Spending Smart: Investing 101
It’s easy to feel overwhelmed by investment terminology like “stocks,” “bonds,” “index funds,” and more when talking about investing. These terms are commonplace in the news and discussions about the market. What’s often missing from these discussions is a simple explanation for the non-finance major. In this column, I plan to break down some of the fundamentals of investing to help prepare you to navigate discussions about investing and your future financial decisions.
What It Means to Invest
Investing, by definition, means using money to buy assets with the expectation that they will grow in value or generate income in the future. When people are writing their budgets or deciding how to spend their money, saving and investing are often modalities they turn to for long-term wealth. Saving typically involves storing money in low-risk accounts (like savings accounts) with minimal returns, while investing involves taking on more risk in pursuit of higher returns.
Stocks
One of the main ways to invest is in the stock market, specifically through stocks. A stock represents a percentage of ownership in a company. Often, when referring to the sale or purchase of stocks, people use the term “shares” of a company. A share is another term for the part of a company they own, representing a small percentage of ownership. As the stock price changes, the shareholders (those who own stock) either make or lose money. Stock prices move based on the company’s overall performance, market conditions, and supply and demand. When companies issue stock to raise capital to fund investments, such as in an IPO (initial public offering), that is called a primary market transaction, where new shares are created. Stocks traded on the stock market are usually secondary market transactions, meaning existing shares are being traded between investors.
Bonds
Another type of investment is a bond. A bond is a loan you (the bondholder) make to the government or a company. The borrower (government or company) agrees to pay interest to the bondholder and the principal amount on a set date. Bonds are considered a safer form of investment, because they get paid before stockholders. In addition, bonds are “fixed-income” vehicles, meaning they define a schedule of principal and interest payments at the outset and are a more predictable investment. Bond prices fluctuate based on the interest rates and their credit risk. Credit risk is the risk that a borrower will default on a loan, but for loans made to the United States government, this risk is assumed to be very low.
Mutual Funds
Another form of investment is through mutual funds. A mutual fund is a pool of money from different investors. Many people will put their money into this fund, and a professional manager will actively manage it, choosing what to buy and what to sell with this money. Managers charge fees for managing the fund’s investments. Investors in the mutual fund own shares in the fund that represent proportional ownership of the fund’s investments. A mutual fund can own a combination of stocks, bonds and other securities.
Index Funds
An index fund is one of the most popular investment options. A market index is a hypothetical portfolio of investments that measures the performance of a specific market, such as the S&P 500, which tracks the 500 largest publicly traded companies in the U.S. While you can’t invest directly in a market index, you can invest in ETFs (Exchange-Traded Funds) or mutual funds. ETFs are baskets of investments that track the companies in the market index. Other market indexes can be used to create index funds, such as the Russell 1000 and the Dow Jones Industrial Average. Index funds are not actively managed; rather, they are passively managed, meaning they track a market index rather than trying to beat it, resulting in lower fees. Index funds are created to mirror market performance.
Diversification
Investors who hold more than one asset have a portfolio of investments. Whether they choose to invest their assets in funds, indexes, stocks, or bonds, the mix of these investments is known as their portfolio. Diversification is the idea of not putting all your money into a single asset but spreading it across different assets. The goal of diversification is to reduce reliance on a single investment, thereby mitigating the risk that a company-specific incident will affect your entire portfolio.
Risk and Return
When working with investments, two key concepts to understand are risk and return. Risk refers to the uncertainty of an investment’s outcomes, including the possibility that its value may fluctuate over time. Return is the percentage gain or loss on an investment over a given period. When you invest, returns are not consistent. In general, investments with higher expected returns tend to come with higher levels of risk. Importantly, investors do not evaluate risk based only on short-term changes. Instead, they consider their investment horizon. A longer time horizon often allows investors to tolerate more short-term volatility in pursuit of higher long-term returns.
Compound Growth
Compound growth, also known as compound interest, is earning returns on both the original investment and the previous returns that you have accrued. This is what helps investments grow exponentially over long periods of time. For example, if you invest $100 today, growing at 5% annually (meaning you earn 5% on that $100 each year), at the end of one year, you will have $105. The following year, instead of still making 5% on the initial $100 investment, you are now making 5% on $105, which by the end of that year will become $110.25. The interest rate is applied to higher sums of money as time goes on, giving you greater returns.
How to Invest
People can invest using brokerage accounts, retirement accounts or even employer-provided plans. These accounts hold investments but are not investments themselves. In addition, there are investors and wealth managers who are trained to help you with your investments and make smart choices in the market tailored to your personal needs.
Investing is a system with rules and structure that, when followed, can help the user make responsible decisions to grow their money. It’s important to be cautious because many people will try to sell “get-rich-quick” schemes through investments, which usually come with high risk. Investing can be a powerful tool to grow wealth when used properly and responsibly.
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Photo Caption: Stock market
