Chapter 1
IN THIS CHAPTER
Comparing common investments
Explaining investment terminology — risks and returns
Deciphering the gobbledygook of professionals, credentials, and investment companies
So many fields and disciplines are packed full of jargon. Some of this is the result of “progress” and advances, and some of it is caused by workers in the field not going out of their way enough to explain and define things.
In this chapter, I give you the lay of the land regarding the enormous numbers of choices and foreign-sounding terminology that await you in the world of investing. I also explain the types of companies that offer investments and their strengths and weaknesses. And should you want to hire some investing help, I also detail the various professionals pitching their services to you and the common credentials they hawk to convince you of their expertise.
The most exciting thing about investing during your younger adult years is that you can be more aggressive with money that you’ve earmarked to help you accomplish long-term goals. To achieve typical longer-term financial goals, such as retiring, the money that you save and invest generally needs to grow at a rate much faster than the rate of inflation. If you put your money in a bank account that pays little or no interest, for example, you’re likely to fall short of your goals.
Ownership investments are investments like stocks, where you own a piece of a company, real estate, or a small business that has the capability to generate revenue and profits. Over the long term, consider ownership investments if you want your money to grow much faster than the rate of inflation and don’t mind more volatility in your investments’ values.
The downside to such investments is that they can fall more significantly in value than non-ownership investments, especially in the short term. So don’t put money into ownership investments that you may need to tap in the short term for rent money or your next vacation. To reduce the risk of ownership investments, diversify — that is, hold different types of ownership investments that don’t move in tandem.
I cover three major ownership investments in the following sections: stocks, real estate, and small business.
If you want the potential to share in the growth and profits of companies, you can gain it through buying shares of their stock. Stocks are shares of ownership in a company. You can buy stock directly in individual companies through a brokerage account, or you can buy a collection of stocks via a mutual fund or exchange-traded fund (see Chapter 10).
You don’t need to be a high roller to make money investing in real estate. Owning and managing real estate is like running a small business: You need to satisfy customers (tenants), manage your costs, keep an eye on the competition, and so on. Some methods of real estate investing require more time than others, but many are proven ways to build wealth.
Among the key attributes of real estate investment are the following:
See Chapter 11 for the details on investing in real estate.
I know people who have hit investing home runs by owning or buying businesses. Most people work full-time at running their businesses, increasing their chances of doing something big financially with them. Investing in the stock market, by contrast, tends to be more part-time in nature.
In addition to the financial rewards, however, small-business owners can enjoy seeing the impact of their work and knowing that it makes a difference. I can speak from firsthand experience (as can other small-business owners) in saying that emotionally and financially, entrepreneurship is a roller coaster.
Besides starting your own company, you can share in the economic rewards of the entrepreneurial world through buying an existing business or investing in someone else’s budding enterprise. See Chapter 12 for more details.
In the first section of this chapter, “Growing Your Money in Ownership Investments,” I discuss how you can make your dough grow much faster than the cost of living by using stocks, real estate, and small business. However, you may want or need to play it safer when investing money for shorter-term purposes, so you should then consider lending investments. Many people use such investments through local banks, such as in a checking account, savings account, or certificate of deposit. In all these cases with a bank, you’re lending your money to the bank.
Another lending investment is bonds. When you purchase a bond that has been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest. A corporate bond may pay you 4 percent interest over the next three years, for example.
An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to a company through one of its bonds that matures in, say, five years, and the firm doubles its revenue and profits over that period, you won’t share in its growth. The company’s stockholders reap the rewards of the company’s success, but as a bondholder, you don’t. You simply get interest and the face value of the bond back at maturity.
Similar to bank savings accounts, money market mutual funds are another type of lending investment. Money market mutual funds generally invest in ultra-safe things such as short-term bank certificates of deposit, U.S. government–issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.
Who among us wants to lose money? Of course you don’t! You put your money into an investment in the hope and expectation that you will get back more in total than you put in. When it comes to investing, no concepts are more important to grasp than risk and return, which I explain in this section.
The investments that you expect to produce higher returns fluctuate more in value, particularly in the short term. However, if you attempt to avoid all the risks involved in investing, you likely won’t succeed, and you likely won’t be happy with your investment results and lifestyle. In the investment world, some people don’t go near stocks or real estate that they perceive to be volatile, for example. As a result, such investors often end up with lousy long-term returns and expose themselves to some high risks that they overlooked, such as the risk of inflation and taxes eroding the purchasing power of their money.
You can’t live without taking risks. Risk-free activities or ways of living don’t exist. You can sensibly minimize risks, but you can never eliminate them. Some methods of risk reduction aren’t palatable because they reduce your quality of life.
Risks are also composed of several factors. Following are the major types of investment risks and a few of the methods you can use to reduce these risks while not missing out on the upside that investments offer:
Purchasing-power risk: Inflation — which is an increase in the cost of living — can erode the value of your money and its purchasing power (what you can buy with that money). I often see skittish investors keep their money in bonds and money market accounts, thinking that they’re playing it safe. The risk in this strategy is that your money won’t grow enough over the years for you to accomplish your financial goals. In other words, the lower the return you earn, the more you need to save to reach a financial goal. As a younger investor, you need to pay the most attention to the risk of generating low returns because your money will be invested over so many years and decades.
With lending investments, you have a claim on a specific amount of a currency. Occasionally, currencies falter. This is a low frequency but very high impact risk that most folks ignore when thinking about lending investments.
Throughout this book as I discuss various investments, I explain how to get the most out of each one. Because I’ve introduced the important issue of risk in this chapter, I would be remiss if I also didn’t give you some early ideas about how to minimize those risks. Here are some simple steps you can take to lower the risk of investments that can upset the achievement of your goals:
Diversify. Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely related industries. To reduce this risk, purchase stocks in a variety of industries and companies within each industry. Even better is buying diversified mutual funds and exchange-traded funds. Diversifying your investments can involve more than just your stock portfolio. You can also hold some real estate investments to diversify your investment portfolio.
If you worry about the health of the U.S. economy, the government, and the dollar, you can reduce your investment risk by investing overseas. Most large U.S. companies do business overseas, so when you invest in larger U.S. company stocks, you get some international investment exposure. You can also invest in international company stocks, ideally through funds.
Each investment has its own mix of associated risks that you take when you part with your investment dollar and, likewise, offers a different potential rate of return. When you make investments, you have the potential to make money in a variety of ways.
To determine how much money you’ve made or lost on your investment, you need to calculate the total return. To come up with this figure, you need to determine how much money you originally invested and then factor in the other components, such as interest, dividends, and appreciation or depreciation.
If you’ve ever had money in a bank account that pays interest, you know that the bank pays you a small amount of interest when you allow it to keep your money. The bank then turns around and lends your money to some other person or organization at a much higher rate of interest. The rate of interest is also known as the yield. So if a bank tells you that its savings account pays 2 percent interest, the bank may also say that the account yields 2 percent. Banks usually quote interest rates or yields on an annual basis. Interest that you receive is one component of the return you receive on your investment.
If a bank pays monthly interest, the bank also likely quotes a compounded effective annual yield. After the first month’s interest is credited to your account, that interest starts earning interest as well. So the bank may say that the account pays 1 percent, which compounds to an effective annual yield of 1.02 percent.
When you lend your money directly to a company — which is what you do when you invest in a bond that a corporation issues — you also receive interest. Bonds, as well as stocks (which are shares of ownership in a company), fluctuate in market value after they’re issued.
When you invest in a company’s stock, you hope that the stock increases (appreciates) in value. Of course, a stock can also decline, or depreciate, in value. This change in market value is part of your return from a stock or bond investment.
Stocks can also pay dividends, which are the company’s way of sharing of some of its profits with you as a stockholder and thus are part of your return. Some companies, particularly those that are small or growing rapidly, choose to reinvest all their profits back into the company.
Discussing the companies through which you can invest and where to get investing advice may seem out of place to you if you started reading this book from the beginning. But I’m doing this because I strongly believe that you should begin to think about and understand the lay of the land in these important areas so that you can make the best choices.
Selecting the firm or firms through which to do your investing is a hugely important decision. So is the decision about from whom to get or pay for investing advice. In this section, I address both of these topics.
Insurance companies, banks, investment brokerage firms, mutual funds — the list of companies that stand ready to help you invest your money is nearly endless. Most people stumble into a relationship with an investment firm. They may choose a company because their employer uses it for company retirement plans or they’ve read about or been recommended to a particular company.
When you invest in certain securities — such as stocks and bonds and exchange-traded funds (ETFs) — and when you want to hold mutual funds from different companies in a single account, you need brokerage services. Brokers execute your trades to buy or sell stocks, bonds, and other securities and enable you to centralize your holdings of mutual funds, ETFs, and other investments. Your broker can also assist you with other services that may interest you.
Deciding which investment company is best for you depends on your needs and wants. In addition to fees, consider how important having a local branch office is to you. If you want to invest in mutual funds, you’ll want to choose a firm that offers access to good funds, including money market funds in which you can deposit money awaiting investment or proceeds from a sale.
Among my top investment firm selections are firms that offer mutual funds and ETFs and/or brokerage services.
Broker |
Phone Number |
Website |
E*Trade |
800-387-2331 | |
Muriel Siebert |
800-872-0711 | |
Scottrade |
800-619-7283 | |
T. Rowe Price |
800-638-5660 | |
Vanguard |
800-992-8327 | |
TD Ameritrade |
800-934-4448 |
I would always counsel folks who took personal finance courses I taught or who contacted me seeking advice to get educated before engaging the services of any financial advisor. How can you possibly evaluate the competence of someone you may hire if you yourself are financially clueless? You’ve got this book, so read it before you consider hiring someone for financial advice.
By taking the themes and major concepts of this book to heart, you’ll greatly minimize your chances of making significant investment blunders, including hiring an incompetent or unethical advisor. You might be tempted, for example, to retain the services of an advisor who claims that he and his firm can predict the future economic environment and position your portfolio to take advantage. But you’ll find in reading this book that financial advisors don’t have crystal balls and that you should steer clear of folks who purport to be able jump into and out of investments based upon their forecasts.
Because investment decisions are a critical part of financial planning, take note of the fact that the most common designations of educational training among professional money managers are MBA (master of business administration) and CFA (chartered financial analyst). Financial planners often have the CFP (certified financial planner) credential, and some tax advisors who work on an hourly basis have the PFS (personal financial specialist) credential.
You can ask the advisor to send you a copy of his Form ADV. You can also find out whether the advisor is registered and whether he has a track record of problems by calling the SEC at 800-732-0330 or by visiting its website at www.adviserinfo.sec.gov
. Many states require the registration of financial advisors, so you should also contact the department that oversees advisors in your state. Visit the North American Securities Administrators Association’s website (www.nasaa.org
), and click the Contact Your Regulator link on the home page.