How do you choose between investing and saving? How can you invest in a way that will grow your assets but won’t be too risky? Learn how different investments work so you can choose the best ones for you.
What is investing?
Investing involves purchasing securities, which is the umbrella term for any financial investment, including stocks, bonds, investment funds, and other commodities. Buying stocks, shares of a company, or bonds, the debt of a government or company, allows you to benefit from the company or government’s growth over time.
When you invest in the stock market, you are betting on the future of a company or group of companies. You purchase stock hoping you will be able to sell it for a higher price later. Some stocks also pay dividends, income that the company pays its shareholders, the people who own the company’s stocks.
Bonds are money you lend to a company or government, which they promise to pay you back with interest. Stocks are considered riskier than bonds because stock prices vary based on several factors, including the company’s profits, its prospects, and the current economic conditions.
Bonds, while not completely devoid of risk, are usually safer because your initial investment will be returned to you with interest.
What is inflation?
Inflation is the process through which money loses its purchasing power over time, meaning that the prices of items go up over time.
There are periods when inflation is low, meaning that prices rise only 1-2% each year, and times when inflation is high, when prices rise more than 5% per year. If there is high inflation, prices rise quickly, meaning that you will be able to buy less with the money you have.
The main reason to invest is that while purchasing stock can be risky, stocks on average increase in value over time. Meanwhile, the value of cash tends to decrease over time due to inflation. As a result, if you don’t invest any of your cash in stocks, you might actually lose money over time because your cash will not be able to buy as much as it would before.
Investing vs. saving
If you keep all your money in savings accounts, over time you will not be able to buy as much with your savings due a process called inflation. On the other hand, if you invest some of your savings in the stock market, over the long-term, meaning a decade or more, you will most likely see your investments grow at a higher rate than inflation.
Investing a small amount of money now could lead it to grow significantly over time.
For example, Casey invests $1000 in an index fund that gives her a small percentage of all the stocks in the U.S. stock market. If her investment receives an average return of 7% over 20 years, it will grow to $3869.
Over the same period if there is 2% annual inflation, that amount will only be worth $2604 in today’s currency. But that is still more than double her initial investment. So, investing is worth it for Casey if she invests for the long-term and is careful about how she invests her money.
What is risk tolerance?
Risk tolerance is how much risk you are willing to accept when you invest. Your own risk tolerance depends on your personality, but also should be based on your age and investment goals. Your risk tolerance determines what types of investments you should make.
Usually, when you make investments, the riskier the investment, the greater the potential return. If you are investing in a high-risk stock, you could lose your entire investment, you could see incredible growth, or anything in-between. On the other hand, if you buy bonds, your risk is much lower, but you will only earn a small percentage of interest.
If you are investing with a longer-term goal in mind, such as retirement, the later your goal is, the more you should invest in stocks. The closer you are to your goal, the less risks you want to take because you don’t want to lose your savings if you need to use them soon.
Types of stocks
There are two main types of stocks that a company can issue: common stocks and preferred stocks. Common stocks allow people to own a share of the company and to vote in the company’s decisions.
Preferred stocks allow the holders to access dividends, payments the company gives to shareholders, before owners of common stock. Preferred stockholders also have the first right to be paid if a company must liquidate, or sell all its assets.
There are also stock categories based on the type of company. Growth stocks are from risky companies that are growing quickly.
Blue-chip stocks are companies with a long track record of stability and growth. Value stocks are currently priced lower but have potential for growth. Income stocks provide dividends, a regular stream of income, to people who own shares.
When you are investing, you want to make sure to diversify your investments so that you are spreading out your risk. That way if one type of stock loses its value, on average you will not lose as much.
Types of bonds
Some types of bonds include corporate bonds, municipal bonds, and government bonds. Corporate bonds allow you to purchase the debt of companies. Municipal bonds are bonds that buy the debt of local or state governments, and government bonds, such as treasury bonds or securities, buy debt of national governments.
High-yield bonds, also known as “junk bonds,” are bonds from companies that have a higher risk of defaulting but do provide a higher return if the company succeeds.
When you purchase a bond from a company or government, you are promised a certain percentage of interest on your investment over a period. However, you can also purchase or sell bonds on the bond market, since the value of a bond can increase or decrease over time like a stock.
Bonds usually do not provide as high returns as stocks, but they can offer a predictable amount of income from interest and they are usually less risky than stocks. They are important to include in a diversified investment portfolio to lower the overall risk of your investments.
What are investment funds?
Investment funds are like a grab bag of stocks.
Imagine that stocks are like slices of pie that make up a company. If you purchase individual stocks, you are purchasing different slices of pie that make up your stock portfolio.
If you purchase a share of an investment fund, you get fractions of pie slices from many different companies. The companies in the fund depend on the type of fund and are curated by an investment broker, a company that buys and sells stocks on behalf of an investor.
The main benefit of investment funds is that they allow you to diversify your stock holdings. If you hold stocks from many different companies, the overall risk of losing your investment is lower. Investment funds do charge a percentage of fees, but the fees tend to be lower than paying a broker to individually trade stocks on your behalf.
Mutual funds and exchange traded funds
Mutual Funds and Exchange Traded Funds (ETFs) are 2 types of investment funds that are actively managed. This means that an investment broker selects which stocks, bonds, or other securities are included or excluded from the funds, and investors pay fees or commission to the broker to manage the fund.
The main difference between mutual funds and ETFs is that when you buy mutual funds, you won’t know the actual price you will pay for the shares until it is calculated at the end, while exchange-traded funds allow you to see what you are purchasing shares for in real-time.
Mutual funds and ETFs also can allow you to invest in a particular industry. For example, there are several different Environment, Social, and Governance Funds (ESG) funds which invest in companies that meet certain criteria for environmental and social responsibility. There are also target date funds that are popular for retirement savings.
An index fund holds tiny shares of all the stocks in a particular stock index, such as the Standard & Poor’s 500 (S&P 500). Index funds gain or lose value based on the overall trends of the stock market. Since, over time, values of all the stocks in an index increase on average, investing in an index fund allows you to benefit from the growth of the stock market while lowering your overall investment risk.
Index funds also have lower costs than other types of investment funds because they do not require a company to decide which stocks are included or excluded from them.
Benchmarks are the average performance of stocks in a market over a given period that are usually calculated based on the performance of index funds, since they include all the stocks in a market. You can compare other stock holdings’ performances to index funds to see if they are outperforming or underperforming in relation to the overall market.
For example, average annual return on the S&P 500 is 9.71% since its inception in the 1920’s, meaning that on average the stock prices grew 9.71% each year, after adjusting for inflation. If another stock has had higher than 9.71% annual return over that same period, they would be outperforming the S&P 500.
Other types of investment
In addition to stocks and bonds, there are many other types of investments. Stock options give you the option to buy or sell a stock at a particular price at a particular date and time and can be risky. Some companies give their employees stock options as compensation.
You can also invest in commodities such as gold, copper, or real estate. The prices of these commodities fluctuate depending on how much demand there is for these assets.
Cryptocurrency is a type of speculative investment. The more speculative an investment is, the riskier it is considered. Speculation is investing in something that is highly risky hoping for a much higher than usual return. Investing in cryptocurrency involves buying a currency that is not backed by a government with the hope that its value will rise, which may or may not happen.
Ways to invest
There are many ways to invest in stocks and bonds. You can purchase stocks and bonds yourself, which allows you to avoid paying fees but could be riskier than relying on a professional.
You can hire a broker who decides which stocks and bonds to purchase and sell on your behalf, but they will charge higher commissions and fees. Mutual funds and ETFs usually charge a smaller percentage of fees but are still actively managed. Index funds usually have the lowest cost because they are not managed.
When you are deciding how to invest your money and what types of stocks, bonds, or funds to buy, you should look at both what the past performance is and the percentage of fees and commissions that are charged. However, performance isn’t a guarantee that an investment will continue to perform as well in the future.
Fees and commissions
Some brokerage companies charge you fees for each time you make a trade. Others charge fees to advise you on how to invest your money or for managing your portfolio, deciding for you which stocks to purchase.
Other investment products, such as investment funds, charge a percentage of the assets in the fund to manage them. These funds will inform you of their expense ratio, the ratio of total assets in the fund to the fees it charges.
For example, a fund that provides an 8% return on $1000 will give you a return of $80 at the end of the year. If the expense ratio for a fund is 1%, then you will pay about $10 in fees that year, reducing your net return to $70. If the expense ratio is only 0.25%, then you will pay $2.50 in fees that year, which means your net return will be $77.75.
The benefit of holding investments
If you are investing in stocks for the long-term, meaning a decade or more, it is beneficial to ignore temporary fluctuations in stock prices due to the economy and instead maintain your investments.
For example, Casey decides to invest for her retirement. She chooses to buy more stocks than bonds because she knows that she will benefit more from higher returns on stocks over time. When the economy takes a downturn and her stock prices fall, she is tempted to sell off her shares since they are losing value, but she decides to hold her investment.
As the economy recovers, her investments recover as well, and after a few years her investments are performing well despite the dip they took. She realizes that if she had sold her investments when they were worth the least, she would have lost more in the long run.