The different ways you can grow your money

Diversification for Poor People: Understanding Investment Basics

by Gary Foreman

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Getting your savings to grow is important. But, investments are an uncomfortable area for many people. Investing is complicated. It's full of buzz words. And there are a lot of bad guys just waiting to take your money away. Where do you begin? That's simple. You begin by learning a few basic concepts. You also find out if there are any things you can do to avoid major mishaps.

There are only a couple of ways that your savings can grow for you. One way is to own something that physically stays the same, but becomes more valuable over time. For instance, your baseball card collection. These are real items that you can see and put your hands on. The list includes gold, oil, collectibles, land and other similar items. Why would they increase in value? Sometimes it's because only a limited number are available or it's hard to produce more. Sometimes it's just because people want to have the item and are willing to pay more today than would have yesterday.

Investors often refer to these items as 'hard assets' or 'inflation hedges'. That's because they can offer good protection against inflation. But, there's a flip-side to the coin. Remember that any of these items can also decrease in value. It's possible that they will be worth less tomorrow. Why would that happen? Maybe scientists find an energy source that costs and pollutes less than oil. It could happen.

Now let's look at the second way that you're savings can grow. You can let someone else borrow your money and pay you back with interest. That's what happens when you put your money in a bank certificate of deposit or a money market fund. It also happens when you invest in a bond, whether it's a US Savings Bond or one from General Motors. Naturally some loans are safer than others. The bank and government are very safe. GM should be secure. A loan to a brand new business or cousin Joey could be a risk, though!

As you might expect, some loans pay better than others. That's to compensate you for two different kinds of risk. The first is that the borrower might not be able to repay the loan. You would expect to get paid more interest if there were a chance that you wouldn't see your money back. That's sometimes referred to as 'default risk'.

You face a second risk. When your money is paid back it might buy less stuff than it does today because prices have gone up. That's known as 'inflation risk'. If you're loaning your money out for a short period of time (CD, money market fund), you can make a reasonable estimate of how high inflation will be. But if you're investing in a twenty year corporate bond, it's pretty hard to see that far into the future. So you would expect to earn a greater rate of interest on a longer term loan.

The third way that your money can grow is through business ownership. As a business owner you expect to share in the profits of the business. You may own the corner ice cream stand and all the profits belong to you. Or you may own shares of stock in a multi-national corporation like IBM. Then you'll only have a minor participation in the company's good fortune.

Owning a business can be very rewarding. And very risky. Your greatest opportunity to make money is through ownership. It's how most fortunes are made. But it can also be one of the quickest ways to lose money. Your business could do poorly because of mismanagement, competition, because the economy falters or just because of a bad stock market.

There's one final way that your money can make more money. That's gambling. You could put your savings into the commodities market. But it's not a very good or prudent way to invest your money. Professionals claim to make money in commodities. Even if that's true, it's no place for amateurs.

I can hear a number of you asking about mutual funds. Why haven't they been mentioned? The reason is simple. A mutual fund is not really an investment. It's a way of investing. Let me explain the difference. A mutual fund is going to invest your money for you. You haven't really invested in the fund. You've invested your money in the stocks, bonds or hard assets that the mutual fund buys with your money. So a mutual fund is just a way of committing your money to those different investments.

What about IRA's, 401K's and other retirement plans? They're all like the mutual funds. It's just a way to invest. Why is it important to understand the different types of investments? There are a couple of good reasons. People will approach you with different investment ideas. These offers can range from good to dishonest. The quickest way to spot frauds is to understand how an investment works. If you don't understand an opportunity it's time to say "no".

There's another reason to study investments. Each one will react to economic conditions differently. A little basic knowledge can help you combine them so that they work together for your benefit. And it doesn't take a lot of money to get started. But that's the topic of next week's article.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, and Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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