In the bi-weekly Stuff Our Parents Never Taught Us series I will introduce and clarify basic financial concepts in an attempt to increase the level of financial literacy among my Millennial peers. For some bizar reason, the majority of our parents didn’t think it necessary to teach us the 101 course of personal finance. If you’re over 18 and have no idea what stocks and bonds are, or how interest rates and dividends work, this is for you!
In a recent study the European Central Bank found that households in the Euro area hardly participate in financial assets. Only 5.3% of all households own bonds, whereas 10.1% hold shares of publicly traded businesses. Mutual funds don’t fare much better though with a participation rate of only 11.4%.
With investor confidence dropping to all time lows following the 2008 financial and sovereign debt crisis it comes as no surprise that the only popular asset classes among most Euro households are deposits and life insurance accounts, even though the ECB hopes to activate these savings with a low central bank interest rate. Investing does indeed remain one of the essential corner stones to building and preserving wealth since both the power of compounding interest and the 4% rule heavily rely on investment returns.
Especially if you are looking to reach financial independence or early retirement it is necessary to invest your savings because you need them to generate income in the future. Nevertheless, to most people investing remains one of the biggest hurdles to building a retirement nest egg, mainly because of a lack of knowledge.
What is investing?
An investment is, generally speaking, some sort of effort that provides a type of benefit in the future. You can invest in yourself, for example, by going to law school in the hope that you land a well-paying job at a law firm when you graduate. In such a case your current effort of going to school provides you the benefit of a higher salary later on.
In finance, investing means that you purchase an asset with the hope that it generates future income or appreciates to the point that you can sell the asset at a higher price point. You basically try to achieve a future profit within a specific long-term time frame. A good investment strategy furthermore diversifies the assets of a portfolio according to the needs and risk aversion of the investor.
People invest their savings because they want to increase their personal wealth, their sense of security or to be able to afford more things later on. More and more people also turn to investing because they would like to afford a comfortable retirement. Members of the financial independence and early retirement community use investments as a way to put their money to work and provide an income after quitting their day jobs, much like traditional retirement investing, but at a much younger age.
Contrary to trading or speculation, which are short-term practices with a much higher degree of risk associated with them, a long-term outlook is essential to investing. Warren Buffett, the most succesful investor of the 20th century, is famously quoted as saying: “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” This makes sense since wealth creation is highly dependent on compounding interest, which shows its true power in the long-run only.
Traditional types of investments
Investors traditionally differentiate between four types of investment vehicles: cash, bonds, stocks and real estate.
Contrary to the types of investments below, cash investments are more easily redeemable with no or only a small penalty for withdrawal. Most popular cash investments include bank accounts, savings accounts and certificates of deposits. The downside to the high liquidity of cash is a lower interest rate than other types of investments due to the relative short-term nature of the investment.
Bonds are certificates of debt issued by governments or companies. They provide an annual return in the form of interest or coupons until the outstanding debt is payed off. Even though the value of a bond is the same at the start as at the end of the term, its value can fluctuate over time because bonds can be traded on the secondary market. As a result, a bond is quite a liquid investment.
Generally speaking, bonds are considered more risky than cash investments and less risky than stocks. This is because the principal of a bond has to be repaid by the debtor at the end of the bond’s term, except when the issuing government or company defaults. Even then, a bondholder’s payments receive priority over stockholders’ because he has a creditor stake rather than an equity stake.
Stocks are probably the best-known type of investment to the general population because most people find it easy to imagine owning a small piece of a company. The total stock of a company, which constitutes the equity stake of its owners, is divided into shares that are often publicly traded on stock exchanges.
Unlike cash investments and bonds there is no fixed interest rate, even though some stocks provide a fairly steady level of dividend payments. The value of a stock furthermore fluctuates at any given time because its share price is determined by the principle of supply and demand. As a result, stocks have an even higher investment risk than bonds, which is why most people buy mutual or index funds instead of individual stocks.
Even though most investors favor a certain degree of liquidity, some much rather enjoy the safety of owning a property for the purpose of renting or reselling at a higher price. By far the most popular real estate investments happen in the residential and commercial sector.
Many investors are drawn to real estate because it is the least efficient or organized market of all traditional investments. Indeed, individual properties are not interchangeable themselves, which increases the chance of information assymetries. Even though this provides bargain level opportunities to investors, many overestimate their appraisal techniques to determine fair property value. Real estate is also highly cash flow dependent and very capital intensive.
Just like many roads lead to Rome, many investment strategies lead to wealth building. While they all have clear advantages and disadvantages – this is why you diversify your investments as much as possible – increasing financial security without investing is next to impossible.
Personally, I’ve taken to stocks mostly. The majority of my investments are in exchange-traded index funds and recently I’ve kickstarted my own dividend growth stocks portfolio. I furthermore own a fixed income life-insurance type account, which could be considered a cash investment. In the future I hope to add some real estate through some Real Estate Investment Trusts. Bonds will probably be added into the mix as I exit the wealth building stage and enter the wealth preservation stage of my life.
Because of my current holdings I’m among one in ten Europeans who own financial assets other than deposits and life insurance accounts. Clearly, most people don’t seem to enjoy investing as much as they should. “Investing is risky, I don’t want to lose my money!” is an often-heard excuse, mostly the result of a lack of knowledge or outright fear.
Nicola from The Frugal Cottage, for example, recently admitted that investing scares her. Even though she did plenty of research, she is still afraid to make mistakes. Not too long ago I felt exactly the same way, but two things helped me overcome my fear.
First, I turned to the personal finance community and looked for bloggers that recently started their own investing adventure. Learning from others’ mistakes is an excellent way to avoid the beginner pitfalls. Of course, don’t forget to read up on some more seasoned investors! They provide invaluable experience and information you won’t find anywhere else.
Second, I decided to try things out with a virtual portfolio. I started with an initial investment of €10,000 to see how the entire process of buying and selling stocks worked. After a month I felt confident enough to try things out with my own savings. I haven’t looked back since.
How did you first feel about investing? Which investment vehicle or strategy do you prefer?