October 22, 2021
John Brennan and Franco Maniaci from Cape Ann Savings Bank talk with John Maher about investing basics. They discuss how inflation and compounding interest affect investments. Then, they look at the life stages of investing, when to start investing, and what to do before you start investing. Finally, they explain how to balance risk and reward.
Transcription Disclosure: Below is a transcript of the conversation between John Maher, John T. Brennan and Franco Maniaci. Please note, this is an unedited "word for word" rendition of the actual conversation and is not intended to be grammatically correct.
John Maher: Hi, I'm John Maher. I'm here today with John Brennan, Vice President and Senior Trust Officer, and Franco Maniaci, Trust Investment Officer at Cape Ann Savings Bank in Gloucester, Massachusetts. Today we're talking about investing basics. Welcome John and Franco.
John Brennan: Hi John.
Franco Maniaci: Hi John.
Life Stages of Investing
John Maher: John, can you talk a little bit about the life stages of investing? What are those?
John Brennan: Sure. This is a very broad overview, but we usually like to start our financial presentations with it. The financial life stages begin at the beginning, your birth, okay. Or to really be more accurate is when you enter the age of majority or perhaps graduate from college. When you come out of the gate like that, oftentimes people have debt, they might have something like student loans, for instance.
So meaning, when they start working, they might have a negative net worth because they actually owe money. But as you start to work and as you start to accumulate salary and hopefully accumulate some savings and pay off those debts, you eventually reach a positive net worth. So throughout your life, you're going to be balancing back and forth between a really positive net worth and negative net worth because you'll buy a house and houses are expensive, but they also incur debt.
Think of a long wavy line. Okay. And then you get to not quite a bell curve. As somebody reaches middle age, probably a wider bell curve with a larger base as your assets accumulate, and your assets will accumulate, accumulate, accumulate until the top of the curve hopefully, at which point you retire. And then you start to draw on those assets as you're in retirement. And hopefully before you pass away, you still have some assets in the bank. So you're remaining sort of above the positive net worth line, but obviously life is complicated and things can happen but that's the idea. The beginning stage, the accumulation stage, and the retirement and distribution stage are the three key stages
What Is Investing?
John Maher: And Franco, another sort of basic question would just be what is investing? What is that?
Franco Maniaci: Yeah. John, so investing individuals may have a different take on what investing is. Some may look at it as risky, a speculative way to use your assets, and other investors look at it as a way of saving. A note that compares the risk of speculating. For them it's like I'm gambling on a volatile, maybe uncertain app value in hopes that potentially you could make money in the long term. For others, the savings approach is a way of methodically saving or a long-term strategy to save for the future. In my opinion, investing is a little of both. I look at investing as involving a certain amount of risk.
I mean, we know investing, there's no guarantee that it will be successful, which includes potentially losing some of your principal or amount that you invest in. But on the flip side, investing gives you the potential to grow your money over time. So for me, I define investing as a planned, carefully crafted approach to managing risks, trying to achieve your financial goal in an appropriate amount of time with the appropriate amount of risk. It's about having discipline, it's patience, but it doesn't have to be speculative, where it may not want to be involved in investing at all.
John Brennan: And John, one point on Franco's take there, which I think is apt is that we advocate a very disciplined approach to investing here in our department. And that's outlined in exactly what Franco said.
How Does Inflation Affect Investments?
John Maher: So I understand that there's a thing called inflation, as we know, where the dollar just ends up sort of not being worth as much as time goes on. What is the effect of inflation over time on your investment?
Franco Maniaci: Right, John, that in a nutshell is what inflation is. It certainly is an important concept to understand when investing. Inflation, as you mentioned, has the effect of reducing your purchasing power in the future. Meaning a dollar today buys less of something in the future. Historically, inflation has been around 2-3%, meaning something that cost 100 dollars today would cost in excess of $180, in 20 years.
Another example would be, let's say you had some money and you kept it under your mattress, instead of investing it, assuming an inflation rate of 3%, that money would be worth $108,000 in 20 years. And then in 40 years, it will be worth less than 60,000. Again, that assumes a 3% inflation rate, but that's historically what it's been. So that means if you're not using, if you're not investing, your money is just not keeping up with inflation, you have less purchasing power than you will in the future. So it does make sense to have some way to hedge the inflation effect through either stock or other assets.
John Maher: So if you just have your money in the bank, and it's only making one and a half percent interest every year or something like that, you're just not even keeping up with inflation.
Franco Maniaci: Right. You're actually losing money each year. That's the real return, which is your rate of return minus inflation, if that is negative. So let's say, you said you're earning one and a half percent in your bank account and inflation was 3%. Your real return is actually minus one and a half percent. You're losing money. You're correct.
John Brennan: And John, right now we'd be thrilled if your savings account was returning one and a half percent. We're returning below that these days.
John Maher: Right. Absolutely.
Franco Maniaci: Very good point.
What Is Compounding Interest?
John Maher: What is compounding interest and how does that play a role in your investing?
Franco Maniaci: Right. So we just talked about how inflation reduces the value of your investments. Compounding actually has the opposite effect. Compounding is earning interest on your interest. We use the rule of 72 as a basic example. So you take the number 72 and divide it by the rate of return. And that will give you the amount of years it will take for your money to double. For instance, let's say you had $5,000 and your rate of return was 7.2%. So in 10 years, that money would have doubled from 5,000 to 10,000. So that's what compounding does. It's an essential tool in investing. It really does make a significant difference over the long term.
When Should You Start Investing?
John Maher: And when should somebody start investing? John Brennan, you mentioned in the life stages that somebody may be just coming right out of college has a negative net worth, they might have some school loans or things like that, that they have to pay back and they don't have a lot of savings, but is that the right time to start investing? Or when do you think the right time to start is?
John Brennan: Well, one thing we do know for sure is the sooner you start, the longer time your investments have to grow. So what we know is that somebody who starts at age 20 and even puts around a modest amount away, say if they put $3,000 away. Assuming a 6% interest rate, if they start at age 20, at age 65, they wind up with $679,500. If you start at age 35, and you do the same thing, again, $3,000, 6%, you wind up with $254,000 at the end.
So that's a pretty dramatic difference for a 15-year delay. So we're realistic. We recognize that you have debt, you have other obligations, things you have to do, but it's always your best move to put a little something away because you cannot make up for that lost time later, or I suppose you could, but it gets expensive. You really have to put a lot of cash away. You're better off letting the power of compounding work for you, as Franco illustrated in describing both inflation and returns.
What Are the Benefits of Matching 401(k) Contributions?
John Maher: Another thing that I think of too is when you start working and you get a job a lot of companies will start a 401k, or allow you to start a 401k, and they might match your contributions, that kind of thing. So, by taking advantage of that early, you're really getting free money from a company by getting those matching contributions to a 401k, is that right?
John Brennan: And I would say to any young person, at least put away enough to get the match. If they're matching 3%, put away 3% if that's all you can afford, but that 3% is really 6%. At least hit that low bar and then do a little more each year.
A rule of thumb is as you get a raise, and the other thing too about investing, and we get into this in other tracks, is if it can be invisible to you. If it can be money that you never have to write a check for, meaning it's taken off the top of your paycheck each month and you never really see it, in fact, you never really miss it. So, that's a great way to at least get started with it, even if it's a trickle, a trickle can become a stream over time.
What Should You Do Before You Start Investing?
John Maher: What are some of the things that you really should do before you start investing? Are there some things that you need to take care of before you start?
John Brennan: Well on that ideally you erase high interest debt, namely credit card debt. If you're paying 17.5% on a credit card balance, you'd really want to pay that off because it's very tough to make that back. I'm still creating an exception for my little trickle for the match on that example.
Financial planners talk about emergency funds, building an emergency fund. I think we touched on this in another podcast, but it's good to have some amount of savings, but I don't think it always makes sense for somebody to have something like $20,000 in the bank. If you have a little something that's appropriate for you, maybe a month's rent, $2500, $3000, great.
The other thing you just have to be aware of is you have to make sure you're insured for disaster. Insurance is, a lot of this conversation in investing is about risk. Insurance is about risk. You want to be protected in case a tree limb falls on your car, or somebody breaks into your apartment, or you break your leg skiing. Those are things you want to be insured for. So, what you want to do is hopefully live within your means, pay off high interest at first, build a little bit of savings, and then make sure you're properly insured.
Balancing Risk and Return in Investing
John Maher: You brought up the point of risk. Another thing that I've heard of is risk versus return. You hear that a lot. Maybe Franco, can you explain that and what that is and how we should be thinking about risk versus return in our investing?
Franco Maniaci: Yeah, sure. So I guess risk really depends on an investor's tolerance for a potential loss and their time horizon. So an investor that has a longer time horizon typically can have a higher risk profile or more aggressive tolerance for risk because they have a longer period to catch up in case the investments do perform poorly. So that's really the important two distinction is personal preference and your time horizon.
Also, the other factors may be, what are the goals. Maybe it's short term in nature. So you would have… say you're building for a down payment towards a house, then you may want to have a lower risk profile because it's a shorter term strategy. If you're saving for retirement and you're in your early twenties, then you should have a higher, more aggressive profile on your portfolio because you have, assuming you work till 65, you have almost 45 years of potential time to invest.
So those are the two important parts of risk tolerance. Then there's the risk return relationship, which you were asking about. And while yes, a stable investment like a CD or a treasury bill is going to return very little, you also have very low risk. So stocks, which have a higher potential return, carry more risks. So that's really, in essence, that's your risk return trade off. When you asked me about the lower risk investment, they're going to have a lower potential return versus something like a stock, which has more volatility, more risk, but offers the potential of a much higher long-term return.
Investing to Enable Financial Independence
John Maher: John Brennan, any final thoughts on investing basics?
John Brennan: The big three sort of long term investments that most Americans make now is they're investing for their retirement savings, they're investing for education goals, and they're investing for, healthcare costs are really kind of coming to the force as another biggie. So as you know, your sort of average American puts money away, that's really kind of the big three that's going to enable financial independence down the road.
Contact Cape Ann Savings Trust and Financial Services to Talk About Investing Today
John Maher: All right. Well, that's great advice, John and Franco. Thanks again for speaking with me today.
John Brennan: Thank you, John.
Franco Maniaci: Thanks John.
John Maher: For more information, contact Cape Ann Savings Trust & Financial Services at 978-283- 70-9 or visit the website at capeannsavings.bank.
Investments purchased from the Cape Ann Savings Trust & Financial Services department are not FDIC insured, not FDIC guaranteed, not bank guaranteed, and may lose principal value.