Investing 101

Investing 101

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.

How Investing Works

Before we get into the nitty-gritty of how to invest, you should understand a few fundamental principles underlying all investing:

Risk Tolerance

The first step to investing is to determine for yourself how much risk you are willing to take on. When it comes to investing, risk is the possibility that your investments will perform worse than you were hoping or expected. As a general rule, the younger you are, the more risks you can take, because if something goes wrong at age 30, you have time to start building up your money again. Plus you can ride out dips in the market and be confident it will eventually go back up. But as you get closer to retirement, you’ll be more cautious with your money. (Find out your risk tolerance with our quiz.)

Return

So why would people want to invest in anything high risk at all? It has to do with your return, or the profit you hope to make. As a general rule, the higher the risk, the higher the potential return. So investing in a tiny startup is very risky, but if that startup succeeds, it could grow ten times. (On the flip side, it could disappear and take your money with it.) Investing in Coca-Cola is much less risky, but it will probably only grow a fraction of that each year. And bonds are the safest, but you pay for that safety by making less money than you would in stocks during boom times.

Diversification

So, how do you avoid undue risk? Diversification, which means putting your money in more than one type of investment so that bad performance in some of them will be offset by good performance in others. Investing all your money in one company is never a good idea because if it goes south, so does all your money. You want to spread your investments out across a wide variety of companies, industries and even countries.  This doesn't only distribute risk; it also means you have a variety of growth opportunities that you might not have if everything is in one stock.

Common Investments

Stocks
When you buy a stock for $10, you are actually buying a tiny piece of a company and becoming a type of owner, called a shareholder. The company will use your money to expand—by hiring more employees or opening new locations, for example—and increase profits. As the company grows, it becomes more valuable, and your little piece of it becomes more valuable too. If all goes well, you can eventually sell that little piece for $12, $20, or $50, depending on the circumstances. Of course, it’s also possible that the company will lose value or go out of business, and then your little piece isn’t worth much or anything at all. That’s the risk you take.

Bonds
You can also invest in bonds. When you buy a bond, you are essentially loaning the government or a company money in order to finance their business. For example, when you buy a U.S. Treasury bond, you are loaning the federal government $1,000 for a certain time period—say, 10 years. They will pay you back the interest every year, and then at the end of the 10 years, you’ll also get your $1,000 back. Bonds are the safest type of investment, since it is safe to assume the U.S. government will pay you back. (If it can’t, we all have much larger worries.)

Mutual Funds and ETFs
We talked above about the importance of diversification. Mutual funds and ETFs do a lot of the work of diversification for you. They are collections of stocks, bonds and other types of investment vehicles. Some hold a variety of stocks from a certain country or region. Some hold stock from a certain industry. Some just mimic the makeup of indexes like the Dow Jones or Nasdaq.

The difference between ETFs and mutual funds lie in how they are managed and how often they are traded. ETFs can be traded like a stock, while mutual funds can only be sold and bought in certain intervals. Mutual funds are also often managed by a person and have different fee structures as well. But both can serve almost the same purpose in your portfolio.

What to Keep in Mind When You Invest

Before you jump into investing, you’ll want to keep some general principles in mind:

1. Remember that there are ups and downs, not just ups.

Historically, over the long term, the stock market has tended to go up, but it will have days, months and even years where it will go down. The key to dealing with the inevitable swings in the stock market is to keep a cool head and think about the long term. Don’t follow day-to-day market news or try to “play” the market. Instead, check in just a few times a year and rebalance according to your needs.

2. Choose a strategy and stick with it.

From time to time, you might hear about a hot new investment strategy or tip. An IPO everyone is buzzing about (Netscape), a fabulous investment firm run by a friend of a friend (Heard of him? His name is Madoff) or a complicated investment vehicle that is giving unheard of returns (collateralized debt obligations backed by subprime mortgages!). It’s best to not get caught up in a bubble or hype, and instead stick to your original strategy.

3. A down market isn’t the time to pull out, it’s the time to buy.

People normally feel confident enough to invest when the market is going up, and then they get scared and pull out when the market goes down. Unfortunately, this is the exact opposite of what they should be doing–not only because they’ve forgotten that there are natural ups and downs (point #1), but because they are then buying investments at their most expensive and selling them at the moment they are least likely to get much for them. You should do the opposite and view a down market as an opportunity to buy at a discount. Like a sale at Kate Spade, the temporary dips in the market help you get your hands on investment shares you want for the future at a better price.

Remember ...

Investing over the long term is the best way to grow your money and outpace inflation. And you don’t have to be a business school graduate to do it well. You just need to know the basics and keep your eye on the prize: a comfortable retirement that includes lots of travel and a beach house.

*This is if your parents had invested in a broad basket of stocks tied to the Dow Jones Index. In 1982 it was at 776. Today it stands at 12,217. That’s an increase of 1,400%.

Learnvest

Financial planning made simple.

Get your free financial assessment.

Related Tags

Get the latest in your inbox.

Subscription failed!

You're Now Subscribed!