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Basics of Investing: The Hidden Cost of Investing

There are some things you have to look out for when you start investing. They may not seem much, but when you add them up, they could come up to quite a bit.

Inflation

No matter where you keep your money, inflation would eat up a portion of it every year. Take a look at some of these US statistics. For all the examples, we factored in an inflation of 3.2% annually, a rate that has ran historically.

  • At an average annual growth rate of 10.9% a year, stocks will double your money every six-and-a-half years. Factor in inflation - it will take closer to ten years to double your actual buying power.
  • Likewise, bonds, which have historically grown at 5.2% annually, will double your money every 13 1/2 years. After taking into account inflation, however, it will take 35 years.
  • Worst of all, if your money is in cash, you'll have to wait 19 years for the nominal value of your account to double, assuming the cash earns the historical 3.7% annual return from your savings deposits. But even your grandchildren won't see the real value of your money double. The reason? After inflation, it will take 139 years (based on 3.7% - 3.2% = 0.5%).

Inflation makes it all the more important that your money is invested in good mutual funds that can generate good returns over time. If you kept your money in savings accounts, you'll realise that you may actually get poorer over time, as inflation may overtake your interest income, making your deposits worth less than when you first put it in.

Commissions and Management Fees    

The payment of commissions to your brokers when you buy and sell stocks, and the upfront entry load and the annual management fee that you pay up for your mutual funds are all costs items. As such, every time you buy and sell, you are incurring more costs. If you take this cost as a percentage, add them together and compound them over the period of time that you are trading, it can come to a pretty hefty number.

Mutual funds are designed for medium to long term investment. If you switch often, and incur the entry and exit loads each time, you may find that it takes a much longer time to achieve your financial goals. So before you commit yourself to buying a stock or mutual fund, make sure you have done careful research and that you can and want to hold on to the mutual fund for a reasonable period of time.

If you sell too soon, not only you may have to pay the exit loads, but you may also miss out on the mutual fund reaching its full potential.

Next: Chapter 3 - Investing in Unit Trusts