Starting when I was in college, I became interested in expanding my knowledge of finance and investing topics and began building a library of useful resources to help accomplish this task. Although these books presented solid information from cover to cover, most had one or two concepts that stood out, making a profound impression on my view of investing and personal finance that continues to this day. I have outlined below five of these valuable nuggets of wisdom that will show you how to better manage your money:
- Pay Yourself First Although these magical words originated from another investing classic The Richest Man in Babylon by George Classen, I first came across them in the book Rich Dad, Poor Dad by Robert Kiyosaki. The essential message of pay yourself first is one of forced self-discipline. Most of us spend every dollar we make, without really considering what we are spending our money on and whether or not we really need the items we purchase. The more money we make, the more money we spend. Pay yourself first has us set aside money for our future BEFORE we start spending for the month. Therefore, after we pay ourselves first we can spend the rest however we wish, with the peace of mind of knowing we are preparing for our future. It is almost like we are tricking ourselves into being self-disciplined without feeling deprived or constrained.
- Magic of Compound Interest According to Albert Einstein, compound interest is the greatest mathematical discovery of all time. Einstein is one of the greatest minds in the history of the universe, and when he speaks, I listen. You may be wondering, What is compound interest, anyway? Compound interest is merely when an invested sum earns interest, and then the sum and that interest earn more interest, and so on over many years. One of the best sources on the magic of compound interest is the book Bogle on Mutual Funds by John Bogle, the founder of Vanguard Mutual Fund Company. Compound interest is one of those concepts that are more easily illustrated than defined. Suppose I gave you a choice between a million dollars, or one penny doubling every day for a month. Most people would jump at the million dollars, but the penny doubling every day for a month actually yields the larger sum. After 30 days, the doubling penny becomes over $10 million dollars. The key takeaway from the concept of compound interest is that time is the key ingredient to successful wealth creation, more so even than the rate of return. So start your investment program as soon as possible!
- Rule of 72 I love the Rule of 72 because it allows me to make accurate financial decisions on the spot without needing calculators or computers. Phil Town in his book Rule #1 outlines the usefulness of the Rule of 72 in excellent fashion. The Rule of 72 basically says that 72 divided by the rate of return on an investment gives you how many years it will take that investment to double in value. Let say you are planning on going to Florida for senior trip following high school graduation. You figure this trip will cost about $1,000 of your graduation money. To find out what the trip will really cost, you need to find out what the sum could be worth in the future, at say retirement. We will assume that this $1,000 will earn a 10% rate of return, the long term stock market average. Using the Rule of 72, 72 divided by 10 gives us about 7, meaning our money will double every 7 years. Doubling at this frequency will allow us to double our money 7 times until retirement, putting us at 67 years old. At 67, our $1,000 will have grown to $128,000. Is the senior trip worth $128,000? Maybe it is, maybe it isnt, but you have to be able to calculate what the trip will really cost you to make that decision. The Rule of 72 helps to make that calculation an easy one!
- Proper Asset Allocation Asset allocation involves the split between stocks and bonds within your investment portfolio. As you may already be aware, stock values can be very volatile, while bond values are typically much more stable. As a rule of thumb, the farther away you are from retirement, the larger your stock allocation should be because you have plenty of time to recover from downward swings. Inversely, the closer you are to retirement, the smaller your stock allocation should be because you are much closer to needing these assets to live on. John Bogles book Bogle on Mutual Funds provides excellent guidance on proper asset allocation techniques. Also, mutual fund companies such as Vanguard and T. Rowe Price have introduced new products, known as target retirement funds, which incorporate asset allocation into the management of the funds based on an individuals investment time horizon. These products become especially attractive compared to active portfolio management when expenses are taken into account, as these target retirement funds are no-load funds with expense ratios in the 0.2% neighborhood.
- Dollar Cost Averaging Many people are unsure of themselves when it comes to the timing of stock purchases. They will continually wonder, Did I buy at a low enough price? One way to eliminate those concerns is to practice dollar cost averaging. What is dollar cost averaging? It is the systematic investment of a set amount of money at some set interval over long periods of time. An example of this is how 401k plans automatically take money from your paycheck, usually bi-monthly, and invest it in the stocks and mutual funds you choose. The main advantage of doing this is that major stock market declines actually become fantastic buying opportunities. According to Robert G. Allen in his book Multiple Streams of Income, Dollar cost averaging works only if you continue buying especially during the bad times and hold on until good times return. If you stop buying during the bad times, you lose your advantage when things rebound. Therefore, the key to successfully implementing a dollar cost averaging approach is to ignore your emotions and continue investing no matter the current state of the market.
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