Okay friends, let’s talk about investing. Over the next few posts, I’ll talk in-depth about what it is, and how we’ve chosen to do it. Before we get into the nitty-gritty details, though, I want to make something super clear: The most important aspect of saving for retirement is actually, well, saving.
It’s kind of a “duh,” right? If you don’t save, you won’t have savings. Yet I talk with people all the time who aren’t saving because they are unsure how much to save, or what the “best” investment is. There’s a great term for this, called analysis paralysis. But as long as you’re not investing in complete nonsense (and we’ll talk later about how to make sure you’re not), saving anything at all is going to get you ahead of everyone else not saving because they’re too scared to pull the trigger. In short:
Why You Need to Invest Despite Market Unpredictability
You need to save, but let’s talk a little about why you specifically need to invest. After all, investing is risky. Putting money in the stock market means you have the possibility of losing some of that money. Why bother? The answer is that you literally cannot afford not to invest.
Let’s say you were born in 1951, and were fortunate enough that your parents decided to fund your retirement at birth. They decide that you’ll need about $100,000 in 1951 dollars to be able to retire at 65 in 2016. So they put that amount a savings account. You’re set, right? Except, whoops, you actually need closer to a million bucks in 2016 to be able to buy the same amount of stuff as in 1951. Meet inflation. Inflation is the decrease in the amount of goods and services a dollar can buy. Inflation has averaged 2.75% since 1913, the first year the Consumer Price Index (which I talk more about here) was calculated.
You need your money to grow at a rate faster than inflation. A savings account, which at most pays out 1% these days, isn’t going to cut it. Instead, you need another wonderful friend on your side: compound interest. Compound interest is how you get your money to start making more money for you. It’s when you earn interest on interest, then interest on that interest, and so on. Let’s say you invested that same $100,000 in 1951, and managed to earn the average that the US stock market has returned since its inception (7%). You never add another penny and ignore it for 65 years. Today, you would have over $8,000,000. That’s more than enough to beat inflation, by about eight times over.
You need to get compound interest going for you, at a rate higher than inflation. You need to invest.
So When Do I Start Investing?
NOW. Just kidding (sort of). The sooner you get started, the better, because the longer that compound interest has time to accumulate, the more money you’ll end up with in the end. There is risk involved in investing, though, and there can be penalties for withdrawing investments early from certain types of accounts. You don’t want to find yourself having to tap into your investments before you intended to because you are working from a weak financial foundation. Before you invest, you should have:
- No non-mortgage debt. At 15% or more, credit card debt outpaces any earnings you might get from investments, plus the payments tie up more of your income, decreasing financial flexibility. Credit cards need to be cleaned up immediately, do not pass go, do not carry a balance ever again. It’s worth remembering that any sort of debt, though, signifies a loss of freedom on your part. You’re not just losing money to interest, you are also less financially flexible. Your debt payments will be due regardless of whatever happens in life. Best to remove debt from the picture all together. [As a personal aside: the one way that we broke this rule was by investing up to our companies’ matches, even while we were paying off my student loans (which is how I’ve done any investing to be talking to you about it). We decided to do this because we had plenty of margin in our budget to follow an aggressive repayment plan, and because the allure of an instant 100% return on our investment was too much for our greedy selves. More on the joys of the guaranteed 100% return later in this series.]
- An emergency fund of 3-6 months of expenses. The emergency fund is there to cover any unforeseeable expenses that you would otherwise end up covering with debt, such as a sudden job loss. You calculate your expenses by adding up everything you spend to live and cover your bills in a month. The larger your number of dependents and the more unstable your work, the larger your emergency fund should be.
- Appropriate amounts of insurance on all the things that need insuring. You need decent medical insurance. You need 10x your income in life insurance if you have dependents, to cover the period that they will remain dependents. You need car insurance that will cover whatever level of loss you can’t afford, including medical problems for yourself and others in an accident. You need renter’s or homeowner’s insurance. You need these regardless of whether you are investing or not. The whole point of insurance is to protect your assets in the event of a hugely expensive catastrophe. Investing (and living!) without appropriate insurance is just asking for something to come along and wipe you out.
If those three things are in place, you’ve got a great foundation from which to begin investing. We’ll tackle what is assuredly your next question, “Okay, but what do I invest in?” next time. (EDIT: Next time is now the present. Click here to go on to part two.)