Ultimately, you shouldnt start investing unless you can afford to. Remember we talked about asking yourself 3 questions to help determine whether you are ready?
- Do you have an emergency fund?
- Are you committed to leaving the money in place for a few years?
- Can you weather the ups and downs of the market?
So, if you have some money available in case of an emergency and can answer yes to questions 2 and 3, you are in a better position to get started.
In this lesson, well discuss the difference between starting earlier and later but also stress that it is never too late to start. We will also review whether you should try and time the market every time you invest, or if dollar/pound cost averaging is a better approach. Additionally, we will touch upon investing in a period of market uncertainty and discuss whether this is a wise thing to do.
Over the last two lessons, we have stressed the importance of being patient, having a long-term investing mindset and reinvesting your returns. Now lets look at the numbers that demonstrate the benefits of investing as soon as you can.
Investing early
You wont be surprised to hear that the earlier you start, the better but lets have a closer look at the details.
For the following example, we will use individuals investing $100 a month and receiving on average a 5% annual compound interest return. Again, let us stress the returns could be higher or lower and of course, one could invest more or less. Remember, the average return of the US Stock Market is 10% so we are looking at the lower end of things here.
So lets say we have two people, one called Thierry and one called Dennis. In this example, both Thierry and Dennis will retire at 65 and, as mentioned, they will both invest $100 every month and see a 5% return.
Thierry starts investing at 25 whereas Dennis starts at 35. That extra 10 years of investing can make a massive difference. Thierry will have about $160,000 whilst Dennis will have $89,000 by the time they are both 65. Thierrys account will be almost double Denniss account and he only invested $12,000 more of his own money.
This example shows the difference of starting 10 years earlier while investing the same amount every month for 30 or 40 years. Of course, as people get older, get pay rises and so on, they might invest more each month than they would have at the beginning of their investing career. Last lesson we talked about using the 50/15/5 rule as a way to go about it, with the 15 representing investing 15% of your take-home pay.
So how is it that 10 years can make such a huge difference? When youre young, investing for your future retirement can seem so far away, but the difference could be tens of thousands of dollars/pounds all thanks to compound interest.
In investing, compound interest is when the interest you earn on your investing account is reinvested, and therefore earning you more interest. This exponential growth is the snowball effect. As a snowball rolls down the hill, it starts to grow as it gathers more snow. Now, not only does the original snowball grow in size but each additional pack grows too.
Lets go through another example to demonstrate the potential benefits of investing early. For this one, we will use the average stock market returns as our base which is 10% on average. However, this time lets use an example of someone investing $200 a month.
If you started at 25 years old and invested that $200 every month until 65, how much do you think you would make? The answer? $1.2 million. While that person would have only invested $96,000, the power of compounding, reinvesting returns and regularly investing means they would have ended up with a total investment value of $1.2 million.
Some people will be able to afford more than $200 per month, so just imagine what those numbers could look like. For comparison, if someone invested for 30 years (instead of the 40 we used in the above example), their investment value would be $450,000. This is well under half the amount and really highlights that investing earlier could be better.
Timing the market vs dollar cost averaging (DCA)
Is timing the market better than just averaging in every month? Firstly, it is worth noting that it is incredibly hard to time the market. That includes highs and lows. If we just rewind to 2020, it was very hard to precisely call the market bottom and there were many incredibly smart minds that thought the market would continue on lower when it started to recover and move higher. As an investor, if you were to successfully buy or sell at the very low or high points, there is no doubt that that would be a very rewarding strategy.
Lets review some pros and cons of regularly investing every month (dollar cost averaging) versus investing a lump sum at a specific point in time.
A con of DCA, and therefore a pro of lump sum investing, is that markets do tend to go up over time. So if you do buy a lump sum earlier or a big dip in the market, the returns are likely to be greater than if you just invested the same amount every single month. However, as mentioned, timing the market is tough, and therefore a pro of DCA is that it can help to avoid bad timing.
Investing a large sum at one time runs the risk that you could have invested just before a big market fall. Imagine investing a large sum in January 2020 right before Covid? Or before other decent-sized moves lower in 2018, 2015, 2011 and of course the great financial crisis in 2008.
The good news is that the market has recovered from all of those, but DCA can help you avoid investing everything at the worst possible point. This can also help mitigate the emotional aspects when it comes to investing (we will cover this in more detail in a future class). By investing the same amount every month, you arent tied to one price like you would be if you had invested a large sum at once.
Some investors will try both strategies. They might invest the same amount every month but if the market takes a bigger than usual dip, they might then invest a larger sum to take advantage of the potential recovery from a lower level in the market. Again, there is no guarantee that all markets recover, but this is the theory.
At the end of the day, if someone was to be able to time the market efficiently, then this could be a great way to invest and see bigger returns than someone who dollar cost averages, but it is worth noting just how hard it is to time markets perfectly. A combination of the two is not a bad way to go; whether it is adding a lump sum on a 10% dip or a 20% dip for example.
You might be reading this during a period of market uncertainty and wonder whether it is the right time to invest. Well as the saying goes, bull markets are built on bear markets and last longer too! So, while there is no guarantee the market cant go lower, investing during a period of downturn could potentially be fruitful in the future if things recover. Dollar-cost averaging can help with smoothing out the volatility but could limit your returns compared to timing the market perfectly. By the way, if you can time the market perfectly, please do let us know your secret!
So while we have discussed why investing earlier could be better, we do want to stress that it is never too late to start.
Our next lesson will focus on what type of investor are you and what this could mean for how you choose to invest.
Login to your TBanque account and use the demo portfolio with $100,000 in virtual funds to practise your investing.
TBanque is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without taking into account any particular recipients investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. TBanque makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.
