonds, as an example. When you are young and have time in the market, your percentage of stocks would be higher.
Whew! We made it through the definitions. Not too bad!
The point here is to know enough information so we can benefit from the stock market, too, for the purpose of investing in it and growing our wealth.
Next, we need to know what the S&P 500 is and how we use it to invest.
2. What is the S&P 500?
A stock market index is a group of stocks’ data compiled together to determine the performance of the stock market and give you the ability to determine how the market is performing over time. There are several stock market indices; however, for our purposes, we are going to focus on the S&P 500 only (AKA Standard and Poor’s 500 Index).
The S&P 500 Index is comprised of the largest 500 companies in the United States. The S&P 500 is used as a measure of the performance of the U.S. stock market. For a company or corporation to be a part of the S&P 500, they must meet certain eligibility requirements such as being a U.S. company, having a value of $13 billion or more, and being publicly traded, amongst other things.
The S&P 500 is rebalanced quarterly, which means that some companies are removed if they no longer meet the criteria. On the other hand, new companies will be added, meaning that the companies that underperform are removed and new companies are added. This rebalancing of the S&P 500 is great because it keeps the index organic and fresh.
Let’s look at the performance of the S&P 500 before we discuss how to invest in it.
3. Performance of the S&P 500
First, let’s look at two key points in modern times when the stock market crashed on the graph. We don’t want to sugar coat anything.
2008: The market took a big hit – the S&P dropped dramatically. As a result, many people took their money out. What does that mean?
We lose money when the stock goes down. HOWEVER, we only really lose money if we sell while it’s down. If they had left their money in the stock market, 10 years later in 2018 they would have doubled their money. Remember, the strategy that we are working on here is the long term!
Personally? I didn’t take my money out. I just kept on investing. I know this is a long-term play and I just kept going. I continued to invest and doubled what was lost.
2020: This was an unprecedented time. The world’s economy shut down and there was a major drop in the stock market. We didn’t know when the economy would re-open; we didn’t know how long it would take to recover or what the recovery would look like. People became scared and just like before, they took their money out.
What would have happened if they had left their money and kept on investing? They would have taken advantage of the dip by buying when the stocks were low AND made even more money when the stock market went higher again. Turns out, the crash was a short window and the recovery hit record highs.
Look at the graph of the two time periods. Notice the upward trend that followed each dip. Here is a live version of the S&P 500.
You can see that despite these dips, the stock market has continued to increase. In fact, the S&P 500’s average annual return has been greater than 10% since its inception in 1926.
So, what does that mean for us?
Put simply, we want to invest money in a stock market index – we want to invest in the S&P 500. We aren’t going to pick individual stocks; we are going to invest in the top 500 U.S. companies, and we will let someone else do the challenging work of picking the companies for us.
The great news is that this spreads our risk to many companies based on the strength of the U.S. economy. Investing in the S&P 500 Index is a terrific way of investing for the masses because it keeps it simple and easy.
Now that you understand how the individual stocks make money and have a very basic strategy for how to invest, let’s look closer at how we make money from the stock market. The answer lies in compound interest.
4. What is compound interest and how does it work for investing?
We talked about capital gains and dividends as part of the stock market story of how shareholders make money. But we also need to see the bigger picture of making your money grow from a higher point of view.
For this, we need to talk about the power and magic of compound interest, which has been called the Eighth Wonder of the World – a phrase attributed to Einstein.
What is compounding interest? Compound interest when applied to stock market investing is not a set interest rate, although it is similar. Instead, think of it from a value point of view. When the value of your investment increases through capital gains and dividends, you earn money. With continued investing, leaving your money in the stock market along with the newly earned money will earn even more money over time.
The best way to explain compound interest investing is to show it to you in some examples. This is how to get to $1 million based on amount of money invested, growth percentage, and time:
· The same investment every year per scenario
· A stock market growth rate of 7%
· Over 40 years
In Scenario 1, based on the market conditions described above, if you invested $200 over 26 paychecks or a total amount of $5,200 per year, you will be a millionaire in 40 years. The great news is that you would have only invested a total of $208,000. Wait…what?
Yes, do you see why it’s the Eighth Wonder of the World??
You only invested $208,000 and you became a millionaire using the power of compound interest and time. Even better – the more money you invest, the more money you will make. Look at Scenario 2 and Scenario 3 after 40 years – a substantial amount of money at $2.8Million and $4.4Million.
Put simply, when you reduce some of the variables like which stock to pick, this becomes a math problem. The wonderful thing is that we have the power of the internet and great people who create online calculators to help you. This calculator gives you the ability to cut your money in several ways. It is my go-to calculator when I’m trying to look at investments from different points of view to decide how I want to invest.
Look at this blog post, the next in the series, to calculate how much money you need to retire based on your own data.
The Stock Market Is Variable
The above example shows how your money grows over time using an average stock market growth rate of 7%. However, the stock market doesn’t have a set schedule; therefore, there will be times when the stock market will go up and you make a higher percentage, or it goes down and you make a lower percentage.
Also, keep in mind that the type of investing we are doing here is playing the long game. This is the best way to let compound interest investing work to your advantage, therefore:
Be patient. Don’t touch your investments. Compounding only works if you let your money grow.
Start early. The sooner you start, the more time you have to let compound interest investing work for you. Didn’t start early? Start now.
Stay disciplined. Make regular contributions to your investment accounts and do what you can to increase your investments.
5. Is there risk in the stock market?
The answer is yes, BUT let me give you more information:
We are doing long-term investing, so we are not impacted by day-to-day activity.
We are investing in a Stock Market Index which has 500 companies instead of just one, spreading out the risk.
The S&P 500 is updated quarterly, removing companies that underperform and replacing them with high-performing ones based on set criteria.
Investing in the S&P 500 Index is managed passively, making it a low-cost expense when compared with more hands-on investments.
Adjusting the percentage of investments in stocks versus bonds is one of the ways we reduce the risk on our investments as we age.
Again, the simple answer to the above question is yes; however, you can also see how we are addressing some of the key risk issues.
What about the 7% in the example?
Is the 7% a guarantee? No, but the best way to look at this is to look at past performance. As stated before, the stock market averages 10% over time, but we showed you the dips and crashes that can and do happen. Past performance gives us directionally how the stock market performs, but there is no guarantee.
What about timing the market – is this possible?
6. Can you time the stock market?
The simple answer to timing the market is no, this is not an ideal plan for investing in the stock market.
Timing the market is the strategy that some investors attempt by buying stocks when the market is down and selling when the stocks are high. This is extremely hard to do, plus every transaction you complete has a potential tax implication, so you must be careful. Check out this info from The Balance:
"Recent research from Dalbar Inc. found that the average equity mutual fund investor earned a return of 26.14% in 2019 while the Standard & Poor's 500 Index returned 31.49%. Based on net purchases or sales from each month of that year, the average equity fund investor guessed correctly whether to get in or out of the fund only three times out of 12".
For us, we are keeping things simple and quite frankly, boring. We aren’t trying to do anything fancy pants with our investments. We are thinking of long-term investing, and the best way to accomplish this is with compound interest in the stock market.
The most recommended way that finance advisors invest money is called Dollar Cost Averaging (DCA). This is the practice of dividing up the total amount of money you are investing over a set time. If you have a 401k at work, this is a form of DCA. Every paycheck, they take out a certain amount of money. During that entire year, the stock market will go up and down, but you’re not changing your strategy – you are on your merry way investing regardless of what’s happening. Simple.
Does that mean you shouldn’t take advantage of dips in the market? Sure, I might take advantage of a dip in the market. However, this is different from waiting to invest until the stock market goes down.
We know the power of compound interest and the magic it produces with time in the market, so waiting to start investing is not a good option.