There is a subtle difference between investments and savings that many people don’t understand fully. The purpose of saving is to not spend and accumulate money. The purpose of investments is to make return on your hard earned money. Put in $100 and $120 comes out if all goes well.
ROI = return on investment. In this case $20 or 20%
Investing is not hard. Anyone can do it if you follow the rules. Why do we invest? We want to be rich! We don’t want to work. Have the money work for you instead of the other way around. Sounds good right?
Risk vs. Reward
In finance there is a concept called the efficient frontier. It spells out the optimum trade off between maximum risk you should take to get the maximum reward. You don’t want to take a lot of risk to get minimal return. That’s just not worth it.
If you offer to lend your deadbeat friend $500 for a year and he offers to pay you $510 well that’s a 2% return for a lot of payment risk as he may not pay you back in time or at all. Risky loans should get the higher return. The same goes for the investment world. Savings investments like bank CDs don’t yield much but high risk high flyers like the next Facebook, Google or Microsoft could make astronomical returns.
Rule of thumb: try to set aside 10-20% of what you make each month after tax. This is separate from 401K. If you have debt such as credit cards or student loans to pay focus on getting that paid off first.
There are several types of investments we will go over
- Savings accounts: As the name says you lend your money to the bank and they pay you some interest. Usually this is a trivial amount of interest unless you have a credit union. Then it might be one percent. Banks currently pay close to zero as rates are so low. These are FDIC insured or by NCUA so you won’t lose your principal. You may however not keep up with inflation (less real money over time).
- CDs/certificates of deposit: These are time bound loans where you give the bank your money locked in for say one year and they give you a slightly higher return. Again these are insured but the gains are very small given rates are low.
- Bonds: Bonds are debt instruments where companies or government agencies or local governments lend money from you and pay you return either as a coupon or as part of the principal. These could lose value due to changes in rates, credit risk and maturity. Examples include savings bonds, treasury bonds, municipal bonds and corporate issues.
- Stocks: Shares of a company such as say Intel or Chevron. You as a stock holder may get paid a dividend and hope the value goes up over time as the company grows its profits. These are not risk free and you could lose it all if the company goes bankrupt.
- Mutual funds: A pool of stock and/or bonds managed by a fund manager whose job is to make the fund grow in value. Great for beginners.
- Index funds: A portfolio of stocks that hopes to mimic some index like the SP 500 or Russell 2000. These are passively managed and have low fees. They are a type of mutual fund. Also good for beginners.
- ETFs: Exchange traded funds. Basically portfolios of stocks in certain sectors or one that cover the whole market. You trade them like stocks.
- Private loans: Peer to peer lending. You may not get paid back at all or the full loan amount by deadbeats.
- Real estate/REITs: Investments in properties whether they be hotels, apartments, storage units or shopping malls. REITs are also good for beginners as a professional manager does the work.
- Private equity: Shares of private companies. For the rich, not us.
What is diversification?
Diversification is a fancy way of saying don’t put all your eggs in one basket. Mutual funds for example have a portfolio of hundreds of stocks. They are diversified. If one stock does badly it’s not a big deal as others may do really well. Diversification protects you from putting all your money in dud stocks like Sears, K-Mart or Toys R US that have folded.