April is National Financial Literacy Month in the United States. This brings attention to the lack of a financial education young people receive in this country, both from their parents and from the education system. I disagree with most people about how to solve this issue. Many call for mandatory high school courses in personal finances, but there are many reasons why this has not been and will not be generally successful.
In the spirit of National Financial Literacy Month, I occasionally take some time to focus on some of the financial basics. This is information I would have liked to have had or to have thought about earlier in my life. It’s not necessarily the information that’s important, but having a role model — someone to emulate — who is proficient with money, to guide a young individual on a path towards financial independence. I’ve covered the basics of savings accounts, checking accounts, budgets, and interest previously, and today’s I’ll attempt to tackle the topic of investing.
Investing is a massive topic. It can get quite complicated when you look at the types of investments available, each having their own quirks, rules, and purpose. Investing means different things to different people: you can invest in stocks, invest in an industry, invest in a business, and invest in your future. You can invest your money, your effort, or your time. All of these concepts can be radically different.
There is a general theme to all investing, however. While the purpose of saving is to have a foundation or short-term financial safety, investing is the choice people make when they want to build long-term financial stability or independence. When you create a plan for investing — and it’s better to start with a plan in mind even if you don’t really know what you want to do in the future — you think about the future. The expectation when you invest is that your wealth will grow. Compare this to savings, where your expectation is that your wealth is safe.
What do people invest in?
The most common investments are stocks. Stocks are shares of a business. When business owners want to raise money to help their businesses grow, they sell to investors pieces of ownership in that business. Most of the time the pieces are very small. For example, if you invest in one share of a company like Google, you’ll become an owner of the business — but you’ll own only about 0.0000003 percent of the company. And almost always, when you buy stocks, you don’t buy them from the company. Once a company decides to sell shares, the stocks are traded on exchanges like the New York Stock Exchange. When you buy stocks, you’re buying them from another investor who happens to be selling.
Overall, stocks perform well over long periods of time. If you buy a varied collection of stocks and hold them for several decades, your investments have a great chance of increasing in value. The best way to buy stocks, especially for someone new to investing, is to invest in a pre-determined package of stocks designed to match your investing goals and needs. That’s where mutual funds come in. Mutual funds are packages of stocks (or other investments) managed by a professional investor, and these packages often have a goal or style that the manager follows.
With any investment, stocks, mutual funds, or otherwise, there is a chance that you will lose money. This is the risk that’s associated with investing. While there’s a chance of your investment increasing in value over time, increasing your wealth, the opposite might happen. You could buy shares of a company that fails one month later, losing all your money. Investing in shares, therefore, requires lots of research to protect yourself from bad investments, but even lots of research can’t help you accurately predict whether your investment will be successful. That’s why mutual funds are more attractive investments. With mutual funds, you can use the same money to spread out among many investments, so if one company fails, it doesn’t affect your investment as much.
Besides stocks and mutual funds consisting of stocks, the next most popular investments are bonds. Companies and governments issue bonds to raise money. Sometimes a government is looking to raise money for a specific project, like building a bridge, and will seek investors, promising to pay the investors back their contribution plus interest. Like stocks, bonds are designed to raise money, but for the investor bonds are safer, meaning they’re less likely to lose value than stocks.
In exchange for that safety, the possibility of growing your wealth with bonds is less than the possibility for doing the same with stocks or mutual funds consisting of stocks. Bonds have a maturity, though. You can buy and sell most stocks whenever you’d like, but when you buy bonds, you are committing to a relationship. When you buy a five-year bond, you will receive some income from the investment over the course of five years, but you won’t get all of your money back until the five year term is complete.
Mutual funds come in handy once again; if you like the relative safety of bonds, you can buy a mutual fund consisting of bonds. These can, with some exceptions, be purchased and sold at any time. Investing is a long-term activity, though, and investors shouldn’t be too concerned about frequent buying and selling.
The best type of mutual funds
I mentioned above that mutual funds are managed by a professional investor. This is an individual who makes decisions for you about which stocks or bonds to buy and sell. All of these professional investors cannot consistently pick the best investments, however. Index mutual funds are designed to take some of the human errors out of investing.
When the financial media talk about the Dow being up or the S&P being down, they’re talking about an index. Indexes (or indices if you prefer) track the overall progress of a representative sample of investments. Most investors can’t pick investments that outperform the indexes, so you’re better off just copying the indexes. You can do that easily by investing in an index mutual fund.
An additional benefit of index mutual funds is the low fee. Whenever you invest — whether you buy or sell — you pay fees. People invest with the intent of growing their wealth, and the best investors do that by reducing these fees. The worst investors buy and sell frequently and, for the most part, make the professionals who collect the fees rich rather than building wealth for themselves over the long-term. If you choose wisely, index mutual funds are often the best investments for reaching your long-term goals while saving money. It’s a great value.
ETFs have increased in popularity in recent years. ETFs are exchange-traded funds. The financial industry loves these investments because they have the appeal of mutual funds with the added benefit of being able to be bought and sold during the day, unlike mutual funds which trade only at the end of the day. Of course the industry loves ETFs; they encourage investors to trade investments frequently, thus increasing fees from trading. There’s no need for long-term investors to invest in ETFs. You can avoid these rather than playing into they hype.
The menu of investments is lengthy, particularly once you start looking at derivatives, stock options, and other complicated investments not particularly relevant to a beginning investor. Stick with stocks (broadly invested), bonds, and mutual funds unless you have a large sum of money you don’t mind losing. Most people don’t.
The government offers tax benefits for people who invest for the future. Many people working in a career look forward to the day they can leave their jobs behind and relax with the remaining decades of their lives. The government help subsidize people who no longer work, so you can be sure those in political power are interested in encouraging people to fed for themselves.
The 401(k) investment, named for the section of the tax code that contains its definition, is one of the most popular ways to invest for your retirement and receive a tax benefit for doing so. You may be automatically enrolled in a 401(k) when you start a new job, or you may need to sign up for yourself. You can reserve a portion of each paycheck for your retirement. All that you reserve must be left invested in order to receive the tax benefit (and avoid a penalty) except in certain circumstances. As a result, you’re putting some money away, untouchable, for many years.
An IRA (Individual Retirement Account or Agreement) is similar to the 401(k) in that respect, but you can also sign up for an IRA as an individual rather than as an employee of a business by contacting a broker directly.
Neither an IRA nor a 401(k) are investment types. They are not like stocks, bonds, or mutual funds. Instead, they are packages that can contain a varied array of investments. Most 401(k) plans contains mutual funds, but you can invest in almost anything within your IRA.
Points to keep in mind
- When you invest, keep in mind that the idea is not to guess which investments will make you rich in a short period of time. Investing is a long-term endeavor, and you need diversity and patience in order to succeed.
- Risk and reward are correlated. The riskier investment types like stocks can grow your wealth more, but they can also devastate your finances. Finding the right balance is a personal decision.
- Studies have shown that the best predictions of long-term performance are the fees. Always research the fees involved with any investment type or activity so you understand completely where your money is going and how much you get to keep.
Published or updated April 23, 2012.