Let’s face it: investment choices are fun and exciting. Hot tips are the subject of cocktail chatter, water-cooler discussions and newspaper and magazine articles. It draws attention and holds interest. But do the investment choices that you make really matter? The answer depends on the stage you’re at in your financial progression.
Are you familiar with the “power of compounding” spreadsheet (PDF)? It shows that if you start saving a large amount early on, then stop saving, someone who saves the same amount, but starts years later (eg. 10 years later), will never catch up (assuming you both earn the same return). The point is made that the earlier you start, the greater your success. As I reviewed the calculations, I realised where the “transition” point is. When the investment return for Saver 1 is greater than the savings rate for Saver 2, the first person could stop saving and the second person can never catch up.
Not only is it important to start early, it matters little where you put your money. Suppose you have $5000. Whether you put it in a term deposit at 4% (to have $5200 next year) or a stock market index ETF and earn 15% (to have $5750 next year), your account will grow much faster if you save another $1000 (or more). Later on, however, the investment return becomes much more important. As an example, with an account balance of $200,000, the term deposit ($208,000 a year later) falls far behind the hypothetical ETF ($230,000 a year later), but neither is affected much by a $1000 deposit.
This is not a licence to make bad choices. No matter what amount you start with, if you lose all your capital, you will be set back to zero. You can save the cash in your mattress, in a term deposit, in a bond fund or in a stock-index ETF, as long as the chance of permanent and total loss is minimised. Avoid buying shares in a single company that you don’t know well, a real estate investment that’s promoted in the media or any investment scheme that seems too good to be true.
There is no rush to be able to distinguish between a gamble and a wise investment. You can take your finances one step at a time. The first priority is to control your spending. Next, when you’re spending less than you earn, set aside savings each paycheque or each month. Once those two habits are in place, you are ready to invest your savings wisely.