2. Saving vs. Investing
d. Major types of investments
The problem with leaving money in a savings account is that the return is very low. The money is safe in the short-term because it is usually insured against loss, but in the long run it is likely to lose ground against inflation, which is a general rise in the price of goods and services that reduces the purchasing power of money. As a result, most people use savings accounts for money they need in the short-term – to pay monthly bills for example, for their emergency funds or to build up an amount of money to invest. After building up savings, they turn to the investments to put a portion of their money with hopes of making their money grow faster. These major investment categories include the following:
Stocks – A stock represents a share of ownership in a company. People who own stock are considered shareholders, or stockholders, in the company. Because they own part of the company, shareholders get one vote per share of stock to elect the company’s board of directors.
Investors make money from a stock in two ways. The first is by receiving a dividend. A dividend is a payment received by stockholders from the earnings of the corporation. When a company is profitable, it can decide whether or not to pay their shareholders some of the earnings in the form of dividends. If it decides to pay the shareholders a dividend, it decides exactly how much to pay per share.
The other way to make money is by selling stock when the stock price goes up. This is how most people make money from owning stock. The price of a stock will go up when there are more people who want to buy the stock (demand) than there are people who want to sell it (supply).
If more people want to sell the stock than want to buy it, the price of the stock will go down. The money made from selling stock for more than you paid for it is call a capital gain, while the money lost if you sell the stock for less than you paid for it is a capital loss.
Mutual Funds – Mutual funds allow people to invest in stocks without doing all the homework necessary to pick individual companies. They’re also a good option for people who don’t have enough money to invest in the number of stocks necessary to achieve diversification.
Diversification is a strategy for reducing risk by spreading investment money among several investment types and industries. With a mutual fund, investors send their money to a mutual fund company, which puts their money with other investors’ money. They then invest the money in many different stocks or bonds. If you buy a mutual fund, your money is automatically diversified or spread around in hundreds of companies. Diversification reduces risk because it allows individuals to offset losses in some individual stock with gains in others. It’s just like Grandma said, “don’t put all your eggs into one basket” because, if that one basket drops, you will lose all your eggs! (We discuss this topic in more detail later in this unit.)
Another advantage of investing in mutual funds is professional management. Each mutual fund is run by professional fund managers, who might have dozens of analysts and researchers working for them, studying companies for investment opportunities. However, even with professional management, it is still very important for investors to do their homework and learn about the management, the fund’s track record, and the goals of the fund—all of which are discussed later in this section.
Mutual fund companies calculate the price of their funds’ shares at the end of every business day. Investors can sell (redeem) some or all of their shares at any time and receive the current share price. The current share price, which is known as the net asset value (NAV), is calculated by taking the market value of all funds’ securities, minus expenses, divided by the total number of shares outstanding. The NAV changes as the value of the stocks in the mutual fund rise or fall.
Along with the chance to share in the gains from a fund, mutual fund investors also pay a share of the management fees and fund expenses. These fees and expenses are paid out of the fund’s assets and generally cost investors between 0.5 percent and 2 percent annually.
Bonds – Corporations and governments, like people, sometimes need to borrow money. If you buy a bond, you are lending money to these entities. As a bond investor, you pay a set amount of money, and the issuer, like the government or corporation, promises to pay it all back to you on a certain date with a set amount of interest.
Bonds are known as fixed-income securities because the amount of income the bond will generate each year is “fixed” (or set) when the bond is sold. Investors know in advance how much they will be paid and how often, as well as when the original investment will be paid back. The longer it takes for a bond to pay off or mature, the greater the risk that inflation will reduce the value of their money before they get it back. That is why bonds often pay a higher rate of interest than short-term alternatives such as CD’s, savings accounts, or money-market accounts and longer term bonds generally pay a higher rate than shorter term bonds.