Monday, January 27, 2014

Investing Tutorial (AND $25 Amazon Giveaway--Ends Tomorrow!)

We've received a couple of requests to do a really basic overview of what investing is-- so here it is! First, we'll define investing and then some common types of investments.





What is an investment?
I love how Prof. Bryan Sudweeks of BYU starts off by defining investment in very broad terms, comparing it to a sacrifice-- you give up something now because you expect to get something greater in the future. That's a concept we're familiar with in nearly every aspect of our lives-- for example, he lists "education and skills, knowledge and friendships, food storage and emergency funds, and finances" as common areas we make investments in. (His website, personalfinance.byu.edu, is a great resource if you find yourself really wanting to dig deeper into a topic.) Here, we're going to focus on financial investments.

Financially, it makes sense that an investment would mean that you don't "consume" your money now, but buy some other asset (such as stocks, real estate, or a business) that you expect to earn some sort of financial return on, whether it be through interest, dividends, rental income, appreciation (increase in value), etc.

Of course, you don't get something for nothing, so let's talk about why you can make money on investments.

Time Value of Money. This is one of those phrases that people with a financial background like to throw around, so I'm telling you about it so you can be in the in-crowd. The in-crowd of nerds that may or may not be cool. Basically all it means is money now is preferable to money later. Duh, right? But the concept has a lot of implications. It means that giving someone access to your cash (even if they plan to pay it back later) is something that you need to be compensated for (they need to pay you interest), based on the rate of return (e.g., a 3-percent interest rate) and how long the other party has access to your money. In other words, part of the way you make money investing is that you give up access to your funds (at least temporarily).

Risk. In financial investments, the risk we typically think of is that the investment won't produce as much money as we think it will, or that we may lose some or all of the money we invested. Generally speaking, you will be compensated for taking on more risk. This certainly isn't to say that that means you should always invest in the riskiest of investments. Investing is not the same as gambling. Things aren't completely random and there is a huge spectrum of risk and how to handle it. And that could be the subject of multiple, multiple blog posts and books. But I think we'll do one follow-up post on it for now (coming soon-- and by soon, I mean eventually :) ). My husband and I have most of our investments (retirement, our son's 529 plan), etc. in index funds that track the market-- given the long time horizon, I consider this very low-risk. But we do also have some of it in specific stocks, which, given the lack of diversity (we can talk about how owning lots of different stocks lowers your risk in the follow-up post) is more risky. Honestly, I really don't recommend picking stocks on your own unless you are willing to spend the time to do the research to decide if it's a good investment and have deep industry knowledge and a super solid financial background (in our family, this is more my husband's area than mine-- I am an index fund kind of girl). In this category of risk, we don't invest more than we could stand to lose. On the other hand, the money that we would need immediate access to, (like our emergency funds), we keep it in an online savings account (basically no risk).

Humans doing their business thing. Whether you bought some lemons and sugar and sold them at a profit at a lemonade stand, or "gave" the money to someone else (either by buying ownership in the company--stock, or giving them a loan) to get their business off the ground, human ingenuity can grow the amount of money through a smart business.

What are some common examples of investments?
Now that we've talked about what an investment is, and how you can make money from them, let's outline some of the most common types of investments.

Stocks. This is where you buy a small portion (a share) of ownership in a particular company. When a company decides it wants to "go public," it means in exchange for a large amount of cash, they give up ownership to whoever buys the shares of the company. (Typically shareholders will elect a board of directors that vote on the big company decisions.) All shares of ownership are sold at an Initial Public Offering (IPO-- have you heard that acronym floating around?). After which, the already purchased stocks (and their ownership rights) are sold second-hand in the stock market. You can make money on stocks either through appreciation (you buy them and resell them for more as the value of the company is perceived to increase), or through dividends that the company chooses to pay its shareholders.

Mutual Funds. A company like Fidelity or Vanguard will take money from many different investors, and buy large portfolio of many different stocks with it. Each investor owns a small portion of the entire portfolio. The fund manager selects which stocks to buy and sell. In exchange for this service, the fund will charge you some management fees. The diversification makes this a less risky choice, in general, than purchasing individual stocks.

Index Fund. An index fund is a mutual fund that is constructed to track the performance of a stock index (like the S&P 500-- a collection of 500 large companies used to track the performance of the stock market as a whole). Because the stock picks are more routine in nature (they are just trying to mimic the index, not evaluate the merits of each stock as an individual investment), the fees tend to be lower than "actively managed" mutual funds.

Exchange Traded Funds (ETFs). Similar to a mutual fund, ETFs pool together multiple stocks, bonds, or whatever the ETF is focused on. They typically track an index, like an index fund, but unlike an index or mutual fund, they are traded on a stock exchange.

Money Market Accounts (MMAs). A Money Market Account is a type of savings account offered by banks with a higher interest rate than your typical savings account. You get a slightly higher return because they have higher minimum balance requirements (think anywhere from $500 to many thousand  dollars) and withdrawal limitations. Because these are offered through banks, they are very low risk.

Money Market Funds. These are different from Money Market Accounts. Instead of being offered through a bank, they are a type of mutual fund that invests in short-term debt. These are also very low risk, and usually offer a slightly better return than Money Market Accounts.

Bonds. This is different from a stock - it's essentially a loan to the company. You don't get a share of ownership in the company, you get a share of ownership of the right to be repaid a specified amount of money at a specified rate of interest. You might not have access to the high appreciation potential of stocks, but you are subject to much lower levels of risk (if a company goes belly-up, bondholders will get paid before stockholders). If the government needs more money, sometimes it will issue bonds.

Savings Account. Some people don't really like to call this an investment, since the return is next to nothing and the risk is essentially zero, but I still think it qualifies, at least in principle. You lend your money to the bank, and they pay you interest for the favor of having access to your money. They lend it out to other people and businesses and charge them a higher rate of interest on it.

Certificate of Deposit. You can buy one of these (also called CDs) from banks if you know you won't need access to your money for a specified amount of time (such as a year or five). They offer a slightly higher rate of interest than a typical savings account, since they know they have your money for a specified amount of time, but not by much. Super low risk, and pretty low return.

Real Estate. If you buy a house/apartment/building that you intend to rent out, or fix up and resell, this would be an investment. Under most circumstances, I would not consider your personal home as an investment. That's certainly not to say that buying your own home is not a smart financial choice (given the right set of circumstances).

Business. Buy or create a business. Easier said than done :)

Tell us -- Which of these types of investments (or aspects of investing) would you like to learn more about?








Sources:
"Understand the Definition of the Term Investment." Personal Finance. Bryan Sudweeks.
"Defining the Three Types of Investments." Andrew Beattie. Investopedia.com. September 2, 2012.
"What is a Mutual Fund." Dave Kansas. wsj.com.
"Mutual Funds and Other Investment Companies." Personal Financial Planning: Seventh Edition. G. Victor Hallman & Jerry S. Rosenbloom. 2003.
"Exchange-traded Fund." Wikipedia. January 19, 2014.
"How Does a Money Market Account Work?" Keybank.com

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2 comments:

  1. Great post, Lauren! You really broke it down and I definitely learned a thing or two about investments. Can't wait for part two!
    Because of hubby's job, we haven't been able to hold many individual stocks for a while, which is nice because as his tax preparer, I told him he had to stop doing so many small trades because it wasn't worth the cost of my time to deal with the compliance. :)

    ReplyDelete
  2. This is so helpful. I'm bookmarking to save for later reference.

    ReplyDelete

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