Saving money is amazing, but knowing how to invest that money can be more confusing than a small child in a beauty pageant. I always suggest keeping the money you need short-term in a high yield checking or savings account, and if your debt is paid off, contributing as much as possible to a retirement fund. For many of us, knowing that our money is being invested in our retirement is about as far as our investment knowledge goes – so I thought it would be helpful to break down the basics of investing so you can feel a little more financially savvy.
Stocks
Ok, so we all know that stocks represent a share of ownership in a company, and as a shareholder you actually own part of the assets of a company. If you feel like the company is going to be successful and the value of the stock will rise, you buy a certain amount of shares knowing that you’re also taking the risk of your shares becoming worthless if the company fails.
That being said, although the market has it’s highs and lows, stocks have historically outperformed all other investments – close to 10% over the long term. Ultimately, the best way to manage your risk exposure is to diversify your “portfolio” by owning a variety of different stocks so that no single companys poor performance can hurt you (which is why most beginners invest in mutual funds).
The Motley Fool has a great article for how to pick a stock for beginners: Investing Strategies: Your First Stock
Bonds
The next best performing asset class is bonds. This is an agreement to loan money to a company or the government in exchange for a predetermined interest rate. You purchase bonds with the understanding that the company will pay back the original amount you loaned to the company (principal), plus any interest that is due by a set maturity date.
A general rule of thumb when investing in bonds is the higher the interest rate, the riskier the bond – but unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Another nice thing about bonds is that they pay interest at set intervals of time, which can provide valuable income for people like retirees or those who need the cash flow.
SmartMoney’s article on how to choose the right bond fund: How to Choose a Bond Fund
US Treasury Bonds
U.S. Treasury bonds are considered as close to a sure thing as an investor can get, historically returning an average 5% over the long term. The return is consistent because the U.S. economy has historically been fairly strong, and therefore it’s unlikely that the government would ever default on their bonds. The minimum amount required to buy a Treasury bill or note is $1,000, and the rate of return is directly affected by the interest rates – so if interest rates rise after you bought the bond, it is unlikely you will be able to sell it for the same amount you paid if you do not hold it until maturity (but if they fall you will make a profit).
Want to buy a US Treasury Bond? Treasury Direct explains how here: How to Buy a US Treasury Bond
Mutual funds
Most retirement funds have your money invested in a mutual fund, and they are the easiest and least stressful way to invest in the market. Mutual funds allow investors to pool their money to buy stocks, bonds, or whatever else the “fund manager” thinks is a sound investment. This gives you have a certain level of security since if one particular company gets hurt, you don’t have a huge impact on your overall portfolio like you would if you invested in only that company’s stock.
If you want to check out how certain funds are performing, Morningstar or Standard and Poors (S&P) both issue mutual fund rankings based on past record. You have to take these rankings with a grain of salt, though, since past success is no indication of the future, especially if the fund manager has recently changed. Another thing to keep in mind is that there are many fees involved in investing with mutual funds that can eat into your return, and higher fees do not always indicate a better performing fund.
Investopedia did a good article on choosing a mutual fund here: Mutual Funds: Picking a Mutual Fund
Index mutual funds
An index fund’s primary investment objective is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index (the stocks of 500 leading companies in leading industries) or the Wilshire 5000 Total Market Index (all the publicly traded companies in America). This simple strategy is used as opposed to actively picking which stocks to purchase like they do in mutual funds, hence why the fees to invest in index funds are lower. Surprisingly, index funds often beat the majority of competitors among actively managed funds, but this could be because few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.
Some other good-to-know terms:
Inflation may be the biggest threat to your long-term investments. The stock market will always flow up and down, however inflation has historically stripped 3.2% a year from the value of your money and rarely recovers what it has taken from you.
IPO is an initial public offering. It is the first sale of stock in a company to the public (aka “going public”), and is usually used to raise capital so that the company can grow. If you purchase one of these shares, the price you pay is your basis – and this will change when the stock splits, merges or spins off, or through dividend reimbursements.
Stock option is when you are given the right to buy a stock as a form of compensation – usually by the company you work for. This is usually at an agreed upon price that is less than the market value of the stock. This is offered to employees because its cheaper than paying out cash, but it also gives employees the right to future growth in the company.
Hopefully that covers the basics of investing for people like me who really only use the term investing when I’m referring to a pair of expensive shoes. Now maybe you have a better idea of what the hell is happening with your money, and you can sound educated the next time you’re talking to some cute broker at the bar.
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