Investing 101

Alden Wicker
Posted

If there’s one thing that all wealthy people have in common it’s this: They invest.

That’s because investing money is the smartest and most reliable way to grow it over the long term, after you have first built up your emergency savings (which never gets invested). (Learn more about your emergency fund here.) Let’s say you have $1,000 to invest and you won’t need it until ten years from now. If you put it in a savings account, you might earn about 1% per year. Over ten years, that interest adds up to $105. Or you can put it in a diversified investment account. While short-term dips happen, we can assume over ten years an investment account will grow by an average 7% per year. Given this, you could earn $967. That could mean actually doubling your money, which is a huge difference. Yup, those wealthy people are on to something.

Even knowing what your money could be worth, you might still be nervous about investing, which is very normal. It’s true, investing poorly could lead to that $1,000 disappearing forever and there is no such thing as a guaranteed investment. But investing is a necessary part of building wealth, and yet even when you include employer-sponsored retirement accounts like 401(k)s, an April 2011 Gallup study found that only 54% of Americans hold investments like stocks and mutual funds. And the recession has only scared people even more: That’s the lowest percentage since Gallup started tracking this statistic in 1999.

But you don’t need to be a financial analyst to make smart investing decisions. You just need to know some ground rules about how to protect your money while letting it grow.

Investing in a Nutshell

Investing is putting your money in a financial vehicle that might enable it to grow more quickly than it would in a savings account.

While most of us think of “earning” as putting in hours of work and getting paid for that, investing essentially puts our money into a marketplace where companies and governments and other entities can use it to create a profit that will be returned to us. (At least that’s the hope—some investments do go bust, taking our money with them.)

Most commonly, people invest by buying financial assets like stocks, bonds, mutual funds and ETFs (and if you don’t know exactly what these are, don’t worry, we’ll describe them later). When we sell them, we hopefully make a profit by selling at a price higher than what we bought them for. If you have a 401(k) or IRA, you are likely already investing. By the time you retire, that money will likely have grown significantly.

What investing is not: gambling or a get-rich-quick scheme. While you always hear about how much you would have made if you had invested in Google X years ago, that’s a rarity. Could you name the next Google today? Not likely. But if done prudently and with an eye to long-term gains, investing is an intelligent financial strategy.

Term Sheet

Inflation
n. The rate at which the average prices for goods and services rise each year, which lowers the purchasing power of your dollar. For example, if inflation is at 2%, you will be able to buy 2% less next year with the same amount of money.

Stock
n. Also known as a “share” or “equity,” a stock is a type of investment vehicle that gives the stockholder part ownership of a corporation and a claim on part of its assets and earnings.

Bond
n. An investment in which one loans money to a corporation or government entity and earns interest on that debt until it is repaid at a predetermined time.

Mutual Fund
n. An investment made up of a collection of stocks, bonds or other investments. Buying a mutual fund enables the investor to easily diversify without buying a number of investments. Mutual funds are run by money managers, who invest according to the stated investment objectives of the fund.

ETF
n. A investment that is similar to a mutual fund, but trades like a stock on an exchange, experiencing price changes throughout the day. ETFs tend to be cheaper than mutual funds in terms of fees, because they aren’t managed by a person but instead are designed to move up or down along with the market for certain types of commodities or companies.

Why Investing Is Important

The biggest benefit to investing is that it helps your money grow faster than inflation. Inflation is the force that slowly erodes the purchasing power of your dollar, making everything from bread to cars a little more expensive every passing year. That’s why people used to be able to pay 50 cents for a movie and now get charged $15.

To understand this better, let’s say your parents had $1,000 in 1982. Let’s consider two things they could have done with it: saved it or spent it.

  • If they had kept it in a savings account … Let’s say it had been earning 1% per year in interest. That account would now be worth $1,740. Sounds great, right? Except for the fact that inflation over the last 30 years was 3.43% per year.
  • If they had spent it … Back then, that $1,000 would have bought them goods that, in today’s dollars, would be worth $2,940. So, inflation in the price of goods outpaced the 1% interest rate in the savings account. 

But saving and spending aren’t the only two things your parents could have done with their money. Their third option would have been to invest it.

Investing helps you beat inflation by a lot, which makes it a crucial part of saving for retirement. For instance, if your parents had invested the same amount of money in a diversified basket of mutual funds, they would have grown their money 15 times over, to have $14,740 in 2012.* You can see why if you want to grow your money over a long period of time, investing is the way to go.

Why Investing Is Important for Women

Before we dive into why investing is important for women, let’s take a step back for a second and think about one of the main purposes of investing: to be able to retire.

When it comes to retirement, women need to save more—much more—than men. First, because they live longer (on average), and second, because during retirement they tend to have higher health costs than men. (Learn more about why retirement is especially important for women here.) But despite these two big reasons for women to save more than men, in reality, they save less. On average, women today retire with two-thirds less in assets than men. If there’s anyone for whom investing is important, it’s women.

Unfortunately, women tend to be much less confident than men when it comes to investing. While 88% of men say they are very knowledgeable when it comes to financial planning, only 57% of women say the same. That lack of confidence often leads women to hand over management of their money to the men in their lives.

That’s a bad move, because women tend to make better investors than men. They are more likely to buy and hold investments, a characteristic especially important in financial crises, such as the one in 2008. That tendency to stay calm instead of panicking translates to better returns over time.

In short: You can totally do this.