Overview

Investing is the secret to real wealth. Unfortunately most people don’t understand the true power of investing or where to begin. This article is meant to serve as a basic guide to people who find themselves in this situation. In this article I will cover: Compound Interest, what to invest in, and how to go about purchasing stocks, or in this case large baskets of stocks also known as Exchange Traded Funds (ETFs). If you currently don’t have an investment account, then this article is also a call to action. By the end of this article you will have the necessary information to get started. I challenge you today to open an account and buy one or both of the ETFs I recommend below. But don’t just listen to me. Much of what I learned is from two books: A Random Walk Down Wall Street, and The Intelligent Investor. These are two MUST READ books if you want to take it to the next level. 

Compound Interest

Albert Einstein once said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Simple Interest is when you earn a set percentage of your investment per time period, let’s say over a year. So if you were earning 8% interest on a $1,000 investment, you would earn $80 per year. Example: Year 1 = $1,000, Year 2 = $1,080 ($1,000 + $80), Year 3 = $1,160 ($1,080 + $80), and so on. 

Compound interest on the other hand is when you earn interest on your principal investment + your earned interest. For example, take your $1,000 investment from above earning 8% interest compounded annually. The first year you earn the 8% on $1,000, or $80. The next year, that $80 interest you earned is added to the initial $1,000 and now for the second year you are earning 8% interest on $1,080, which is $86.4. This is added to the $1,080 from year 2, and now for the third year you will earn 8% interest on $1,166.4, which is $93.15. The difference is substantial over time. Take a look at the image below to see just how big an impact compound interest has. When you invest in stocks and bonds, you are taking full advantage of compound interest, as long as you are reinvesting what you earn and not spending your investment income. The stock market will take wild swings from time to time in what are known as Bull Markets (up) and Bear Markets (down). Some years it may be up 35%, some years it may be down 35%. But when averaged over a long period of time, historically, the stock market rises about 8% per year. This price appreciation, compounded, is the secret to growing rich. 

Figure: Graphic representation of the difference between simple vs. compound interest over time. Initial investment of $10,000 with an 8% interest rate. 

The bottom line is: Buy stocks and bonds (or ETFs of them – explained below), never sell them, and watch your portfolio skyrocket over time. This is not a get rich quick plan, it is a get rich slowly plan. 

What to invest in

Now that you understand how compound interest works and the importance of it, let’s explore what the ‘Stock Market’ is and what to invest in. The stock market as a whole is composed of thousands of public companies. When I refer to the stock market, however, I’m loosely referring to the S&P 500, which is an index that tracks the stocks of the 500 largest companies in the U.S. Think: Amazon, Facebook, Coca Cola, Netflix, Google, Microsoft. There are a number of exchange traded funds (ETFs) that track this index, which anyone with a brokerage account can buy. The largest of its kind (and the largest ETF in the world) is the SPDR S&P 500 trust. More simply referred to as SPY. This will be your main investment. But before you go and dump all your money into the SPY there’s one other factor to consider. Most experts do not recommend investing in just stocks. 

A healthy portfolio should also include bonds. Bonds are much less risky but provide lower returns on your investment. So what percentage of your portfolio should be made up of bonds? This is a question that will yield many different answers depending on who you ask. Some suggest the ‘age rule’, which states that X% of your portfolio should be made up of bonds, where X is your age. This results in more risky investments when you are younger, and less and less risk the closer you get to retirement. Some say that everyone under the age of 50 should be invested in only stocks, stating their relatively longer time horizon (too aggressive for my taste). I loosely follow a rule from one of the most renowned economists of all time and the mentor to Warren Buffett, a man named Benjamin Graham. His rule, the ‘75/25 rule’, states that your portfolio should never be less than 25% stocks, and never more than 75% stocks. The remainder would go to bonds. The percentage you choose when following this rule would be directly based on your thoughts on the current market conditions. 50/50 being neutral. 75% stocks / 25% bonds when you feel that stock prices will continue to rise. 25% stocks / 75% bonds if you feel the market is going to crash. Of course this approach means paying close attention to the stock market, which isn’t something everyone wants to do. If that sounds like you, then follow the ‘age rule’ and invest your age in bonds and the rest in the SPY. One of the largest and most common bond ETFs is the ‘iShares Core U.S. Aggregate Bond ETF’ or AGG. Feel free to use this as your core bond fund. 

Using myself as an example here: I am 28 years old. Say I have $10,000 to invest. Using the age rule explained above I would put $2,800 into the bond ETF ‘AGG’ and $7,200 in the stock ETF ‘SPY’, which tracks the stocks of the largest 500 companies in the U.S. Adjust yearly as you get older. 

How to buy and sell stocks

You now hopefully understand compound interest and have information on two ETFs that will passively accomplish what most active traders will not: average stock market returns. Now let’s have a look at how to purchase your shares of these ETFs. 

The first step is to pick a brokerage. There are a handful you can choose from: eTrade, Ally, Fidelity, Robinhood. I personally use Robinhood because they were one of the only brokerages offering commission free trades at the time when I started. This is now a widespread and common feature amongst brokerages, so do some quick research and pick the best option for you. If you choose Robinhood, use my link to sign up and you’ll get a free stock: https://join.robinhood.com/edwardw2

After you sign up you will link your bank account for transfers and you’ll be set to purchase stocks and ETFs as you please. Search for SPY and AGG to find the aforementioned ETFs. Buy at whatever rate you can afford. 

Yet another way to invest is with a Robo Adviser like Wealthfront or Betterment. You can choose your level of risk and they will do the investing for you for a nominal fee. 

So you’ve bought these ETFs. Now what? Hold them as long as you can and enjoy the returns in retirement! Delay your gratification, do not sell to pull out your earnings. Let compound interest do it’s thing. 

Conclusion 

The one takeaway I hope you get from this is: investing is simple, and it’s the secret to growing wealthy. The approach I lay out above is a very basic one. It’s an approach meant for anyone who is not investing at all at the moment but should be, or someone who is picking stocks blindly because it’s the cool thing to do right now *cough-tesla-cough*. This is a time tested strategy that is all but guaranteed to work in the long term. This approach is best to get started. When you are comfortable with this, you can develop your approach to include different strategies, dividends, options, etc. But these all warrant their own posts. Keep an eye out for more in the future. Enter your email at the bottom of this page to sign up for automatic updates. And as always, please get in touch if you have any questions. I’m always happy to help.