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Chapter 5: Investing

Now that you have saved some money and become an expert money manager, you can do what some adults never do – have your money work hard for you, instead of just the other way around.

Your investment portfolio
A portfolio is a collection of investments, which can include stocks, bonds, cash equivalents, and mutual funds. So what should you have? That depends on many factors, including your risk tolerance, goals, and age. Since you are young, time is on your side. You can afford to take more risk with your investments than someone who is older and doesn’t have decades to recoup a loss. If you are a minor, you may have to open a custodial account with a parent in order to make purchases or have a parent make them. Once you turn 18, you should have no problem investing on your own.

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. They are an important part of a portfolio because, long-term, they have the greatest potential to make the most amount of money. However, stocks are naturally volatile – 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. Organizations issue bonds when they want to raise funds. Generally, you receive the principal, called the par value, at maturity of the bond and the interest, called the coupon interest rate, periodically while you are holding the bond. Bonds tend to be more stable than stocks, so having both in your portfolio is a good way to spread risk. However, the return (profit) on bonds is usually lower than the return on stocks.

Cash equivalents
Cash equivalents are assets that can be readily converted into cash. They tend to be low-risk, so there is little or no danger that you will lose the money you deposit. Because they are safe, cash equivalents provide a low return, which may not even keep up with inflation. Still, having a portion of your savings in cash equivalents provides a safety net – you know you will be able to access some money if you need it. There are many types of cash equivalents:

  • Savings and checking accounts. With savings and checking accounts you deposit money in a financial institution and receive interest or dividends in return. You can withdraw your money at any time. The interest rate is usually low or may even be non-existent for some checking accounts. Savings and checking accounts are insured, meaning you will still be able to access your money if the financial institution goes out of business.

  • Certificates of deposit (CDs) or term share certificates. Like with savings and checking accounts, with these types of certificates you also deposit your money in a financial institution, but you are required to leave it there for a set term, or, in most cases, you will have to pay an early withdrawal penalty. These products are insured and generally have higher interest rates than savings and checking accounts.

  • Money market deposit accounts. Money market deposit accounts are similar to savings accounts, but the interest rate is variable, not fixed, and usually higher as well. They are insured and may come with limited check writing privileges.

  • Money market mutual funds. Money market mutual funds are mutual funds that invest in short-term debt obligations, such as Treasury bills and CDs. While generally safe, money market mutual funds are not insured and provide no guarantee against loss.

  • U.S. Treasury bills. Treasury bills are short-term debt obligations of the U.S. government.

Mutual funds
A mutual fund pools together money from many investors and purchases different stocks, bonds, and/or cash equivalents. Because each fund is made up of a wide variety of investments, they are already diversified, which is important for spreading risk. After all, if all of your money is invested in one company, and it does poorly, you could lose everything. With a mutual fund, you don’t have to research hundreds of companies to know which stocks and bonds should be in your portfolio because the fund manager does this for you. However, professional management comes at a price - management fees are built into the cost of funds.

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