Financial experts have, time and again, given the advice that people should save and invest.
Saving is something that many already understand – it is putting aside money and not using it for current spending – but investing seems more complicated.
Still, it is the next step in having a more secured financial future and, if you are aiming to build wealth, then you should take the time to learn and understand what investing is about.
Savings vs. Investing
Saving your money in a bank means that your funds are liquid – that is, you can readily withdraw or convert those numbers in your account into cash, which you can use, say, as capital for a business, as down payment for your house, or for other uses at any time.
And while you are letting your bank keep your money for you, the amount in your account grows – it earns interest. There is less chance of you losing your money and, often, it is insured by the FDIC or the Federal Deposit Insurance Corporation, up to a certain amount.
Your bank savings also contribute to the country’s economy. In contrast, if you hoard your money in a drawer or under your mattress, it does not earn interest nor does it become part of the money circulation.
Investing, on the other hand, is usually for long-term. The returns are usually greater than the interest you earn from a savings account. You can also support companies that you believe in, such as an environmentally responsible manufacturer.
However, your money is not as easily accessible so you won’t be able to immediately get to it. Also, depending on which product you invest in, could be more at risk – that is, there is a chance that you can lose some of your funds.
Moreover, the money you place in mutual funds, securities, and other investments are not insured by the FDIC.
It would be good, therefore, to have both savings and investments and create a balance between the two.
Investing vs. Gambling
Many have the notion that investing money is simply gambling it away. While both certainly have risks, there are stark differences between the two. For one, when you gamble, the odds are usually against the bettor – you.
For another, you are placing your money on nothing more than chances. Investment, on the other hand, is placing your money on something more tangible and with value, with the expectation that it will grow, either through income or interest.
There are other differences, too. One, investing is business while gambling is entertainment; two, investing is geared toward wealth building while gambling is trying to have a big chunk of money all at once; three, investing requires knowledge, skill, and patience, gambling is more about emotions, e.g., luck, fear, greed, confidence, etc.
For example, if you buy stocks, you are buying shares of a company so you essentially become one of the owners of that company. You receive dividends or a share of the profits, and if you decide to sell your share of the company at a price higher that your purchase price, you can earn from capital gains.
However, the risk factor is how the company does in the market – if its stock price goes down and you decide to sell, then you will lose some money. If something happens, such as if the stock market crashes or a stock market bubble bursts, you could lose all. These, however, are investing phenomenon, not the trend.
Similarly, if you purchase bonds, you are lending your money to a company or the government and, after a set period, you get your money back along with the interest it earned. With real estate, the value of the property usually has an upward trend.
With gambling, though, you are using money on a wager based on chance. You have no control except hope that your horse or your number would win. Moreover, according to Investopedia, a casino always has an edge over the player.
For example, the house has a 15.2 percent advantage on the slot machine while in the double-zero roulette, it has a 5.26 percent edge. In horseracing, the favorite only wins 33 percent of the time, on average.
Let us say you buy a $2 lottery ticket twice every week so, each year, you spend $208 trying to win the jackpot. In 30 years, your spending on tickets would be $6,240, with no guarantee of returns, given that your chance of winning is 1 in almost 14 million (or even 1 in around 292 million in the case of the Powerball, according to The Washington Post).
If you invest the same amount over the same period in a product that has a rate of 5 percent annually, your cash out would still be $6,240 but with earnings of $8,478, for a total of $14,718 in 30 years before taxes and inflation.
According to The Independent, you are more likely to be struck by lightning or getting crushed by meteorite than win in a lottery. You can also try the Incredibly Depressing Mega Millions Lottery Simulator on Cockeyed and see how much winnings you get in return for your pretend bet.
Any financial expert would tell you that it is better to invest your money than put your financial fate on a pair of dice.
When investing, it’s never a good idea to place all your eggs in one basket – you need to distribute it. Investors call this diversification. Having a diversified investment portfolio means you place your money in different products in order to reduce the risk of losing all your funds.
You will be able to manage risk better and offset any decline of one asset with the growth of another. It’s better to choose assets that generally don’t move in the same direction.
For example, if you use all your money to buy shares in one company, you will feel the effects greatly if the performance of that corporation in the stock market experiences a sharp downturn. On the other hand, if you distribute your funds in different companies in different industries, then you won’t be affected too much if one sector suffers a decline.
Better yet, if you have a combination of different investment products, say, stocks, bonds, cash, and real estate, then should the stock market go on a bearish streak (or when stock prices fall and the general economic outlook is pessimistic), then you still have your bonds, cash, and properties, which are separate entities.
There are numerous investment products that you can consider for your portfolio. Here are some of them:
Time Deposit such as CDs or certificates of deposit, allows you to save money and make it earn interest higher than a regular savings account. The bank will keep your money for a specified period of time, so you won’t be able to withdraw it until the predetermined time lapses.
When you purchase bonds, you are actually lending your money, either to the government (which is called treasury bond) or a company. The bond will earn interest and will mature after a specified period. Corporate bonds usually offer higher yields than government securities, but you should make sure that the company is well-established and stable and is not bound to collapse.
You might also consider municipal bonds. While the income is rather low, you usually benefit from tax benefits.
There is also what is called a convertible bond or preferred stock convertible, which means you can exchange your bond into a predetermined number of shares.
As mentioned above, you can invest in a treasury bond, which is a fixed interest debt security of the United State government. It has a maturity of more than 10 years. If you want a shorter period, then you can consider treasury bills, which matures in less than a year, or a treasury note, with maturity between 1 and 10 years.
This is a very safe investment, even considered risk-free, so the returns are not very high. Still, it is very liquid and if you are looking for an investment that secures your capital with a bit of income, then you should make this option a part of your portfolio.
Like bonds, the money market is about debt but it deals mostly with short-term debt, which has a maturity period of less than a year. Money market instruments include treasury bills, certificates of deposit, commercial paper, and so on.
As mentioned earlier, stocks are shares of a company. If that corporation does well, you can earn from the dividends and, if you decide to sell, from capital gains. There are two types of stocks: common stock, which is available for people to buy and sell and gives them voting rights; and preferred stock, which offers higher dividend and is less volatile but sometimes does not give the investors voting rights.
Life insurance offers financial protection for your beneficiaries in case you die. This means you need not worry about how they will pay for the mortgage or where they will get money if something happens to you. The premium you have to pay depends on your lifestyle, medical condition, and so on. You can either choose permanent life, meaning you pay the policy throughout your years, or term life, or a shorter period of payment.
Another product that you can purchase from an insurance company is an annuity. You regularly pay the company a fixed amount over a specific period and they will make your funds grow. You can then get your annual income payments, either immediately or at a later time.
Annuities have two major types: fixed annuity, which means you will get a specific amount during the duration of the contract, which is usually good for life; and variable annuity, which means the payments will depend on how your portfolio performs.
This is considered a safe investment, especially for increasing your capital, and taxes are deferred until you start receiving payments.
Investing in real estate is a good idea since it’s something that cannot get lost or stolen, and you can pass it on to your kids and grandkids. The value can also appreciate over time, depending on the location.
When you’re thinking of investing on a property, think of what you want. Are you looking for capital appreciation? Then choose one in a place that is likely to boom. If you want income, then choose one that you can rent out such as an apartment building, a condo unit, or a rest house.
Remember, though, that real estate ownership comes with expenses, such as property tax, insurance, and so on.
If you are not ready to buy real estate, then you can consider investing in a real estate investment trust. This is like stocks, only in the real estate sector. An equity REIT can let you earn from rentals, while a mortgage REIT can let you earn from interest on mortgage loans. There is also the hybrid REIT, which is a combination of both.
Collectibles are physical items whose value go up over time, usually because of its rarity. These include antiques, coins, stamps, collectible cards, and so on.
There is no guarantee that the value of a particular object will increase after many years and it does not provide income. Moreover, your investment is not liquid and, depending on the demand, you may have a hard time exchanging it for cash at a desired amount.
It would be good to have collectibles as an asset, but do not rely on it for earnings or future funds. If you do want to directly manage your investments, then you can look into the following options:
A mutual fund is a pool of funds from a number of people that a management company invests for them. This is a good option for those who are not very comfortable doing the trading themselves. The kind of mutual fund that you invest in would depend on your risk tolerance; you could choose equity funds, fixed-income funds, or money market funds.
The nice thing about mutual funds, apart from having a professional handling the trading for you, is that you get diversification – the pool of money from investors are placed in different instruments.
Unit Investment Trusts
Unit investment trusts are more inclined to provide dividend income and/or capital appreciation. It has a fixed portfolio, meaning its not actively traded, unlike mutual funds in which a manager may buy or sell securities.
You can choose a stock trust if you want to grow your capital or a bond trust if you are looking for income.
There are many other types of investment, such as Closed-End Fund, American Depository Receipt, Futures, Mortgage-Backed Security, Options, and more. You may have also encountered Index Funds and Exchange-Traded Funds.
If you have a 401(k), a retirement investment account, or a health savings account, then the money you are contributing are placed in investments. You do not have to actively follow the market, but you get to earn primarily through compound interest.
How to Start Investing
As mentioned earlier, do not put your money in one investment. It’s important to diversify in order to protect yourself because even the best companies can encounter issues once in a while. Here is a suggestion on how to start investing:
Evaluate Your Financial Situation
Before you start investing, you should assess your current financial situation.
- Net Worth
First, find out your net worth, also known as your wealth. List down your assets like your house, your savings, etc. then list down your liabilities or what you owe. Your assets should be bigger than your liabilities.
For example, you have a house and lot currently worth $300,000, two cars valued at $150,000, savings of $20,000, plus other assets worth $25,000; and you owe $100,000 in mortgage, $50,000 in car loan, plus $3,000 in your credit card balance.
Net worth = ($300,000 + $150,000 + $20,000 + $25,000) – ($100,000 +$50,000 + 3,000)
= $495,000 – $153,000
So your current net worth is $342,000. This will change as your assets increase or decrease in value and as you increase or decrease your debts. For example, a year from now, your house might be valued higher but your cars, lower. You might have paid off your car loan and some of your mortgage and added to your savings but you might have incurred new loans.
Regularly determining your net worth would allow you to assess if you are getting closer to your financial goals.
- Personal Cash Flow
Next, understand your personal cash flow by listing down your monthly income and expenses. Remember, cash flow management is not just about getting your paycheck and paying the bills – it is about understanding where your money is coming from and where it is going, and then making wise decisions so that you will have a more secured financial future.
To do this, you need to list down your income sources. These include your pay from your regular job, your part time job, your commissions, and other earnings that you have. This is more difficult to determine if you are a freelancer and take projects, but you should at least try to figure out your average income.
From here, find out where your money goes. These include taxes, your contributions to Social Security, 401(k), and retirement plans, your savings, your emergency fund, and your expenses.
There are different kinds of expenses, namely: fixed expenses, which means payments remain the same each month, such as mortgage, loans, etc; variable expense, which are your necessary expenses but the amounts change, such as electricity, food, gas, credit card bills, and others; and discretionary expenses, meaning what you spend on fashion, dining out, books or music purchases, and other leisure activities. Break your expenses down so you can have a clearer picture of what things you spend your money on.
Some of the questions that you should ask yourself at this point include: Are you saving a portion of your income? Is a big bulk of your paycheck going to discretionary expenses? Are you struggling to make your money last until the next payday?
Assess how you are currently managing your finances then make conscious changes if and where you think it’s needed. For example, if you are spending too much on dining out or buying coffee at the nearby café every day, then you can decide to lessen it. If you are paying for a subscription or membership that you hardly use, then you can unsubscribe. If your electric bill is exorbitant, then find ways to cut down.
If you have not been doing so, start budgeting and make sure to stick to your budget; otherwise, it will just be a wasted effort. But before setting your budget, ask yourself what you want to achieve.
Set Your Goals
Next to evaluating your current financial health is determining your financial goals. Do you want to have a house? Do you want to retire comfortably? Do you want to save for your kids’ education? Are you dreaming of putting up your own business? Do you want to have a certain amount of money by the time you reach a certain age?
By setting a goal, you can move purposefully and make conscious decisions to reach that goal – that is, you won’t just be spending your money as casually as you might do if you don’t have something you want to attain.
Find out how much your goal would cost, how much you have to start with, and how much you need to regularly contribute toward that goal to reach it within a certain time.
For example, you want to put up a business and you think you would need $50,000 to set it up. You do not yet have funds so you’re starting from scratch.
You think you can save $500 a month, so it would take you more than 8 years before you can have the capital. If you want to reach it in a shorter period of time, then you would have to contribute more toward that goal by cutting down on your spending and increasing your funds. If you put in $700 per month, you’d have $50,400 in 6 years.
Instead of letting your funds sit, you can invest them in higher-yield products before using them on your business. Let’s say you invest $700 a month in a product that has a 5 percent annual rate. In 6 years, you’d have $58,434 before taxes and inflation.
By familiarizing yourself your net worth and your cash flow and setting your goals, you can then adjust your budget accordingly. Make sure that you have savings and an emergency fund separate from the money you will allot for your investments.
Find Out What Your Risk Tolerance Level Is
Risk tolerance is, basically, how much risk you are able to bear. If you are risk-averse or you are more concerned about preserving your capital, then you are likely to be a conservative investor so you should invest in low-risk products. If you are risk-tolerant – that is, you don’t mind losing some of your money as long as you get higher returns – then you could be an aggressive investor and are likely to invest in high-yield, high-risk products. Or you could also be somewhere between the two, a moderate or balanced investor.
To determine your risk tolerance level, you can look back at how you handle your money. If you need a bit of help, then you can take some online quizzes, like the ones on Bankrate, Vanguard, and Wells Fargo. However, since these quizzes are only general guides, it would be better to talk to a financial or investment expert.
That is not the whole story, however; you should also consider your risk capacity. For instance, if you are 20 years old and have decades ahead of you before you retire, then you can be more aggressive. You will have time to recover if the value of your assets takes a dip. If you are a successful businessman with high wealth and income, then you can also afford to be more risk-tolerant.
If, on the other hand, you are nearing retirement or if you have limited funds and income, you cannot really risk a dramatic decline in the value of your portfolio, even if your risk tolerance is high and you are basically an aggressive investor. You would also need your funds to be easily accessible, so you need high liquidity. Unlike younger investors or those with lots of money streaming in regularly, you might not be able to afford to wait for market prices to bounce back if they experience a great, long dip.
Learn Investing Basics
Once you know your risk tolerance level and risk capacity, then you can choose from the investments available to you. Make sure to do your research and ask your financial advisor to clarify points that you don’t understand. If you want help in setting up an account, you can call a brokerage firm or your bank and ask the customer service representative on how to do it.
You can choose the platform that you feel most comfortable with, namely getting the help of a financial planner, using a robo-advisor, or managing your investments on your own.
Start Small and Simple
Diversification is important but you should take it slowly. It’s better to start with simple investing, learn, and then move forward. Invest small first, then add funds regularly and/or put in any extra money that you might have. You can also have the process automated – you can transfer a certain amount from your paycheck into an investment account. Just make sure that you only use money that you won’t need in the short term.
Rebalance Your Portfolio Regularly
Your needs and financial situation regularly changes, and you should also expect your risk capacity and risk tolerance to change. Therefore, you should make it part of your investment practice to rebalance your portfolio, preferably every year.
For example, you were an employee when you started investing last year, so you had regular income. This year, you shifted to freelancing so how does that change your financial situation and your risk capacity? Since you can no longer expect to receive a set amount each month, you might decide to shift to a more conservative portfolio to manage the risk better.
What NOT to Do When Investing
Many first-time investors commit mistakes and it’s fine if it’s considered a learning experience. However, it would be better to not commit the same mistakes that others have already made. Here are some common ones:
One mistake that many first-time investors make is jumping in head first. It would be helpful to initially learn as much as you can first about the investment product before putting your money in.
For example, you should know what price ratio, book value, and dividend yield are before investing in the stock market. You can attend seminars, view online tutorials, and/or use a stock simulator like the one on Investopedia.
Going with the Fad
Another mistake that novice investors make is going with the fad. They invest on what seems to be up and coming companies but have yet to establish themselves. These penny stocks sell for much less than blue chip companies, but they are also more volatile.
It would be better to invest on quality or safe stocks first – those that you know and trust are more likely to still be in existence in a decade.
Also, be careful about following hot tips and rumors about the next big thing in the stock market. While it is certainly good to keep abreast with the news, you should try to analyze these predictions before you decide to invest in any company.
Using Money You Can’t Afford to Lose
One of the rules of thumb in investing is not to use money that you can’t afford to lose. This means you shouldn’t use your emergency fund, savings, retirement funds, or any amount that is intended for your groceries, housing, and other needs. Instead, you should first set aside an amount that you are willing to invest, say, a part of your year-end bonus or your commissions, or you can save a little each month until you have funds for your investment.
When you have money, don’t put everything in right away. It’s better to use a little at a time, testing the waters, and gradually adding more as you become more knowledgeable and confident.
Timing the Stock Market
While professional traders watch technical charts closely and try to analyze which direction the market is going, it wouldn’t do you much good to obsess about it. Of course, you should learn and understand how it works and what company you are investing in, but it would be better, for the meantime, to choose corporations that you know and believe in, those that are stable and unlikely to go bankrupt in a year or so.
Also, while you’re new, you should avoid leveraging – that is, do not borrow money just to buy more assets. For example, you have $1,000 and you borrow funds to buy $1,500 worth of stocks from a company. If the prices go up by 50 percent, your investment would be worth $2,250, giving you earnings of $750 after you pay what you borrowed (provided there is no interest). However, if the stock declines by 50 percent, your $1,500 investment will only be worth $750, so after you pay your debt (again, pretending that there is no interest), you will have only $250 left. In other words, leveraging magnifies both the gains and the losses.
Another mistake that many new investors commit is to get carried away by their emotions. They become afraid when the market dips so they start selling their shares or get too excited if a stock rises in value so they start buying in bulk. You shouldn’t let your feelings control your decision. Instead, try to look at the situation objectively: do you think (not hope) that the stock will recover or has it proven itself to be a “loser”? Do you think the price will go higher or is it at its peak?
Also, while it’s advised that you invest in a company that you believe in, it’s not a good idea to get too attached to it, especially if it is not doing well in the market. There’s no point in getting sentimental just because you love the product that the manufacturer makes, not if it’s pulling the value of your portfolio down.
As mentioned earlier, do not put your money in one investment. It’s important to have a diversified portfolio in order to protect yourself because even the best companies can encounter issues once in a while. Also, it’s good practice to review your investments regularly and rebalance when needed.
Most of all, be wise so you can watch your net worth grow.