Whether you're considering getting started with investing or you're already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect the way your money grows.
Here’s a breakdown of the basics of investing, different risks to look out for and other factors to consider before putting your money to work.
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How Investing Works
Investing lets you take money you're not spending and put it to work for you. Money you invest in stocks and bonds can help companies or governments grow, while earning you compound interest. With time, compound interest can take modest savings and turn them into larger nest eggs, as long as you avoid some investing mistakes.
You don't necessarily have to research individual companies and buy and sell stocks on your own to become an investor. In fact, research shows that this approach is unlikely to earn you consistent returns. The average investor who doesn't have a lot of time to devote to financial management can probably get away with a few low-fee index funds.
People often put money into investments as a way to reach long-term goals. These could include reaching a financial milestone like buying a home, saving to pay for a child’s education, or simply putting away enough money for retirement.
Financial investments are financial products that are bought with the goal of making money. Common financial investments include:
- Stocks: Individual stocks are shares of a company that can increase in value as a company grows. Investors add them to their portfolios when they are prepared to take on additional risk in exchange for potentially higher returns.
- Index funds: This asset is a portfolio of stocks or bonds that tracks a market index. It tends to have lower expenses and fees when compared with actively managed funds, and is based on a long-term strategy that relies on the market to outperform single investments.
- Exchange-traded funds (ETFs): These combine features from stocks and index funds into a diversified investment that similarly tracks the returns of a market index and can also be traded. ETFs typically require smaller investments and also carry lower fees.
- Mutual funds: This asset pools money from investors to buy a collection of stocks, bonds and other securities that are bundled and traded as one investment. These are typically best for retirement and other long-term investments.
How to Calculate Return on Investment (ROI)
Return on investment (ROI) allows you to measure how much money you can make on a financial investment like a stock, mutual fund, index fund or ETF.
You can calculate the return on your investment by subtracting the initial amount of money that you put in from the final value of your financial investment. Then you would divide this total by the cost of the investment and multiply that by 100.
While you can use ROI to determine how profitable a financial investment can be, you should note that it does not account for how much time that asset will be held. And depending on your time horizon and other financial needs, this is something you should keep in mind when calculating how much money you can earn.
Factors to Consider Before You Invest
All investments carry risk. Therefore, you should consider carefully how your investment can perform based on different factors. Here are five common factors that you should keep in mind to maximize potential returns on your investment.
Risk and Return for Investments
The closer you are to retirement, the more vulnerable you are to dips in your investment portfolio. Conventional wisdom says older investors who are getting closer to retirement should reduce their exposure to risk by shifting some of their investments from stocks to bonds.
In investing, there's generally a trade-off between risk and return. The investments with higher potential for return also have higher potential for risk. The safe-and-sound investments sometimes barely beat inflation, if they do at all. Finding the asset allocation balance that's right for you will depend on your age and your risk tolerance.
Starting Balance for Investments
Say you have some money you've already saved up, you just got a bonus from work or you received money as a gift or inheritance. That sum could become your investing principal. Your principal, or starting balance, is your jumping-off point for the purposes of investing. Most brokerage firms that offer mutual funds and index funds require a starting balance of a few hundred dollars to $1,000 or more. You can buy individual equities and bonds with less than that, though.
Contributions for Investments
Once you've invested that initial sum, you'll likely want to keep adding to it. Extreme savers may want to make drastic cutbacks in their budgets so they can contribute as much as possible. Casual savers may decide on a lower amount to contribute. The amount you regularly add to your investments is called your contribution.
You can also choose how frequently you want to contribute. This is where things get interesting. Some people have their investments automatically deducted from their income. Depending on your pay schedule, that could mean monthly or biweekly contributions (if you get paid every other week). A lot of us, though, only manage to contribute to our investments once a year.
Rate of Return on Investments
When you've decided on your starting balance, contribution amount and contribution frequency, you're putting your money in the hands of the market. So how do you know what rate of return you'll earn? Well, the SmartAsset investment calculator default is 4%. This may seem low to you if you've read that the stock market averages much higher returns over the course of decades.
Let us explain. When we figure rates of return for our calculators, we're assuming you'll have an asset allocation that includes some stocks, some bonds and some cash. Those investments have varying rates of return, and experience ups and downs over time. It's always better to use a conservative estimated rate of return so you don't under-save.
Sure, you could count on a 10% rate of return if you want to feel great about your future financial security, but you likely won't be getting an accurate picture of your investing potential. That would lead to under-saving. And under-saving often leads to a future that's financially insecure.
Years to Accumulate for Investments
The last factor to consider is your investment time frame. Consider the number of years you expect will elapse before you tap into your investments. The longer you have to invest, the more time you have to take advantage of the power of compound interest. That's why it's so important to start investing at the beginning of your career, rather than waiting until you're older. You may think of investing as something only old, rich people do, but it's not. Remember that most mutual funds have low minimum investments.
As a seasoned investment professional with extensive experience in financial management and wealth-building strategies, I bring a wealth of knowledge to the table. Having navigated the complexities of various investment instruments and witnessed firsthand the dynamics of financial markets, I am well-equipped to guide you through the intricacies of investing.
Now, let's delve into the concepts discussed in the provided article:
Basics of Investing:
1. Investing Mechanism:
- Investing involves putting money to work, allowing it to grow over time through stocks and bonds.
- Compound interest plays a crucial role, turning modest savings into substantial nest eggs.
2. Investment Approaches:
- Research suggests that for the average investor with limited time, low-fee index funds are a suitable option.
- Long-term goals drive investment decisions, such as buying a home, funding education, or saving for retirement.
3. Types of Financial Investments:
- Stocks: Represent shares in a company, offering potential returns as the company grows.
- Index Funds: Portfolios mirroring market indices, characterized by lower expenses and a long-term strategy.
- Exchange-Traded Funds (ETFs): Blend stock and index fund features, offering diversification with lower fees.
- Mutual Funds: Pooled investments in stocks, bonds, and securities, often ideal for long-term goals.
Return on Investment (ROI):
1. ROI Calculation:
- ROI measures the profitability of financial investments.
- Formula: (Final Value - Initial Investment) / Initial Investment * 100.
- ROI doesn't consider the holding period, emphasizing the importance of aligning investment strategy with time horizon and financial needs.
Factors to Consider Before Investing:
1. Risk and Return:
- Trade-off between risk and return in investments.
- Older investors nearing retirement may shift from stocks to bonds to reduce vulnerability to market fluctuations.
2. Starting Balance:
- The initial sum, or starting balance, is crucial.
- Brokerage firms may require a few hundred to $1,000 for mutual funds and index funds.
- Regularly adding to investments is termed as contributions.
- Contribution amount and frequency are customizable based on financial goals and capacity.
4. Rate of Return:
- The rate of return is influenced by asset allocation, with SmartAsset's default at 4%.
- Conservative estimates are advisable to prevent under-saving and ensure financial security.
5. Years to Accumulate:
- The investment time frame significantly impacts compound interest.
- Starting early in one's career is emphasized to leverage the power of compound interest.
In conclusion, understanding these fundamental concepts is crucial for anyone looking to make informed investment decisions. Whether you're a novice or an experienced investor, a thoughtful approach, considering risk tolerance, and aligning strategies with long-term goals are key to achieving financial success.