How greedy are you?
No, I'm not trying to insult you. I'm responding to all those people who write to me - and there are plenty of them - to ask how to turn their measly savings into a whopping amount of money. Really? You think there's a magic formula? If there were, and I knew it, do you think I'd be a working grunt?
For some unfathomable reason, people have huge expectations about how investments should perform. I think it may be because of the media that hype The Bestest Investments and promote the idea that someone knows what's going on. Hello. I have some breaking news for you… Nobody knows. So that's the first thing you need to wrap your brain around. Again, if all those gurus actually had the key to making buckets full of money from their investments, why wouldn't they just do that instead of trying to convince us of how smart they all are?
The second thing you need to wrap your head around is this investment creed: the higher the return the greater the risk. Yup. That pretty well sums up investing.
So back to my question: how greedy are you? Or put another way, how much risk are you prepared to take?
Everything has some risk attached. Doing nothing with your money means leaving it to wilt under the pressure of inflation. Your $20,000 has to grow to $36,000 to have the same buying power in 40 years. So doing nothing means you could end up poorer by virtue of the fact that your money just won't go as far. If you don't believe me, go ask your grandmother what she paid for a loaf of bread.
Want to take the least amount of risk? Hey, I'm not here to judge you, just to inform you. There's a rule you need to know about if you're trying to figure out how your money will grow and it's called The Rule of 72. It's a simple way to determine how long it will take for an investment to double. It's often used with people who are investing in interest-bearing options like saving accounts or GICs, usually to make them feel small and stupid because their return is low and it's taking so looooong for their money to grow. But it's a good rule and you should know it. It goes like this:
72 divided by the return on your investment will give you the number of years it'll take for your money to double in value.
So, if you're getting 5% return on a GIC, then the formula would look like this:
72 ÷ 5 = 14.4 years
This formula is actually a little off, and gets more "off" as the rate of return increases, particularly when you're looking at returns of 20% plus. But it's handy, particularly for the math-challenged. And it can be used backwards too: Want to double your money in six years? Divide 6 into 72 to find that you'll need to earn a return of about 12%.
That means, that if you invest in a GIC earning 4%, according to The Rule of 72, it'll take 18 years for your money to double. Hmmm.
So, you're thinking to yourself, who would settle for a pathetic GIC when you could jump into the stock market and earn stellar rewards.
Hang on to your hats. Before you go dissing GICs, might I point out that if you are in any way concerned about protecting your capital - making sure the money you sweated your ass off to earn doesn't disappear into the ether - then you're concerned about risk. The least risky investments make sure your capital is completely, totally and utterly safe. Of course, they also have a tendency to earn the lowest return going.
Which is how I come back to the question: So, how greedy are you?
If you're not prepared to settle for taking 18 years to grow your $2,000 to $4,000, then you're willing to accept more risk. In doing so, you're prepared to accept that some of your sweat-money might evaporate. You are? Well, let's have a look at the investment pyramid then, shall we?
It's important that you understand how much risk you can stand before you start waking up in the middle of the night with the sweats. That's no way to live. And it's no way to invest. You should not only know how much risk you're prepared to take, but also what you're investing in.
And don't think that because something has been recommended to you, that it's okay to buy it. Recently, a senior executive in an investment house asked one of his sales people to explain a particular investment option to him. When the sales guy said, "I don't know how to explain it," the executive said, "Then maybe we shouldn't be selling it!" Rocket-science, man!
If you don't understand what you're buying, you shouldn't be buying it. If you don't know the risks involved, you shouldn't be buying it. And if you think it's too good to be true, you shouldn't be buying it.