šŸŒ¼Important Investing Concepts Explained Through Simple Analogies(GREAT IDEAS)

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šŸŒ¼Important Investing Concepts Explained Through Simple Analogies(GREAT IDEAS)

Life often has a way of making things more difficult than needed. Investing concepts are no different. Photo courtesy of Dan DeAlmeida.

Simple is always better. Unfortunately, life has a funny way of making things more difficult than needed. Investing concepts are no stranger to this.

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Financial literacy is one of the most crucial skills one can possess, but itā€™s rarely taught in school. Here are some of the most important concepts in investing, made simpler through analogies.

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Diversification

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Diversification is the process of spreading your capital across assets to reduce your portfolioā€™s dependence on the performance of one or a few assets.

Analogy: Diversification is like owning a farm. Think of each asset you own as a farm animalā€”pigs, sheep, cows, horses, chickens, etc. If you only owned a few cows, your farmā€™s profitability would be highly reliant on the production of just a few cows. If the cows do well, no problem. If one cow gets sick or dies, your farm suffers immensely.

Adding sheep, pigs, and horses now better protects your farmā€™s profitability. If one pig dies, you have plenty of other animals to compensate and ensure the farm remains profitable.

Investing is no different. If you hedge all your bets into one or a few stocks, your portfolio becomes far too dependent on the performance of a small collection of assets. The good times may be good, but the bad times could be infinitely worse.

No matter how risky or aggressive your portfolio is, diversification should always be present in some form.

Compound Interest

Compound interest can best be thought of as ā€œinterest on interestā€. When your assets accrue interest, that interest and additional dollars are now able to earn interest. This process repeats itself for as long as you let it.

Analogy: Compound interest is like a snowball rolling down a hill. Initially, the snowball starts small and only grows in size gradually. But as time passes and it continues to collect snow down the hill, exponential growth begins to become more apparent. The snowball becomes larger and larger and larger.

Exponential growth in an investment portfolio gets stronger with time. The longer you invest, the more you allow compound interest to generate exponentially larger returns. As your dollars earn more dollars through interest, those additional dollars now earn even more dollars. So on and so forth. This is how strategic investing becomes more powerful the longer compound interest is allowed to work.

The Magic of Compound Interest Happens At The End

How you get rich from investing; slowly and then suddenly

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Dollar Cost Averaging

Dollar cost averaging is the process of investing your capital over time on a fixed cadence. Instead of investing all of your dollars at once, dollar cost averaging is designed to invest your money on a fixed schedule (every day, week, etc.), regardless of asset prices. Sometimes you will invest when asset prices are inflated, other times when they have fallen in price. Hence average.

Analogy: Dollar cost averaging is like filling your car back up with gas at the end of each day. The price of gas might change every day, but you will always have gas. Over time, you will ā€œaverageā€ the price you pay for gas. Instead of trying to ā€œtimeā€ when you purchase gas, you just consistently purchase smaller increments of gas to ensure your car always has gas.

Dollar cost averaging allows investors to consistently invest in the market, ā€œaveragingā€ the price they pay while they do it. Instead of trying to time the market with larger lump-sum investments (all at once), the focus is on consistent investment over time. This is one of the most popular investment strategies and is a financially friendly way to ensure continued investment in the market.

Patience and Volatility

The primary goal of investing for the majority of investors should be long-term growth. The market naturally fluctuates and impatient investors are often inclined to sell when the market begins to decline. Having patience and enduring volatility is part of maintaining a long-term, growth-oriented portfolio. The market is incredibly resilient and historically has always returned to a positive growth trend.

Analogy: Having patience in a volatile market is like taking a shower on a cold morning. Initially, the water is brutally cold and you might be inclined to get out of the shower entirely. Given youā€™ve taken many showers before, you know the water will eventually get warm. By staying in the shower, you might find you reduce the amount of time spent showering and therefore saved more money on your water bill.

While many of us wish investing in the stock market was as easy as taking a shower, it really doesnā€™t behave all that different. It has its ups and downs. Its ā€œcoldsā€ and ā€œwarmsā€. Savvy investors know the market will eventually heat up and grow. By remaining in the market and continuing to invest, you give your money a longer timeline to grow. Time in the market is far more powerful than timing the market. Avoid the temptation to exit the market when things get ā€œcoldā€. Donā€™t panic sell if you have a long-term growth strategy in place. Market volatility is natural, and having patience is one of the greatest skills an investor can possess.

Roth IRA

A Roth IRA is a type of investment account that allows you to invest your money tax free. Traditional brokerage accounts tax your money on any gains yielded from asset growth.

Analogy: A Roth IRA is like free parking on the street. You leave your car parked and donā€™t pay a fee when you leave. Valet parking serves the same purpose, but you owe money when itā€™s time to leave.

Traditional brokerage accounts can grow your money with the same power as a Roth IRA, but your capital gains will be taxed when those gains are finally realized. A Roth IRA grows your investments completely tax free. Free parking. There are restrictions and income requirements, but when you are younger and likely arenā€™t making a significant six-figure salary, maxing out your Roth IRA should be a priority.

Read also: How to make enough money to retire in the next 5 years (great insights)

A Different Perspective

Sometimes in life we just need things explained differently. The above investing concepts are extremely important to long-term wealth creation. Investing has the undeniable power to change your financial future.

These analogies will hopefully provide another way of thinking about what are often considered complicated concepts. Master these important concepts and you will be well on your way to building financial freedom.

CONTRIBUTED BY Ben Tucker

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