Guide to Investments 101
Investing can be an intimidating term. Although investing is a very broad term, it is probably the term most often associated with financial planning and financial advisors as, traditionally, financial advisors were mostly focussed on managing their clients’ investments. Nowadays, however, investing in stocks, bonds and other investment vehicles, is much more accessible to non-financial professionals, and as a result, good financial advisors have broadened their product offering substantially.
This guide offers a very basic, surface-level explanation of investing and saving, and why you should understand the differences between them in order to grow your wealth, allowing you to redefine your relationship with money and live the life you want.
– The stock market
– The bond market
– Why invest?
Imagine that a business is owned in its entirety i.e. 100% by its founder. Let’s call the founder Jack. By owning 100% Jack needs to provide all the cash that the business needs. Jack can, however, choose to divide his business up into shares. If Jack divided his business into 100 shares, each share would constitute 1% of the business. There are many reasons why Jack may decide to create shares, which we won’t get into here.
If Jack needs an influx of cash for his business, Jack is able to use these shares to raise the money. Jack could keep 20% of his business i.e. 20 shares, and sell the remaining 80 on the stock market. When buyers purchase these shares (sometimes called stocks), the business receives cash. Jack can use this cash to grow the business or to pay down debt.
In return, the buyers get a certain % of ownership in Jack’s business, which means that they will be entitled to a share in the profits. In addition, the buyers may be able to make money when they sell their shares in Jack’s business. Let’s say Tim pays $10 for one share (in this example that would be worth 10% of the total business).
If the market value of the stock goes up, due to a number of factors, Tim can sell the stock at the higher price, say $15, and earn $5. However, there is always a chance that the stock can decrease in value, to say $7. This means that if Tim sells the stock at this time, he will only get $7 and lose $3. Alternatively, Tim may choose to wait for the value to return to $10, or higher, and then sell. This, of course, may or may not happen, depending on the market fluctuations. He would be taking a bit of a chance either way.
The bond market is similar to the stock market from the perspective of the government or the business, in that, it is a mechanism for them to raise money. It differs in a few other ways though. On the stock market, the buyer receives ownership in the business, this is not the case on the bond market. Buying a bond is similar to loaning money, you don’t receive ownership in anything, but you will be paid interest.
Bonds have a face value (the $ value of the bond), an interest rate (as a %) and a lifespan i.e. they have a maturity date. Bonds are most commonly used by governments, so let’s use the US Treasury and a woman, we’ll call her Carol, as an example. The US Treasury is called the issuer here as they issue the bonds. Let’s assume Carol decides to buy bonds with a face value of $1,000, at an interest rate of 2%*, and a maturity date of 12 years from now. When she purchases the bond she pays $1,000 to the US Treasury. The Treasury can then use the money over the 12 years, it’s almost as though Carol has given them a loan of $1,000. At the end of the 12 years, the US Treasury has to repay Carol the initial $1000, plus the 2% interest that she has earned over the 12 years, $608 i.e. Carol receives a total of $1,608.
The benefit for Carol is that bonds are a safer investment than stocks (the US government is unlikely to not pay her back) and she can potentially earn more interest than a savings account. The benefit for the US Treasury is that they get access to money when they need it.
*assuming 2% p.a. compounded semi-annually.
The biggest benefit to investing, in either the stock or the bond markets, is that it helps your money grow faster than inflation. Inflation slowly erodes the purchasing power of your dollar, making everything from groceries to your car a little more expensive every passing year. That’s why you hear your grandfather mention that it used to cost a quarter to see a movie and now it costs $20.
Your savings are usually put into the safest accounts that allow you access to your money at any time. Examples include savings and checking accounts. There are pros and cons to these savings accounts.
– Security: At some banks, your savings may be insured by the Federal Deposit Insurance Corporation (FDIC) up to a certain amount.
– Availability: If you wanted to pull your money out today, you could without any hassle. In other words, the account is very liquid.
– Low returns: Although the account is very safe, the interest you receive from the bank is very low. At times, the interest is so low, you could …
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