Chapter 2: Investing
Now that you have determined what you want to save for, you may be wondering where you should put your money. There are three basic types of investment classes:
- Stocks: A share of stock represents a percentage of ownership in a corporation. In other words, if a company is divided into a million shares and you buy one share, you would own one millionth of that company. You can make money from receiving dividend payments and selling the stock for more than you bought it for. Historically, stocks have provided the greatest return (earnings) long term. However, there are no guarantees – one day your stock may be worth more than what you paid for it, the next, less.
- Bonds: A bond is a loan to a company or government, with you, the bondholder, as the lender. Generally, you receive the principal, called the par value, at maturity of the bond and interest periodically while you are holding the bond. Depending on the market, you may purchase a bond below, at, or above its par value. In general, bonds are between stocks and cash equivalents in regard to risk and return.
- Cash equivalents: Cash equivalents are assets that can be readily converted into cash, such as savings and checking accounts, certificates of deposit, money market deposit accounts, and U.S. Treasury bills. They tend to be low-risk, so there is little or no danger that you will lose the money you deposit. As a result, cash equivalents provide a low return.
It is best to keep money for short-term goals in cash equivalents. Because you will be using the money soon, your primary concern is that you not lose any of your principal investment. If you put your money that you need in six months in stocks, there is a decent chance the stocks will be worth less when you sell. For emergency savings in particular, you want to make sure you can immediately access the money when you need it.
For long-term goals, the value of your investment in six months is less of a concern than inflation, which is the general rise in the price of goods and services over time. The return on cash equivalents is very often less than the rate of inflation, meaning if you keep your money there, its value will be essentially decreasing over time. That is why it is a good idea to put a large chunk of the money you are saving for long-term goals in stocks and bonds, which, on average, have a higher return than cash equivalents. There is a risk that the value of your investments will decrease, but the risk is lower the longer your investment period is. Inflation can be a concern for mid-term goals, but since the timeframe is shorter, you may want to be more conservative with your investment choices.
A good way to reduce the risk of losing money when you invest is to diversify. A well-balanced portfolio has a mixture of stocks, bonds, and cash equivalents. (What the exact percentages should be depends on how far away you are from your goals and your risk tolerance.) It is also a good idea to diversify within each type of investment class. For example, you can purchase stocks from manufacturing companies, technology-oriented companies, and financial services companies. A simple way to get diversity is to purchase shares in a mutual fund. In a mutual fund, money from several investors is pooled to buy different stocks, bonds, and/or cash equivalents.