Today we continue the series on Adulting your Finances where we cover the basics you need to know when you step out the door of Mom and Dad’s home and start living on your own (or, maybe just start living independently and paying your way while staying at the home your grew up in). We started with the basic budget, then moved on to emergency funds. (To start from the beginning, go here.) Today we move onto investing, a topic even most adults don’t know well. We’ll start by talking about what investing is, then why it is important to invest, and then finally move onto some of the investing accounts you should have. We’ll go more in depth on how to invest a bit later in the series.
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What is investing
Many people throw around the term, “investing,” usually when they’re trying to sell you something. “Buy a new car and invest in yourself.” “Get a college degree and invest in your future.” “Buy this essential oil and invest in your mental health.”
Each of these things can be an investment, but each could also just be an expense. We’ll define an investment this way:
An investment is something you buy or make once that they provides you additional income from that point forward.
So a car could be an investment if you then used it to generate an income, perhaps driving for Uber. It could also be an investment if it allowed you to take to jobs that were too far away from your home to walk or bike to since that would allow you to increase your income over what you could earn locally. In order for it to be an investment, however, it must generate more income than it consumes and the greater the income to the expense ratio, the better the investment it is. So a $5,000 used KIA that gets you to work would be a much better investment than a $80,000 fully loaded pickup truck that also gets to work. You might pay your car expenses for the month and start earning income after a day of work, where the truck might require two weeks per month.
A college degree can certainly be an investment, but only if you get a degree that will increase your income and if the degree is actually needed to do the job. You can’t become a lawyer, engineer, or accountant without getting the needed degree. You can write books or fix cars without one. Also, you could go to the ivy league school, have a great apartment, eat out every day and run up $500,000 in student loans, or you could go to the state school, work summers, and keep expenses low and come out with no debt, then end up in the same job.
When we’re talking about investments, we’re really talking about passive investments – things that you buy that provide you with income without you really needing to do much to generate the income. These are things like shares of stock, rental buildings, and corporate bonds. With these investments, you provide the money and then others do the work needed to generate the income. You give the money someone needs to open up a business and then get a share of the profits they make.
The reason we’re interested in passive investments is that you already have a job and use your time to generate an income. We want to generate an income beyond what we can do through our own efforts. There are only so many hours in the day and if you’re working all of the time, you’re not really living. We want the ability to earn money when we’re not working and earn more than we can through our own work alone. Eventually, we want to be able to live off of the money generated by our investments without working, at a minimum by the time we reach retirement.
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Why you need to invest
Most people do not invest, at least no where as much as they should. They also don’t save up for things that they obviously will need in the future. As a result, they don’t have the $10,000 they need to replace a car or $1500 they need to replace an air conditioner. So, what do they do when the time comes to purchase one? They get a loan and start making payments. They also buy a brand new car because they can afford the payments rather than the used car that will cost them one half to one-forth as much per year due to depreciation.
As a result, they have $1000, $2000, or more each month in payments for things. That’s $12,000, $24,000, or more per year. Some of that is even interest, which is money beyond the cost of things that you’re paying. As a result, it soon becomes impossible to save up for things because all of your income is taken each month and there is nothing left over.
Let’s flip this over and say that you save up and pay cash for the first car or are given one to start out in life by your parents. You then start saving up that $600 per month you would have been spending on a car payment. After doing this for a year, you now have $7200, about enough for a good used car. After two years you have $14,400, definitely enough for a car that will get you through five years or more. You now can start buying cars for around $15,000 every five years, saving yourself $36,000 in payments for a net gain of $21,000 every five years.
So, if you and a coworker are both making the same income and he’s buying a new car every five years on payments where you’re buying a used car every five years for cash, you’ll have $21,000 extra left over every five years beyond what he has. Sure, he might have a newer car at the start, but after a year or two both cars will be basically the same. Certainly not $21,000 in difference.
But let’s then go one step further and say that instead of just saving up the money, you invest it while you’re waiting to need to buy the next car. If you can get an annualized rate of 7%, which is very doable over long periods of time with stocks, bonds, and real estate, you will have about $110,000 more than my coworker after about 15 years. If you then just leave that money to compound in investments and take money out every five years when you need a car, after another 15 years you’ll have about a quarter million dollars in that account. That is while you spend your entire income as you choose while your coworker keeps making those $600 per month car payments, so you’ll also have $7200 more to spend each year or $118,000 over a 15 year time period. That’s almost enough to send a kid to college if you choose a state school.
So, here’s the reason to invest:
By investing, we make interest instead of pay interest. We therefore get more than we earn through our labor. Those who buy things on payments get less.
FIRE = Financially Independent, Retired Early. Want to learn how to get FIREd and become financially independent, please consider picking up a copy of my new book, FIREd by Fifty: How to Create the Cash Flow You Need to Retire Early This is the instruction manual on how to become financially independent.
The type of investing we’re describing is what I would call “income investing,” where you invest to increase your income and increase your spending power. Really what you’re doing is increasing your “free cash flow,” the money that you have left over after you pay for everything. Having a big free cash flow is very important to wealth growth because is gives you money to do things like invest and buy the things you need without taking out a loan and is the main focus in FIREd by Fifty. It’s a lot easier to grow your wealth when you have an extra $100,000 in income you can use than if you don’t. You can then invest this extra income and create even more extra income, creating a feedback loop. That is where the growth of your wealth really gets going!
Investing for retirement
One place many people do invest (often because their work offers a plan and gives them free money if they take advantage of it) is for retirement. In FIREd by Fifty I actually put retirement investing into the category of “required investing” since when you get to retirement age, if you have not saved and invested enough to pay your bills for the rest of your life, you really can’t retire. But sometimes because of your health or a job loss, you end up being retired whether you like it or not.
Retirement requires a lot of money – you could be retired for 30 years or more and will need to have enough money to cover your expenses from your saving sand investments alone. Picture yourself as a farmer, growing the food you need for the year plus putting some on the shelf for the thirty years you’ll not be farming anymore but still need to eat. Plus, you could very well need $50,000 to $100,000 or more per year in medical care and/or nursing care over the last five years or so of your life.
Can you invest your emergency fund?
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.