Investing 101: 5 fast facts every beginner should know
Investing is an incredible wealth building tool and believe us when we say; you don’t need to be rich to get started.
Begin with small amounts, learn the ropes and as your confidence grows, so will your portfolio. We’ve put together a few quick facts to help you better understand some key building blocks of investing. You’ll love the one on compound interest; money #magic.
Long term investing
Long term investors are running a marathon, not sprinting, when it comes to their financial future. This type of investing pays off over years, often decades, and is the smartest path for reaching retirement and long range financial goals.
Long term investment has bunch of advantages over short term strategies. You don’t need incredible investing skills; even if you don’t get your investment choices spot on, over time these ‘mistakes’ can be corrected. Time isn’t on the side of short term investors. Compounding works in your favour — more on that shortly — and you’ll also pay less in tax.
Short term investing
Short term investors; often called ‘day-traders’, buy, hold and sell stock quickly. This type of investing isn’t for you if you don’t understand the stock market or like to sleep well at night. A poor short-term investment choice doesn’t have time to correct itself like long term investments do. While short term investing can pay off, it’s extremely difficult to score higher returns than the average return of the stock market over time.
Defining a clear goal before you start investing, whether long or short term, is crucial to make the decision right for you. Even if short term investing seems more attractive, it’s advisable to set aside a portion of your cash for long term investments.
Passive and active investing
Wherever you decide to invest, you — or your fund managers — can take two different approaches to managing your money: active or passive investing.
In a passive investment strategy, a fund’s portfolio tracks a market index, by using a basket of securities representing a particular asset class. For example, the Vanguard Australian Shares Index ETF seeks to track the return of the S&P/ASX 300 Index, 300 of the top ASX listed companies, weighted by market capitalization.
Passive investors don’t need great forecasting or stock picking skills. The goal for passive investors is not to profit from short term price fluctuations, known as “timing the market” but to steadily build wealth over time.
A passive approach is attractive because it gives investors broad access to a market segment at low cost. Management fees for passive investment strategies are significantly lower than active investment strategies (discussed below) Investors also tend to pay less investment related tax because buying and selling activity is limited with this strategy.
Active investors, or stock pickers, aim to beat the market rather than simply track the index.
Active investment requires in-depth market knowledge; as an investor, you or your fund manager are selecting individual investments rather than following the index.
Get the investment right and you might make a fortune, get it wrong and the loss could be huge. Active fund managers also charge higher management fees to support the costs of stock research and selection. Research by S&P Dow Jones Indices suggested actively managed investment portfolios consistently fail to beat the market indexes of passive investing.
EFTs vs stocks
Even if you’re super green when it comes to investing, you’ve probably heard of EFTs (short for Exchange Traded Funds) and stocks. What’s the difference?
Buying a stock means you’re investing in a single, publicly listed company. A stock is a concentrated investment carrying higher risk; if a company goes under, shareholders can lose everything.
If you’re a savvy investor who loves research and portfolio management, buying stocks may be for you but for less experienced investors, EFTs are probably a wiser choice.
Purchasing an EFT means you’re buying a bunch of different stocks — or bonds etc — giving you diversified exposure to an industry, market or sector. EFTs are a strategy even iconic stock picker Warren Buffet recommends and a smart option if you don’t want to take the hands on approach (or the risk) of buying individual stocks.
A big advantage to EFTs are low fees. Fund managers of EFTs are tracking an entire group of investments, not trying to pick individual stock winners. They don’t need to make a lot of trades so management fees stay low; trading is what costs money. The ease at which you can buy and sell ETFs also makes them attractive.
Compound interest
“I always knew I was going to be rich, so I was never in a hurry to” Warren Buffett
The magic of compound interest can help patient people (with average incomes) amass real financial security over time.
Essentially, compound interest means you earn “interest on the interest.” If an investment pays 8% compound interest annually, on a principal investment of $10,000 you’d earn $800 interest in year one.
Now you’ve got a principal investment of $10,800 so the next year produces an interest payment of $864.
The total principal is now $11,664 and will receive an 8% interest payment based on that figure in the third year and so on. See the incredible potential to grow wealth over time with this method? No wonder Einstein called compound interest the 8th wonder of the world!
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References:
ASX — Difference between active and passive investing
Financial Times — Asset management: Actively failing
AFR — Star active managers fall on hard times
AFR — S&P say aussie-managed funds underperform
ASX — The Official List (Listed Companies)
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