INSIGHTS INTO INVESTING
As complex as our economy has become, there are still basically only two ways to make money: through earning an income, and through investing assets so they grow in value. This section will help you understand the many options the market offers.
INVEST IN STOCK MARKET KNOWLEDGE
Who among us doesn’t secretly wish to strike it rich in the stock market? (Raise your hand if you’ve seen The Wolf of Wall Street.) In real life, investing in the market can be a smart choice if you’re willing to forego some of the Hollywood thrills for prudent decisions. We say ‘some,’ because you must understand that virtually all investing comes with risk. You could end up losing a portion (or all) of your money. Or you could end up a lot wealthier.
THE RISK/REWARD SEESAW
The more you’re wiling to risk, the greater your chance to gain rewards. It’s that simple…and that tricky. Because knowing how much you’re willing to risk (aka your risk tolerance) can change throughout your life, depending on many factors, such as:
- How much money you have available
- How much money you can afford to lose
- Your time frame (usually retirement)
- How well you handle risk, emotionally
Working with a financial advisor is probably the best way to assess your risk comfort level. But if you’d like a quick peek at your potential risk tolerance, take this quiz developed by some Rutgers University professors.
WHY INVEST AT ALL?
It’s no wonder many Americans might be gunshy about entering the stock market. In the last few decades, our country has endured two economic crises: the bursting of the tech bubble, and the housing meltdown. Right now we are recovering from a major recession; and if your parents were among the countless Baby Boomers whose portfolios took a major hit, you’re wondering if you’ll need to help them financially in the future. All things considered, money-in-the-bank security sounds mighty appealing.
But history has shown that saving alone probably won’t help you reach your long-term retirement goals. Interest on savings does not keep up with inflation. You need your money to work harder. And that’s the appeal of investing. If you understand stock market basics, and are willing to actively manage your money (yes, we’re talking about budgeting), you can benefit from a powerful advantage: time. You will have many years for your investments to grow, with prudent planning and the miracle of compounding. So let’s get started!
RULE #1: BEGIN TODAY
You may already be an investor, if you’ve opened an Individual Retirement Account, or IRA, at work. That’s great news, because the money you invest right now is worth way more than the money you invest 10, 20 or 30 years from today. Through the amazing power of compound interest, today’s invested money begins to gain interest (or profits), which are then reinvested, earning you more interest (and profits). And the money you wait to invest simply won’t have a chance to match that kind of growth.
Here’s an example:
Let’s say you’re 30, and planning to retire at 65. You will put $5,000 a year into an IRA, which offers 7% return:
- Start now, and you will have invested $175,000. Your IRA will have grown to $739,567.
- Start 10 years from today, and you will have invested $125,000. Your IRA will have grown to $338,382.
- You will have contributed $50,000 less. But you will have lost $401,185 in ‘free’ money for your retirement.
- Use our compound interest calculator and see how quickly your investment can grow.
MAX IT OUT
Everybody struggles financially when we first enter the work world. But as you continue along your career path, promotions, raises, and perhaps a spouse to share expenses and incomes, put you in position to make your retirement account work its hardest for you. You do that by contributing the maximum amount allowed into your 401(k). This is usually an $18,000 a year salary deferral.
More perks for opening that 401(k): your employer may offer ‘matching’ contributions, up to a certain amount each year, which increases your nest egg exponentially. Plus the money you contribute is pre-tax, so that reduces your taxable income each year. Pretty powerful reasons to make the max of your retirement account.
LEARN BEFORE YOU LEAP
You have a healthy cash flow. You have 6-12 months of expense money saved for emergencies. You’ve set up your IRA. And now you’re ready to invest in the stock market. What’s the best way to start? By learning.
There’s a wealth of information online. Besides sites like this one, you can tap into the resources of Investopedia, Yahoo Finance, The Motley Fool, and Investing for Dummies. Then test your knowledge on a simulator, such as the Virtual Stock Exchange created by Market Watch which measures how well you would do if you invested in real stock. Another resource: a good financial advisor. (S)he will be able to gauge your risk tolerance, and build a portfolio that reflects your life and goals, making necessary adjustments along the way.
WELCOME TO WALL STREET
No matter if you’re conservative or a risk-taker, your first rule of investing is: think long-term. Saving is for your short-term goals; the stock market is for money you can leave untouched for a substantial amount of time. That way you can wait until the opportunity arises to get the best ROI — return on investment. The earlier you start, the greater your chance to accrue wealth.
Whether it is an actual selling floor (like the New York Stock Exchange, America’s largest) or a virtual one (like the NASDAQ, where transactions are electronic,) stock markets exist in order to sell pieces of thousands of different businesses to investors. The businesses are selling those pieces (called shares) in order to raise capital for product development, research, staffing etc. Whatever the business’s plan, your money is going toward the growth of the company. So you buy shares with the expectation that your stock will grow in value.
THE UPS AND DOWNS AND UPS OF STOCK
Your mission as an investor is to buy stock, hold onto it while the market goes up, then sell it for more than you paid. That’s a lot easier said than done. Just about every investor has a strategy for “playing the market.” But knowing the best time to buy or sell is a real challenge. Experts say there are always opportunities for smart investing, whether stock prices are going up (like a bull’s thrusting horns) during a bull market; or whether prices are falling downward (like a bear’s slashing claws) during a bear market.
Though the risk and return can vary, all stocks work in basically the same way. When you buy stock, you are becoming a part owner in that company. The more stock you own, the larger your share of ownership. Here is an overview of some things that can happen as your investment grows:
- Appreciation – As the company thrives, the price of your stock appreciates in value. Each share is worth more than the price you paid. So if you sell, you will be making a profit on your investment.
- Dividends – Companies pay their stockholders a share of the profits. These dividends are usually paid quarterly, and can take the form of cash, or additional shares of stock.
- Stock splits – Can a company do too well? Not really, but sometimes companies think the price of their stock has risen so high it’s no longer attractive to investors. In that case the company may split the stock. This creates more shares, at a lower price, though the value remains the same. For instance, say you own 5 shares of Super Suds Soda, at a current price of $10 per share. Your investment is $50. The company does a 2 for 1 split. You now own 10 shares at $5 per share, and your investment stays at $50.
- Selling – The whole point of investing is to reap a reward. And no matter how much your stocks have risen in value, you can’t realize any gain unless you sell them. The ideal is to sell when the stock is at its peak value. But that’s very difficult. Sometimes you won’t know the peak’s been reached until the stock prices begin to fall. Will they continue to fall or go back up? You should have a pretty good idea of the answer, by tracking your stock value, and knowing at all times how your company is doing. That way you’ll protect yourself against serious loss, and will know when it’s time to sell your stock.
MUTUAL FUNDS, BONDS AND ETFS
What are mutual funds?
Investing all your money in one company is a lot like putting all your eggs in one basket. If you’re not happy with the possibility of ending up with an omelet, the diversification of a mutual fund may appeal to you. Each fund is made up of various kinds of investments, such as stocks, bonds, perhaps real estate. The fund is overseen by a manager, who invests the pooled funds of thousands or even millions of shareholders. When you buy a share of stock in a mutual fund, the cost is called its NAV, or net asset value. A fund’s NAV is calculated every day.
Mutual funds may be focused on a specific sector, such as technology or agriculture. Or they may be made up of strong stocks from every area. There are more than 13,000 mutual funds to choose from, depending on whether you want an income-producing, aggressive or long-term investment.
Some benefits include:
• Simplicity
• Affordability
• Lower management costs
What are bonds?
When you buy shares of stock, you are becoming a part owner of the company. When you buy a bond, you are lending money to the company for a specified length of time. So in essence you become a creditor. In return for the loan, the company promises to pay you interest during the life of the bond, plus to repay you the amount of your loan (which is the face value of the bond) at the due date. The government issues bonds in order to finance projects. In addition to these US government securities, there are also corporate bonds, mortgage- and asset-backed securities, foreign government and high-yield bonds.
Bonds are generally considered a safer investment than stocks, because you know how much you will be earning. However, there is some risk involved, ranging from very safe ones such as Treasury Notes, to high-yield bonds, also called junk bonds, which are often issued by unstable companies. As you might expect, the greater the risk the higher the interest offered, in order to entice investors.
Some benefits include:
• Stability
• Consistent income
• Tax benefits
What are ETFs?
Exchange-traded funds are a popular and innovative investment option that enables investors to buy a diverse portfolio of securities with a single purchase. ETFs basically deliver the convenience of a stock, plus the diversification of a mutual fund with fewer administrative costs. That is because rather than tracking individual securities, an ETF tracks an index, like the NASDAQ-100 Index, S&P 500, Dow Jones, etc.
Some benefits include:
• Diversification
• Lower costs
• Tax benefits