Investing For The Future
Saving means keeping money safe whilst investing means growing money.
As I discussed in the preceding blog, The Art of Saving To Improve Financial Health, saving money doesn’t always have to be hard work. You can easily start small and gradually increase your saving funds by using any of the savings approaches discussed to deposit money in a savings account from each paycheck. Generally in exchange for opening a bank account and giving the financial institution money, your savings will be increased by a certain percentage every year. This percentage is called interest. The longer you leave your savings untouched, the more your money will grow. Or will it? Compound interest and the “Rule of 72” are a couple of ways of determining the growth of money kept in a bank account:
Compound Interest
Interest can help build your wealth for you. For example, if you deposit ₦1000 in a bank account that offers 6 percent interest, by the end of the year your savings will have grown to ₦1060. Compound interest can enhance these savings even more by earning interest on interest. With compound interest, the ₦1060 you have after the first year would earn 6 percent again the next year: ₦63.60, or a ₦3.60 increase. Add that to the total, and you would have ₦123.60. If you were to leave your money in a 6 percent interest account for 40 years, you’ll have ₦10,285, just over ten times the original amount.
Here's the math:
A = P(1+r/n)^nt
Where:
A = the future value of the investment
P = the principal balance
r = the annual interest rate (decimal)
n = number of times interest is compounded per year
t = the time in years
^ = to the power of
The Rule of 72
The “Rule of 72” is a mathematical formula to find out how long it will take to grow your money or specifically double your money. Here you, divide 72 by your account’s fixed annual interest rate. For example, if your rate is 3% per annum. Divide 72 by 3, which will give you 24. So, in about 24 years, your initial investment will have doubled. If your rate is 6 percent, divide 72 by 6. At that rate, it will take 12 years to double your savings. Bare in mind that the rule of 72 tends to give accurate results with lower percentages however slight deviations occur with higher percentages. Nevertheless when you think about your financial goals, the Rule of 72 can make a positive impact on your savings by helping you make informed decisions.
Savings can certainly increase your money modestly over time.
The above illustrations indicate that to save your money to attain wealth you would probably need to save large amounts for a long period that's why savings has to be intertwined with investment.
Investment
Whilst saving means setting aside cash for future use and keeping money safe investment means using cash to buy other assets that you expect to produce profits or income and growing money. This is an important distinction to understand between the two.
Investments can be thought of as comprising of three major categories: stocks, bonds and cash equivalents. There are many different types of investments within each category, and new categories keep springing up, but I will concentrate on these common ones.
Note: I won’t get into cash equivalents - things like certificates of deposit or savings accounts as these types of investment accounts are more about keeping money safe and less about growth. Also I shall only provide a generalised view and not an expansive deep dive into each investment category that'll be discussed. The reader is encouraged to speak with a financial advisor as well as performing their own research to obtain more in depth information.
5 types of investments worth knowing about:
Stocks and equity
Bonds and fixed income
Mutual funds
Real estate
Commodities
Stocks
A stock (also referred to as equity) is a type of investment that indicates ownership of some parts of an issuing company. A share, on the other hand, refers to the stock certificate of a particular company. Holding a particular company's share makes you a shareholder.
There are two main types of stock:
Common stock - usually entitles the owner to vote at shareholders' meetings and to receive any dividends paid out by the corporation.
Preferred stockholders - generally do not have voting rights, though they have a higher claim on assets and earnings than common stockholders. For example, owners of preferred stock receive dividends before common shareholders and have priority if a company goes bankrupt and is liquidated.
Whenever a company needs to raise cash it can issue new shares. Doing this dilutes the ownership and rights of existing shareholders (provided they do not buy any of the new offerings).
Stock buybacks can also be undertaken by Corporations. This benefits existing shareholders because they cause their shares to appreciate in value.
How to purchase stock:
Stocks are generally bought and sold on stock exchanges, such as the Nigerian Stock Exchange (NSE) or the London Stock Exchange (LSE). Typically a company first goes public through an initial public offering (IPO), after which its stock becomes available for investors to buy and sell on an exchange. Investors use a brokerage account to purchase stock on the exchange, which will list the purchasing price (the bid) or the selling price (the offer). Stock prices are influenced by supply and demand factors in the market among other variables.
Two ways of earning money by owning shares of stock is through dividends and capital appreciation.
Dividends are cash distributions of company profits e.g. if a company has 1,000 shares outstanding and declares a ₦10,000 dividend, then stockholders will get ₦10 for each share they own.
Capital appreciation is the increase in the share price itself. If you sell a share to someone for ₦100, and the stock is later worth ₦120, the shareholder has made ₦20.
Bonds
In simple terms, a bond is a loan from an investor to a borrower such as a company or government. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.
Most investment portfolios should include some bonds, which help balance out risk over time. If stock markets plummet bonds can help cushion the blow. Be aware that even though bonds can be a much safer investment than stocks, they still carry some risks, like the possibility that the borrower will go bankrupt before paying off the debt.
Types of bonds
Bonds, like many investments, balance risk and reward. Typically, bonds that are lower risk pay lower interest rates; bonds that are riskier pay higher rates in exchange for the investor giving up some safety. There are different types of bonds:
Treasury bonds
Treasury bonds are backed by the federal government and are considered one of the safest types of investments. The converse of these bonds is their low interest rates. There are several types of Treasury bonds (bills, notes, bonds) that differ based upon the length of time till maturity.
Treasury Bills (T-Bills) are a popular example here, granted it's of a shorter duration and of a lower interest rate. Here the interest rate is the bid rate of your T-bill. Your interest depends on the treasury bill you intend to purchase e.g. if an investor decides to buy a T-Bill for N200,000 with a discount rate of 20%, the investor will only pay N180,000 and will be paid the face value of N200,000 at the maturity date. Hence the treasury bills interest is the difference between the face value and the discounted sales price.
Note that interest earned are currently subject to tax. The minimum amount of a treasury bill you can purchase is N50,000; maximum is subject to availability in the market.
Corporate bonds
Companies can issue corporate bonds when they need to raise money. For example, if a company wants to build a new power plant, it may issue bonds and pay a stated rate of interest to investors until the bond matures. The company also repays the original principal.
Unlike buying stock in a company, buying a corporate bond does not give you ownership in the company.
Corporate bonds can be either high-yield or investment-grade.
High-yield means they have a lower credit rating and offer higher interest rates in exchange for a higher risk of default.
Investment-grade means they have a higher credit rating and pay lower interest rates due to a lower risk of default.
Municipal bonds
Municipal bonds, also called munis, are issued by federal, states and other non federal government entities. Similar to how corporate bonds fund company projects or ventures, municipal bonds fund federal or state projects, like building schools or highways.
Municipal bonds can have tax benefits. Bondholders may not have to pay federal taxes on the interest, which can translate to a lower interest rate from the issuer.
Municipal bonds may also be exempt from state and local taxes if they're issued in the state or city where you live.
Municipal bonds can vary in terms: Short-term bonds repay their principal in one to three years, while long-term bonds can take over ten years to mature.
How do bonds work?
Bonds work by paying back a regular amount to the investor, also known as a “coupon rate,” and are thus referred to as a type of fixed-income security. For example, a ₦10,000 bond with a 10-year maturity date and a coupon rate of 5% would pay ₦500 a year for a decade, after which the original ₦10,000 face value of the bond is paid back to the investor.
Mutual Funds
A mutual fund is a fund managed by professionals that pools money from many investors to invest in securities such as stocks, bonds, short-term money-market instruments, other assets, or some combination of these investments. The combined holdings of the mutual fund are known as its portfolio.
Types of mutual funds
There are different kinds of mutual funds you can select to invest in some of which are:
Balanced Funds: is a mutual fund that generally contains a component of stocks and bonds. Typically, balanced funds stick to a fixed asset allocation of stocks and bonds, such as 60% stocks and 40% bonds. The objective for a balanced mutual fund is to have a mixture of growth and income, which leads to the balanced nature of the fund.
Bond Funds: Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors and a professional or fund manager invests that pool of money according to what they think the best opportunities are.
Dollar Funds: This is a mutual fund that provides consistent income through exposure to USD-denominated debt instruments, has a moderate to medium risk profile and delivers competitive returns over a 3-5 year investment period.
Equity Funds (also known as Stock Funds): An equity fund is a mutual fund that invests principally in stocks. It can be actively or passively (index fund) managed.
Infrastructure Funds: Infrastructure mutual funds are sectoral mutual funds that primarily invest their corpus in stocks of construction companies, capital goods, and metals sectors. For instance, an IT sector fund invests only in IT companies, a banking sector fund only in banks and so on. This one sector only exposure make them one of the riskiest mutual funds.
Money Market Funds (also called money market mutual funds): is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as Treasury bills). Money market funds are intended to offer investors high liquidity with a very low level of risk.
Real Estate Funds: Real estate mutual funds invest primarily in (Real Estate Investment Trust) REITs and real estate operating companies using professional portfolio managers and expert research. They provide the ability to gain diversified exposure to real estate using a relatively small amount of capital.
Shari’ah Compliant funds: Shari’ah compliant funds are mutual funds setup to comply with Islamic law. These funds allow investors to invest their money in instruments and companies that engage in behaviour according to Shari’ah law.
Active vs. Passive Mutual Funds
A mutual fund's fees and performance will depend on whether it is actively or passively managed.
Passively managed funds invest to align with a specific benchmark. They try to match the performance of a market index (such as the S&P 500, FTSE 100), and therefore typically don’t require management by a professional. That translates into lower overhead for the fund, which means passive mutual funds often carry lower fees than actively managed funds.
What makes mutual funds relevant?
These funds attend to the pain points of people who have not got the time to invest, or have not got foundational knowledge of the capital market. Moreover, it gives them an opportunity to save for the future.
By investing in mutual funds, you get an amazing opportunity to invest in a portfolio of rewarding instruments rather than having your money in just one basket. For example, your N300k investment in a single mutual fund can represent investment opportunities in bonds, stocks, treasury bills, and the likes.
Real Estate
Real estate investments can add diversification to your portfolio, and getting into the market is easier than one might think. Here are a few ways to participate in real estate investment -
Online real estate investing platform
Real estate investment platforms connect real estate developers to investors who want to finance projects, either through debt or equity. Typically investors hope to receive monthly or quarterly distributions in exchange for taking on a significant amount of risk and paying a fee to the platform. Like many real estate investments, these are speculative and illiquid in that you can’t easily unload them the way you can trade a stock. There are a few platforms locally that facilitate this market that are open to both experienced accredited and inexperienced new investors.
Purchasing REITs (real estate investment trusts)
REITs enables you to invest in real estate without the physical real estate. Often compared to Munis, they're companies that own commercial real estate such as office buildings, retail spaces, apartments and hotels. REITs tend to pay high dividends, which makes them a common investment in retirement. Investors who don’t need or want the regular income can automatically reinvest those dividends to grow their investment further. Some major REITs exist in Nigeria.
Consider flipping investment properties
This means investing in an underpriced home in need of a little tender care then renovating it as inexpensively as possible and then reselling it for a profit. Called house flipping, the strategy is a bit harder than it sounds and is also more expensive than it used to be given the inflation rate and interests (mortgage) rates. This technique requires cash as many house flippers aim to pay for the homes in cash. Also one needs to have a good estimate of how much repairs are going to cost otherwise turning over a decent return, when sold, might not be achievable.
Rent out a room
You could rent part of your home. Such an arrangement can substantially decrease housing costs, potentially allowing people to stay in their homes as they continue to benefit from price appreciation on their property. Adding roommates can also make a mortgage payment more attainable for people. If you're not sure you're ready for long term tenants, you could try registering on sites that offer holiday or short term rentals which offer some pre-screening of renters and protection against damages. Renting out a room can feel more accessible than other forms of real estate investing. Basically if you've got a spare room, you can rent it.
Commodities
Commodities are raw materials or agricultural products, often grown, mined or pumped out of the ground that are often used to produce finished goods. Many different types of commodities exist today, but broadly they can be broken down into three distinct categories: Energy, Metals, Agriculture.
Energy - Commodities in the energy sector include crude oil, natural gas, coal and other fossil fuels.
Metals - Some of the more popular metals are gold, silver, platinum and other precious metals. There is also a market for industrial metals such as copper, iron ore, aluminum, etc.
Agricultural - These commodities include staple crops, such as wheat, sugar, corn and cotton. In addition, livestock like cattle or hogs are also considered an agricultural commodity.
There are two main types of commodity:
‘Soft’ commodities that are grown or reared: livestock and meat, together with agricultural commodities, such as coffee, wheat, soybeans, cotton and corn.
‘Hard’ commodities that are mined or extracted: energy products, such as crude oil, natural gas, coal and petrol, and precious and industrial metals, including gold, silver, palladium, copper, lithium and aluminium.
Commodities of the same quality or grade are often described as ‘fungible’, meaning that they are interchangeable, irrespective of where they were farmed, produced or mined.
What is commodity trading?
Commodities are bought and sold in bulk on exchanges, in the same way as stocks and shares. Nigeria currently has three commodity exchanges: Nigeria Commodities Exchange (NCX) said to be the largest commodity exchange in West Africa, AFEX Commodities Exchange Limited and Lagos Commodities & Futures Exchange (LCFE).
Why invest in commodities?
There are two primary reasons for investing in commodities, particularly in times of economic volatility and high inflation:
Hedge against inflation - Commodities are one asset class that can be used to hedge against increasing inflation and even interest rates. Commodities are typically the building blocks for other goods and services so it tends to follow that when these goods and services rise in prices their respective commodities also rise in price.
Diversification of your portfolio - This occurs when uncorrelated risky assets are added to your portfolio. Since commodities, on average, have low or negative correlations with stocks and other asset classes they can provide some diversification e.g. as the stocks and equities in your portfolio fall due to market conditions your commodities assets may still retain or actual increase in value.
How to invest in commodities
Exchange-traded funds (ETFs) and exchange-traded commodities (ETCs) are a popular, low cost way of investing in commodities. ETFs typically track the performance of a basket of investments or an index, while ETCs track commodity prices. As they’re traded on the stock market, you can buy and sell them ‘live’ as with shares.
Commodity-based funds and investment trusts pool money from investors to invest in a range of companies involved in the mining and production of commodities including agriculture, natural resources, clean energy and timber.
Invest indirectly in commodities by buying shares in companies that produce, mine or process commodities or related businesses.
Commodities offer a fascinating window into the global economy. As consumers we are all a part of the commodities market. Their prices are important parts of our everyday lives, and provides indicators of market sentiment and economic health. Also watching these markets can inform or offer ideas for an investing strategy or simply act as a source of information.
Investments are a well known and tried path to attaining wealth.
Investing always involves some level of risk, and there is no guarantee that you will make money or even get back what you've invested although diversification of your investment across several holdings can help in mitigating any losses.
Important: What has been discussed in this blog is a high level view on investing. Always do your own research and seek the services of a financial advisor or expert before going into any investment.