For most people, personal finance is not the priority it should be. Millions of Americans close their eyes to their current financial situations. Instead, these people choose consumption over savings. Immediate gratification takes priority over planning for their future and retirement.
We must get back to the basics of finance and money management. An understanding of these two disciplines will be the only way that people become fiscally responsible and build a future for themselves.
Now more than ever, people must take responsibility for their current and future financial situations.
We are at a crossroads where government welfare and corporate responsibility will no longer be there to take care of us. The government’s over-extension of social security and the retirement of the baby boomers will most likely shrink the amount of government funds for future generations significantly. If that isn’t enough, corporations are trimming pension plans in an attempt to cut expenses and reduce their future liabilities.
Now is the perfect time to begin financial planning. If you start now, you can develop good money management habits early. You will also be able to put money to work for decades before retirement, building a considerable nest egg.
However, if you do not start early, peril awaits you. I cannot tell you how many adults I have encountered who have no goals or plans for their future, and have no idea when or even if they will retire. No one wants to become like one of these people, but with a sense of complacency and a disregard for responsibility you may.
To become financially responsible, you must first discard the misconception that finance is difficult and hard. This is the mindset of a complacent individual. The ideas of basic finance are actually very easy to attain and understand.
The first thing you must realize is the idea of interest. Banks offer interest on money market and savings accounts because they want to borrow your money. What they do is borrow your money at a rate, such as 5 percent (the rate they are willing to give you for depositing your money), and they loan it out or invest it somewhere else to earn a higher rate, say 7 percent.
Now, you might not be impressed with an interest rate or average percentage yield (APY) of 5 percent. By itself, the interest rates are not particularly provocative. However, when you add compounding to the equation, you can come up with some pretty good returns on your investment. For those of you who don’t remember compounding from high school math, compounding is the earning of interest upon interest.
For example, if you invest $100 today at an APY of 5 percent, your deposit will grow to $105 in one year. If you reinvest the $105 for one year, your deposit will grow to $110.25. The 25 cents you earned the second year is the interest earned upon the initial $5.
Because of compound interest, at a 5 percent interest rate, your money will double about every 14 years instead of every 20 years.
Now, let us look at the big picture. If you start saving now and deposit $3,600 at the end of each year, you will accumulate over $239,000 in 30 years. If you increase your yearly deposits to $9,600 you will have over $637,000! While these yearly investments may be difficult right out of college, they are not impossible. You just must be more frugal with your money and understand its underlying value in your future.
In the examples I just showed, you could earn a 5 percent return without any underlying risk. Realize that interest rates will fluctuate based on how the federal funds rate changes. If the federal funds rate goes up, interest will go up, and vise versa.
Right now, you can earn up to 5.25 percent on a money market or savings account at an online bank. If you go to a brick and mortar bank they may offer you 1 percent. Online banks that are FDIC insured are as safe as a brick and mortar bank, but they can provide significantly higher rates because of their low overheads. Two online banks I like are ingdirect.com and hsbcdirect.com.
If you want to try your hands at higher returns, then the stock market is for you. The stock market has well-outpaced the returns of savings accounts. The Dow Jones Industrial Average and the S&P 500 have returned average compounded annualized yields of close to 9 percent for the last 30 years.
There is a great deal of money to be made in the stock market. Think of those people who invested in Wal-Mart, IBM, Microsoft or even Google. A small investment would have paid off handsomely. However, for every Wal-Mart or Google there is a stock like Enron or WorldCom, where investors, in some cases, lost their entire savings.
The only way to limit risk in the stock market is through diversification. Invest in different sectors. Do not buy all technology stocks or all retail stocks because a bad downturn in that sector can wipe off much of your savings. An easy way to diversify is to buy mutual funds or exchange traded funds that track a wide market index or which invest in many different companies.
Once you are ready to get your feet wet in the stock market, you might want to check out a discount broker. Brokers like E*trade, Charles Schwab and Ameritrade offer low investment minimums, and you can make trades for between $10 and $15. Keep in mind that trades used to cost $50 to several hundred dollars. If you are willing to get your research from outside sources, you may want to check out Scottrade or Tradeking. They offer $7 and $4.95 trades, respectively, but they do not provide the comprehensive research offered by other companies.
If I may leave with a departing message, it is that time is on your side. But start as early as possible. Don’t wait until you’re 50 years old, because by the time it will be too late, and Uncle Sam will most likely not be there to help you out.