Investments for Beginners
by Gary Foreman
Could you please do an article on where to save? I have finally gotten my budget intact, and am saving up money with every single paycheck. The problem is, I don't know where to put the savings because I'm planning to attend college full time next year. There are several different methods to save your money out there. I'm considering mutual funds, because they seem to pay off really well, but are there maybe some alternatives that I am missing out on??
Scott asks a good question. After you've begun to accumulate some savings, what do you do with them? Although there's no one answer that's perfect for every reader, we can work with some ideas that will simplify matters for you.
First, you need to do what Scott has done. That is to decide what you want to happen. And 'making more money' isn't an acceptable answer. You need to have some idea when you could need the money back. If you'll need it for college next year, you're going to be limited to investments that make it certain that your money will be there when you want it. If, on the other hand, you're saving for retirement fifteen years down the road you can afford to take a little risk that you might even lose money in some years.
Next, consider your ability to take risk. There are two components that determine how much risk you should assume. We just looked at one, how soon will you need the money. The more time you have before you expect to need the money, the greater the risk you can take. If you don't need the money for ten years and your investment loses money one year but gains the other nine it's not a big deal. If, however, you'll need the money next year you don't have that luxury.
The other consideration on risk is your own personality. Some people are mountain climbers. Others prefer a day at the beach. If you're a cautious person you won't be comfortable with a risky, high flying investment. Even if the investment does well, the sleepless nights and money you'll spend on ulcer medicine will make it unsuitable for you!
Finally, will you have all of the money to invest at one time? Or do you plan on saving $50 a month? Also consider how you will ultimately use the money. Will you want it all at once to buy a house? Or will you be using the money a little at a time when you're retired?
Knowing this will help you select the right investment. For instance, if you're saving $50 a month you won't be buying individual stocks. Commissions will take all your money. CD's aren't practical, either. You'll need to consider savings accounts, money funds or mutual funds.
By comparison, if you've just received an inheritance of $20,000 and want to use that as a down payment for a house in two years you'll be able to consider individual stocks, bonds, CD's, treasury bills and notes. All of these investments require a sizable investment to be made at one time and sold or redeemed in one transaction.
Now let's talk a little bit about the vehicle for your investment. You must remember to separate what you're investing in from how you're investing in it. What does that mean? Let's take a simple case that demonstrates how there can be confusion. One of the things that you can invest in is ownership of companies. One way to do that is to open your own restaurant. Another way is to buy a mutual fund that buys common stocks. In both cases you own either part or all of a business and would expect to benefit if the business does well.
On the most basic level, there are really only four kinds of investments. You can be a business owner (called equity). You would expect to make money if the business prospers. Typically, you'll find that this type of investment is best if you have a longer term view. Owning a piece of the action is called for if you believe in the future of the business, industry and/or economy generally.
Another way to invest your money is to loan it to someone for interest. Here you give them a dollar today with the expectation that they will give you $1.05 or $1.10 later. It could be a loan to your brother-in-law or a bond issued by General Motors.
When you consider a debt instrument (loaning your money) there are a number of different variables that will be important to you. Safety, for instance. Money loaned to the US Treasury should be safe. Your brother-in-law will not be so safe. Typically you can expect to earn more interest from a borrower who is less safe. You'll need to balance the interest you earn with the risk of losing your money.
A key variable is the 'term' of the loan. A certificate of deposit is for a relatively short period of time. A few months or years. By comparison, a corporate bond could be issued for 20 or even 30 years. You'll find that shorter term loans are usually safer, but pay less interest. Again, there's a number of different ways to make this kind of investment. You can buy individual CD's or bonds. You can also buy a mutual fund that buys bonds.
A similar category is called 'cash equivalents'. That's where you loan your money for a short period of time (usually one year or less) and expect that your principal will be there whenever you want it without risk of loss. CD's, savings accounts and money funds are good examples.
The last category is made up of 'hard assets'. These are things that are usually found in the earth and/or cannot be easily reproduced by man. Gold, oil and real estate fall into the category. This type of investment will do better in inflationary times. Again, you can buy an ounce of gold or buy a mutual fund that invests in gold companies.
Most beginning investors should begin with cash equivalents until they have a fund big enough to meet unexpected family expenses. After that, you'll want to begin with equity and debt investments. Finally, some hard assets for balance.
Although not the only good answer, mutual funds often are a good selection for beginning investors. Most make putting money in or taking it out in smaller amounts easy. Many mutual fund companies have choices in each of the categories making it easy to match your needs. Yes, there are an awful lot of funds to choose from. And yes, some are better than others. But that's the subject for another column!
Thanks to Scott for an excellent question. Here's to good returns on all his investments. Including that college education!
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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