Even the least money savvy of us have a vague appreciation of investing. It seems like a good idea in the way that it would be better to eat more vegetables or learn a second language.
But investing can be intimidating. What if you make a bad investment and lose your savings? What’s the difference between investing and putting your money in a 401(k) or IRA?
Here is some of the information and advice they shared:
There’s more than one reason to invest. First, I assume you want to retire some day. Wise investments can hasten that day.
Moreover, you know how inflation works. If inflation rises three percent each year, then $200,000 today will have the purchasing power of $59,142 in 40 years. In other words, your money will be worth less money.
Through the power of compound interest, investment does the opposite of that. It makes your money worth more money.
When you invest, you don’t just earn money from your initial investment, the interest from your investment also accrues interest. This can really add up over time. If you invest $5,000 a year for 30 years and see a six percent annual growth rate, then you’ll make $395,291—more than twice what you would have if you just stored that money in shoe boxes beneath your bed.
No less a mind than Albert Einstein said, “The most powerful force in the universe is compound interest.” And, yes, we realize his tongue was in his cheek when he said that; but, still, if you want to harness that powerful force, you need to learn about investing
The sooner the better
The most important thing about investing (or establishing any kind of savings) is that you don’t want to hesitate.
The sooner you begin, the more time your investments have to grow. Playing “catch up” later can be difficult and expensive.
Identify goals and risk tolerance
What are you saving for? Retirement? Your kids’ college? Maybe a new car?
Your investment goals (long term versus short term) affect your time horizons.
In general, the longer your investment horizon, the more potentially high-reward risks you can afford to take. After all, if you don’t plan to retire for 30 years, then you have plenty of time to recover from losses.
There’s often a risk-reward tradeoff. The higher the possible payoff, the larger the potential losses. The spectrum of low-risk/low-return to high-risk/high-return goes something like this: Treasury bills, CDs, government bonds, corporate bonds, preferred stock, common stock and, finally, options and futures present the highest risk and possible rewards.
Know the different types of investments
There are different types of investments: cash alternatives, bonds, stocks, funds, and more. (However, 401(k)s and IRAs are not investments. They’re tax-advantaged vehicles that hold individual investments.)
Here’s a break down of the different options and there advantages.
1. Cash alternatives are low risk, short term and relatively liquid. Examples include CDs, money market deposit accounts and mutual funds, and U.S. Treasury Bills.
The potential return is low enough that they may not keep up with inflation, but the earnings are predictable and there’s little risk to the principal.
2. Bonds are a loan to a government or corporation. The interest is typically paid at regular intervals. They can be traded like other securities.
The risks include the value of the bond fluctuating with interest rates and, of course, default. And the potential returns are lower than, say, stocks.
However, the risks are also lower than in the stock markets and the income is both predictable and typically higher than cash alternatives.
3. Shares of stocks represent an ownership position in a business. The percentage of a business you own determines your share in its profits and losses. Your shares of stock can ultimately be sold for a loss or a gain.
Within stocks there are a lot of categories: common versus preferred; small, mid or large cap. It helps to have a professional to guide you.
Stocks historically have provided the highest long-term total returns. They can provide income through dividends as well as capital appreciation. However, market volatility or poor company performance create a greater risk to your principal.
Consequently, stocks might not be appropriate for short-term investments or goals.
4. Mutual funds are when your money is pooled with that of other investors. The fund invests for you according to a stated investment strategy, and you own a portion of the securities held by the fund. (In other words, your investment is automatically and instantly diversified.)
Mutual funds fall all along the risk-reward spectrum. Before you invest in a fund, you should consider its objectives, risks, charges and expenses to make certain its goals coincide with your own.
The advantages of investing in mutual funds: liquidity, as well as diversification and professional management of your investments. The disadvantages: fund fees and expenses, tax inefficiencies and value fluctuations.
Picking a professional
We’ve just covered the basics here, and it can already seem overwhelming.
Frankly, when you’re talking about your financial future, it helps to have a professional’s insight and experience. A financial professional can help you determine your investment goals, timelines and risk tolerances. They can also help select specific investments, manage, monitor and modify your portfolio.
But how do you pick a financial professional that’s right for you?
Actually, that one’s easy.
When you talk to a financial professional, ask them questions. Ask them about your different options. If you don’t understand or aren’t satisfied by their answers, keep looking for the right person.