Stock Investing Basics - Part II

Real Returns

Compounding is so miraculous that even at relatively low returns you can double and triple your money over long periods of time. When someone brags about doubling his money in 10 years, for instance, you shouldn't just smile and nod about how great he did. You only need a 7.1% annual return to double your money in 10 years. If the Standard and Poor's 500, a widely used barometer of the stock market, has gone up 10.6% a year, the poor fellow who doubled his money in ten years has actually under performed the market. So now the trick becomes: In order to increase your money, how could you invest it so that it outperforms the market?

Now, let's say your investments earned 10% last year. How much did you really make? Well, the last time we checked the taxman wants to grab a piece of what you earn. One of the most significant factors investors tend to leave out when assessing their investment returns is the tax consequence. Even if you have a long-term capital gain that is only taxed at 20%, a 10% return quickly becomes 8%. And for short-term gains, the tax bite is even greater. At any rate, the question of importance for you is: "How much do I end up with at the end of the day?"

Another factor that affects returns, as we mentioned above, is inflation. So if your investments made 10% after taxes last year and inflation reduced your principal's buying power by 2%, then you actually only made a real return of 8%. All you need to do is to take your annualized after-tax return and subtract the annual rate of inflation. How can you find out what inflation was? Every quarter the government reports the Consumer Price Index (CPI), which is what most investors use as a proxy for general inflation at the consumer level. You can find it in your local newspaper's business section.

Investing Versus Speculating

About now you may be sitting back thinking about your brother-in-law who "made a killing" in options. Or maybe you're reminiscing about that Nevada vacation when one lucky quarter magically drew out 700 more with the pull of a slot machine lever. Why put your money in slow-and-steady investment vehicles that merely promise double-digit returns when you could have near-instant riches? With compounding, you have to wait patiently for years for your riches to accumulate. What if you want it all now?

Granted, there is nothing exhilarating about predictability. Sure, tales of your fifth year beating the performance of the Standard and Poor's 500 Index won't make you the life of the party. However, neither will the far more common tales about how you lost your savings on some speculation, and your subsequent adventures in bankruptcy court. (Actually, that might make for some entertaining party chatter, especially given our penchant for reveling in the misery of others. But let's try for the moment to ignore sad musings about human nature.)

What are the odds of winning the lottery jackpot? Well, it depends on the lottery - they may be 1 in 7 million, or 1 in 18 million, or somewhere in between. You have a far greater chance of dying from flesh-eating bacteria - 1 in a million - than you do of winning that jackpot!

You don't need a card dealer, dour strangers, or Wayne Newton background muzak to gamble. There are plenty of stock market gamblers who do an admirable job of losing their money on seemingly legitimate pursuits. At the Motley Fool we think that commodities and options are just as risky as a Vegas craps game. In fact, we believe investors "gamble" every time they commit money to something they don't understand.

This, of course, may be true of stocks as well as of commodities and options. Say you overhear your best friend's dentist's nanny talking about a company called Huge Fruit at a cocktail party. "This thing is gonna go through the roof in the next few months," she says in a stage whisper. If you call your broker the first thing the next morning to place an order for 100 shares, you've just gambled. Do you know what Huge Fruit does? Are you familiar with its competition (Heavy Melon)? What were its earnings last quarter? There are a lot of questions you should ask about a company before you throw your hard-earned cash at a "hot" stock. There's nothing too hot about losing your money because you didn't take the time to understand what you were investing in.

Remember: Every dollar that you speculate with and lose is a dollar that is not working for you over the long-term to create wealth. Speculation promises to give you everything you want right now but rarely delivers; patience almost guarantees those goals down the road.

Planning and Setting Goals

Investing is like a long car trip. There's a lot of planning that goes into it.

• How long is the trip? (What is your investing "time horizon"?)
  
• What should you pack? (What type of investments will you make?)
  
• How much gas will you need? (How much money will you need to reach your goals?)
  
• Will you need to stop along the way? (Do you have short-term financial needs?)
  
• How long do you plan on staying? (Will you need to live off the investment in later years?)

Running out of gas, stopping frequently to visit restrooms, and driving without sleep (this is the last of the travel analogy, we promise) can ruin your trip. So can saving too little money, investing erratically, or, as we said in Step One, doing nothing at all.

You must answer the following questions before you can successfully set about your savings/investing journey:

• What are your goals? Is this money for retirement? A down payment on a house? Your child's education? A second home? Income to live on in the proverbial Golden Years?
  
• How much money can you devote to a regular investing plan?

Don't let yourself get away with fuzzy answers, either. In the end, investing is a lot of numbers. You need to get used to that, and quickly. As a matter of fact, it can be quite liberating. You can see exactly what you need to get to your destination, and can be accountable to yourself along the way. Ask yourself some more pointed questions:

• How much will college cost when my child needs to go?
  
• How much yearly income is reasonable for retirement?

Don't worry ... you don't have to do all the math yourself. There are online interactive calculators available that can help you figure your future money needs. The more specific you can be, the more likely you are to set and achieve reasonable goals.

After you have a rough idea of how much money you'll need and how much time you have to get there, you can start to think about what investment vehicles might be right for you and what kind of returns you can reasonably expect.

continue >> Stock Investing Basics III

Article Souce: The Motley Fool.