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Boosting Financial Literacy: Investing and Compound Interest Explained

Boosting Financial Literacy: Investing and Compound Interest Explained

April 17, 2024 7 min read

The history of money can teach us many things, but perhaps the most significant is that money tends to lose value over time. One way to reverse this decline in purchasing power is to invest funds into something that can gain value in the meantime. This then enables you to focus on your long-term goals such as saving for retirement, purchasing a home, or achieving financial independence.

Yet, investing is not without risk. Like all other important monetary choices, investment decisions should be taken with care and adequate financial information. With that in mind, let’s explore the concept of investing, the different types of investments available and how compound interest can help you accumulate wealth.

Investing Fundamentals

Before investing

It’s always good practice to be debt-free. Ultimately, the interest rates paid on the vast majority of short-term debts are higher than the returns received from most investments, meaning indebted investors would likely lose money overall. No less important, if you’re looking to invest in physical assets like property, is your credit history. Ensure that you don’t miss any payments as this will make it harder to obtain a mortgage.

Equally, budget for the unexpected. Emergencies often occur when we least expect them. In these situations, panicking and withdrawing any investments you have made may not necessarily be the best option for you in the medium to long term. To that end, make sure you are prepared to face life’s inevitable ups and downs before committing any money to future plans. 

What is investing?

In the world of finance, investing refers to the purchase of assets that are expected to increase in value. Unlike placing funds in an account to build up savings, investing is all about using money to make more money.

Investing creates wealth in two ways. In its purest form, investing is about buying an asset at a low price and selling it at a higher price in the future. This is known as a capital gain. In most countries, capital gains are considered part of your income and are therefore taxable.

However, not all investments are made with the intention of selling the asset. Many investors hold on to them and accumulate wealth through dividends; regular payments made to the investor based on the performance of the asset. Like capital gains, dividends are also taxable although some countries allow you to receive a certain amount as a personal allowance before applying income tax. In terms of personal finance, dividends can either be used as a steady stream of income or reinvested to boost future earnings.

Risk and Return

The key to investing is finding the right balance between risk and potential reward. Ultimately, all investments come with a degree of risk, so make sure you weigh up any investment choices carefully.

Typically, riskier investments offer higher potential returns either through more lucrative dividends or a substantial increase in overall value. However, it is important to understand that the possibility of losing money with these investments is far greater. For this reason, many investors are risk-averse, instead favoring a more stable long-term strategy. The benefits of this approach are clear. If you make sensible choices, most investments will deliver healthy returns over an extended period. For instance, a standard investment in corporate stocks of $100 in 1970 would be worth over $22,000 in 2023. Accumulating wealth this way can help you plan for the future and ultimately make strides toward financial independence.

Types of Investment

Stocks

Also known as equities and shares, stocks are one of the oldest investments in existence. When you buy stocks, you are essentially acquiring small pieces of ownership in a company, enabling you to benefit from the financial growth and success of the corporation.

Simply put, if a company performs well, then demand for its stock will rise, increasing the share price on the stock market. In this scenario, you can either choose to sell your shares for profit or, alternatively, hold on to them in anticipation of future growth. While potential returns are difficult to ascertain, over the course of the last 53 years, US stocks have delivered an average annual yield of 7.58% or 10.51% if dividends are reinvested.

Principally, stocks come in two forms: common and preferred. Common stock allows shareholders to vote on company decisions such as appointing board members or changes in company policy. Preferred stock does not come with voting rights, but importantly pays dividends. For this reason, most shareholders own common stock as preferred stock is usually more expensive.

Yet, neither common nor preferred stocks are risk-free investments. The stock market is composed of millions of investors who can all have varying degrees of confidence in a company. As a result, share prices are constantly fluctuating and are prone to sudden shocks. For instance, share prices in most companies fell notably in the early stages of the coronavirus pandemic due to the level of global uncertainty. However, this level of volatility did not last and after 126 trading days the stock market had completely recovered.

Bonds

Essentially acting as a loan from an investor to a government or corporation, bonds are securities that allow you to receive interest payments for the use of your funds. These interest payments are known as coupons and are typically paid annually. Coupon rates can be either fixed or variable, meaning that they would change depending on the interest rates set by central banks

Unlike stocks, all bonds have a maturity date, a specified time at which the bond will expire. When this moment arrives, the original sum plus any outstanding coupon payments must be paid. Given they are not subject to the same degree of fluctuation as stocks, bonds particularly interest those looking for very stable investment opportunities. Typically, government bonds are considered the safest as they are backed by the administration’s ability to raise revenue through taxation. Since 1926, long-term US treasury bonds have returned an average between 5-6%. Corporate bonds however carry greater risk, and this is usually reflected with a higher coupon rate.

Mutual Funds and ETFs

Held by banks and trust companies, mutual funds and ETFs (Exchange-traded funds) are collective investment opportunities that allow you to purchase portions of a fund alongside other investors. Typically, these funds are made up of numerous stocks, commodities and bonds, all placed together in one grouping. The benefit of having multiple investments in one diversified portfolio is that it spreads the risk across multiple companies, sectors, and geographic locations.

However, mutual funds and ETFs are not the same. Mutual funds are generally bought from investment companies and are actively managed by professionals constantly trying to improve the fund to provide you with a better return. This is particularly useful if you have little to no investment experience. That said, investment companies do charge a fee for these services. In 2021, the average expense ratio was 0.6% but they can exceed 1%. So, when you are calculating any potential returns, remember to factor this fee into your thought process.

ETFs are widely considered to be a cheaper version of a mutual fund. Functioning like regular stocks, ETFs can be bought and sold in an open market. However, because they are not actively managed, ETFs seldom achieve a higher return than mutual funds.

The Power of Compound Interest

Once you have invested in stocks, bonds or funds, the all-important next step is to reinvest any earnings from themDoing so allows your investments to produce stronger returns and grow exponentially over time.

For instance, if you invested $10,000 with a yearly interest rate of 5%, after one year your earnings would be $500, giving you a grand total of $10,500. However, unlike simple interest, which is based only on your initial investment, compound interest also includes accumulated interest from previous years i.e. interest on interest.

On this basis, your earnings would increase to $525 the following year, bringing your new total to $11,025. If repeated for 30 years, your total investment would surpass $43,000. We know calculating compound interest growth over an extended period of time can be complicated, but you can use this compound interest calculator to make it easier.

The nature of compound interest and its ability to accumulate wealth particularly benefits younger investors who have plenty of time to see their investments grow. Recognizing this fact, most investment institutions will offer to automatically reinvest earnings on your behalf.

Remittances & Investing in your future

There are lots of parallels between investing and sending money transfers. In many respects, if you send remittances back home, you’re already investing and it’s just a matter of learning to apply these principles to your personal finances.

Like investments, remittances contribute to long-term prosperity. Families often use these funds to further their children’s education or purchase property. Better still, approximately 25% of all remittances go toward savings and investments in activities that generate income and jobs, boosting local communities. In this sense, sending remittances is one of the best investments you can make as they have the power to not only address immediate needs but also contribute toward a better future for your loved ones.

Ready to send money home? We’re here for you. Our Ria Money Transfer App is available for iOS and Android – download it today to get started!

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