No matter how young you are, you are never too young to start investing. The younger you start, the more you learn and the more comfortable you become with investment markets.
Starting young also lets you start small as over the long term, your investment grows in response to market cycles and the principle of compounding returns.
You don’t need lots of money to invest
Young people are often discouraged from investing because they mistakenly believe that investing requires lots of money. In today’s investment markets, it is not necessary to have a large lump sum to start investing. Many accounts can be opened with relatively small amounts and there are also regular savings plans available. Savings plans are an affordable option as they enable you to invest a small amount of money on a regular basis, often with as little as $100 per month or per quarter.
Compounding your way to a larger investment
When you start to invest, you begin to see the powerful way in which compounding enhances returns. Compounding occurs when the return earned in one period is added to the principle (reinvested),
increasing the size of the investment that is available to earn a return in the next period.
A simple example is to take an investment of $1000 that earns 10% per annum, by the end of the first year it will have accumulated $100 in interest. So the balance will rise to $1100. In the second year, at 10% per annum interest it will earn $110 in interest as the principle is $100 higher. So the balance will rise to $1210. With compounding, the dollar amount of interest earned increases every year because reinvestment of previous returns increases the size of the underlying investment.
Regular saving enhances the power of compounding
The chart over page illustrates how a savings plan can grow your investment over the long term. The red line assumes $1000 was invested in the Australian sharemarket in December 2000 with a regular quarterly saving contribution of $100. Over the next 10 years the value of this savings plan grows to $8284. By contrast, the orange line represents a $1000 investment in the same index with no savings plan. The value of this investment only grows to $2241 over the same period. Regular small contributions increase the size of your underlying investment and this enables compounding to work harder for you.
Starting early enhances the power of compounding
The earlier you start to invest, combined with the power of compounding, the greater your long term investment will be. Take two investors who each start with $1,000 and an annual return of 5% on their investment. The first investor starts investing in year one and invests $100 per month for the first five years and then stops the regular savings plan and lets the investment grow over time for twenty years. The second investor starts to invest in year ten and starts a savings plan of $100 per month for the next ten years. By the end of the twenty year time period both investments are roughly equal, but ignoring the impact of inflation, the first investor has invested $7,000 of their own money, whilst the second investor has invested $13,000 of their own money. That is almost twice the amount of the first investor, showing how starting earlier can enhance the longer term rewards.
Keys to successful investing
Three of the most important rules of successful investing are to diversify your portfolio, to invest for the long term and to understand the relationship between risk and return. Diversification involves spreading your investments across different asset classes, sectors, industries and companies in order to lower your risk. Diversification is necessary because different investments will perform well in different market conditions.
If your portfolio contains only one investment and it performs poorly, your entire portfolio will be impacted. By contrast, a portfolio that contains investments in several asset classes or a variety of shares is less risky and is not subject to the fortunes of just one investment. So it should have more stable returns. This occurs because investments in your portfolio that perform poorly will likely be offset by others that perform well.
Chart 1: The Power of a savings plan
Having a long term horizon is also important as it enables you to better manage investment cycles. Investment markets tend to follow cycles – periods of strength followed by periods of weakness. These cycles can vary in length but it is the weaker periods that tend to unnerve investors. By taking a long term view of your investments, it is easier to look through periods of weakness and view them as temporary.
Taking a short term view and selling your investments when markets fall can often result in you missing out when markets start to recover. A degree of risk is inherent in all investments. Higher risk investments, such as shares, usually have the potential to generate higher returns, but the risk of loss is also greater over the shorter term. By contrast, low risk investments, such as cash, tend to have lower returns but a much lower chance of loss. Short term volatility is high for shares.
Short term volatility can be thought of as an investor’s trade off for higher long term returns. Generally speaking, growth assets like shares will experience greater short term volatility, yet commonly provide higher long term returns than defensive assets, like cash and bonds. It could be expected that an investment in the equity market will provide a negative return once every four years or so, and only once every seven to eight years for fixed interest. When investing, you need to be aware of the risks you are taking and make sure they are within your level of risk tolerance.
So how do you start investing?
Starting small and adding to your investment regularly is a great way for a young person to begin their investment journey. As a parent or grandparent, you can also start an investment plan as a gift for a young person – a gift that teaches them the benefits of regular saving and gives them the opportunity to learn about investment markets.
Source: Aviva Investors, February 2011
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