Most everyone would like to have more money. Although people who have a great deal of money could argue that with wealth comes a different set of problems. While that’s true, I have been broke and in debt and I have had money and I can say I’d rather have money and the problems that come with it. If you understand that sentiment, you might wonder ‘How do I make money work for me?’
I enjoy music and especially enjoy learning and playing guitar. That guitar I’m holding was paid for from money that my money made for me. While the guitar is nice, it’s even better knowing you don’t have to part with your capital to pay for it!
Compound interest is the first tool in the investor’s tool box that you need to understand. In the words that follow we’ll examine the basic factors that make the process of compound interest work. Collectively they are called the Time Value of Money (TVM). Not only can the factors here work for you, the same factors also work against you when you choose to use credit or take out a loan. In the ongoing battle in everyone’s personal budget to expand income and control expenses, the characteristics that make money work can be your ally if you know how to put them to work, or a formidable obstacle to your wealth if you let them take advantage of you.
The Moving Parts:
How does money ‘work’?
There are three factors in the relationship known as the ‘Time-Value of Money’ (TVM) that control how money (or value) can be put to work and can return a profit to you. The first is capital. Capital is your own money that you have created or saved. You can earn a profit when you loan your capital out to someone else to use for their purposes. As with most loans, your capital or the ‘principle’ of a loan is paid back to you with interest; more money than you loaned out in the first place. If you don’t already have savings or ‘money left-over’, you might need to eliminate debt or expand your income first. We’ll come back to that idea…
I’m not a bank, how do I create a loan?
The easiest way is to make a deposit to a savings account at a bank or a share account at a credit union. Since these financial institutions use the deposits in your account as capital for loans that they make to other bank customers, you are in effect loaning money to the bank on which they pay you interest. Rates for accounts at banks are notoriously low at present (at or below 1%) and are much less than the rate of inflation (real rates estimated near 11%). Inflation is taking more value from your savings than what you are earning from the bank in this case (1 minus 11, so -10%), so while you are earning interest, inflation is ‘winning’ and you’ve only managed to slow the process down a little (very little). A savings account free of service charges (becoming more rare) can be put to good use keeping savings separate from operational funds, but don’t expect it to earn you much money.
In a more formal agreement, you can take out a certificate of deposit (CD), a type of bond issued by a bank. A bond basically stipulates how much capital you have loaned, how long the borrower can use your capital (the term or maturity date), and what interest rate you’ll be paid. Interest rates paid to you are usually higher on CD’s and bonds because the bank knows exactly how long they can use your money before they must return it. Bond interest levels are also notoriously low at present with even the 30 year treasury at less than three percent (3%). While interest levels are slightly higher, bonds are less ‘liquid’ than a savings account in that you would have to pay a penalty to get your capital back before fulfilling the term of the bond agreement. Other types on contracts with much higher possible interest rates with a lack of exposure to market risk are available to people at nearly all income levels, but are rarely discussed with anyone to whom 401k and IRA type tax-deferred programs are being marketed!
Other securities such as stocks and corporate bonds (loan agreements with a corporation) work in similar fashion only in the case of stocks, there are no guarantees for return on your capital. You must choose the company in which you invest carefully as the value of the stock can fall as easily as it can rise (capital gain and loss). Dividends (income) paid can also be reduced or retracted by the company as readily as they can be increased. The security of a corporate bond rests with the ability of the issuing corporation to expand business operations and investments that produce profit. Will the company be operational and profitable enough to honor your bond at maturity? The potential for loss as well as gain make investing in stocks and bonds a much higher risk venture than banking, though in essence, you are again loaning money to a company in expectation of a return on your capital. While risk can be a bit scary, risk can be fought with education; the more you know about your investment, the better choices you can make, and the less risk there is.
These are not the only investment vehicles available in which you can put your wealth to work, though they are simple examples that many people can understand. If you are paying down debt first or working to save capital, use your prep-time to begin studying investing ideas. What makes a good company and what factors should be considered when evaluating companies to invest in? What sectors are being discussed by other investors as the next growth area? What companies are paying dividends and what is their past track record? Track some companies that you think you might like and see how they perform while you are amassing capital. Use the time you are prepping capital to ‘get your head in the game’.
The Rate of Interest, or simply ‘rate’, is the second factor. Rates of interest are usually expressed as annual rates to keep comparisons among similar financial instruments consistent. These rates are often paid more often than every 12 months with most banks paying interest monthly and stocks commonly paying dividends quarterly. The periodic rate is the rate at which interest is actually calculated and is figured by dividing the annual rate by the number of periods each year.
For example, on a 12% annual percentage rate (APR) the periodic rates would be 1% each month (paid 12x per year) and 3% each quarter (paid every 3 months, 4x a year). Of course, the higher the percentage, the bigger the chunks of interest that are paid out. As the interest rate of various investments increase, the risk for loss of your capital usually increases along with it. The interest rate or yield and the degree of risk you are willing to endure are key factors in choosing the investment vehicles that are best suited for you as an investor.
Performance of businesses offering shares in the stock market will usually be rated as an annual yield, an estimate based on past performance, not as a set interest rate as with banks and other financial institutions. Dividends are portions of the corporate profits paid out to shareholders. Your yield or performance on an investment varies with the level of the dividend paid out per share and what you paid to own your shares. Assuming dividend rates remain consistent, lowering your position (the average price you paid for shares) by buying more shares when they are less expensive increases your yield. Being brave enough to buy shares of a company whose market price is falling is one reason why education and information can trump risk. If it was a good company to invest in at $10 per share, why is it not a good company at $8 per share? If the company paid out $0.50 per share at $10 per share (5%), and continues to pay out $0.50 per share now that you average at $9 per share, isn’t your yield better at 6%? ($0.50 / $9 = 0.06) Of course it is! Do you know that the value of the company and market in general will continue to pay a dividend or increase in value? Of course you don’t! That’s the risk you assume that comes with ownership.
Businesses that operate in similar industries tend to keep dividend rates somewhat uniform within their sector. These businesses are in competition in the market for capital they can use for expansion, acquisition, and other business investment. If two companies in the same industry or sector, both with good fundamentals, are offering slightly differing dividend yields, investors are likely to choose to invest with the company that offers a higher return. If you have enough capital to invest in several companies within a favorable sector, you might choose to ‘spread your risk’ so that one negative company event may affect part of your capital in the sector but not necessarily all of it.
The third factor in the time-value of money relationship is that of Time. Of the three related factors in the time-value of money, time is the most powerful. Read that again and don’t miss that particular point. Since time is the most powerful, the best thing you can do to support your investment success is ‘begin now’. ‘Time’s-a-wastin’ so to speak. Whatever your plan, whatever your chosen investment vehicle, ‘time waits for no-one’. The longer you wait, the more you waste this most powerful factor of time and you lose the work that it could have done for you. The characteristic at work here is called Compound Interest; a phenomena that Albert Einstein called ‘the most powerful force in the universe’.
And in Part II of this article, we’ll take a look at how that works. Until I see you next, my warmest regards…