If you want to know how to learn how to invest, it truly boils down to understanding 3 key variables: time, return, and contribution. These 3 variables underpin the core concept of finance - the time value of money. To learn more about the time value of money, how these variables work together, an investment calculator you can use to see them in action, and how to use them to make informed investment decisions, read on...
How to Learn How to Invest
At the heart of all financial decision-making, including how to invest - is a simple concept: the time value of money. In the simplest terms, it basically says my dollars today are more valuable than they will be in the future. If we've learned nothing over the last year, this is true due to inflation if nothing else, but also due to other factors like opportunity cost - what else we can do with those dollars.
Due to the time value of money, if someone wants you to invest your money today, you expect to be compensated for giving them up, or you want a return on your investment. And you expect that return on a regular basis so long as your money is invested.
That gives you your 3 most important variables when it comes to how to learn how to invest: time, return, and contribution, or your initial investment.
The 3 Most Important Variables in Investing
Those 3 key investing variables - time, return, and contribution - come from the time value of money formula. In the formula, you see how each of those 3 variables combine to determine the future value of your investment.
This is investing in its simplest form. You have a lump sum, you invest it in something. Based on the risk and historical returns associated with the investment, you make a return assumption. Based on your investment goals, you also have a time horizon - or a deadline - for your goal.
Simple Investing Calculator
You can use the Simple Investing Calculator below to play with the time value of money. When might you use this simple calculator? If you wanted to invest a lump sum to pay for your child's college in their 529 plan when they are born, this will tell you how much they might have in the account when they turn 18.
Another example: if you come into an inheritance and you want to invest the lump sum for your future retirement. Finally, you can also use it to gauge how much your existing 401k balance will be worth. Input your current balance, a return assumption, and your years left to retirement, and it will tell you the estimated future value, if you contribute nothing else.
How does being invested for longer impact the future value of your investment? How about if you assume a higher rate of return?
The following help depict some sensitivities - showing how your investment value changes based on time, return and initial contribution assumptions.
Note the key to investing is TIME. This is why you hear me say over and over that TIME IN the market matters more than TIMING the market. The compounding effect and big multiplier effect you get from investing really only pays off after an extended period of time. Be patient.
More Complex Investing Calculator
While it helps to use a simple calculator to start to learn how to invest, understand the concepts, and how the variables move together, it's not the best representation of how most people invest.
Most people don't necessarily have a large lump sum to start with. Instead, most people invest consistently, over time, making annual contributions to either their retirement account or their child's college fund. This basically takes the simple calculation above, repeats it every year, and adds them all together.
You can simplify it into something known as an annuity - if we assume the same annual contribution every year. Note that you still have the same key investing variables: time, return, and contribution.
You can use the annuity investing calculator below to see how these variables work together, and how fast your account balance grows, when you make ongoing annual contributions.
You might use this calculator to take your current 401k balance, plus assume you continue to contribute $10,000 every year, from now until you retire. Or similarly, your child's current 529 account balance, plus assume you contribute $5,000 every year, from now until they graduate high school.
Again, note how your time, return and contribution assumptions impact your end investment goal.
Here are some investment sensitivities to put it in perspective. With more time, you can contribute less and maybe take less risk to reach your goals. If you have less time, you will have to contribute more and potentially take more risk to generate higher expected returns.
If you can understand and make solid assumptions on time, return and contribution, you are already well on your way on how to learn how to invest. You can learn how to fine-tune those assumptions by checking out the posts in the rest of my investing series below.
Wondering how to know what return assumption to use? Check out 10+ Different Types of Investments to better understand the risks and returns associated with different asset classes. I'll cover return assumptions in more detail in an upcoming post, so be sure to subscribe to my newsletter and follow me @familyfinancemom to keep learning!