What is
Investing?
The idea behind investing is that money is
put to use in such a way that it is likely
to turn into more money. This could happen
because someone is willing to pay interest
to use the money or because the value of
whatever security the money was used to buy
increases during the period of ownership.
Destinations for invested money include
savings accounts, stocks, bonds, mutual
funds and numerous other investment options.
It is important to note that because money
can be invested, the value of a given amount
of money changes over time. The longer that
a given amount of money is under your
control, the longer you have to invest it
and make more money from it. For this
reason, it is almost always preferable to
have money sooner rather than later. The
name given to this concept is the "time
value of money"; that is, the idea that a
dollar now is worth more than a dollar in
the future, because a dollar now can accrue
value through interest or other appreciation
until the time at which the dollar in the
future would be received.
At the same time, there is a penalty
associated with not investing the money that
you already have. Because prices tend to
rise over time, the value of money gradually
decreases. This effect is called inflation.
Money that is not invested or that is
accruing value at a slower rate than the
rate of inflation is becoming worth less and
less as time passes. Therefore, investing is
not only an opportunity to make more money,
but it is the only way to protect the money
that you already have.
Another spectacular benefit associated with
many investments is compounding. Money that
is earning interest grows at a constant
rate, paying the same amount of interest at
the end of each time period. However, if
that interest is added to the principal that
began earning money originally, there is
more money earning interest. In this way,
interest causes money to increase in value
exponentially over time. As more and more
money earns interest, more and more interest
is earned. This scenario is constantly
playing out in bank accounts, CDs, and any
other investment that offers compound
interest. The more frequently the interest
compounds, the bigger the payoff because, on
average, more money is earning interest at
any given time.
At this point, it is important to
distinguish between investing and gambling.
Earning interest and taking advantage of
compounding may not produce the immediate
jackpot that comes with winning the lottery,
but the risk of ending up with nothing is
often far worse than waiting for a safe
investment to pay off. Pouring a great deal
of money into one stock is very similar to
gambling. It could pay off, but if it
doesn't the potential losses are great. Safe
and diverse investments may slow the pace of
returns, but they also prevent the bottom
from falling out and leaving you with
nothing. For a further analysis of the
distinction between gambling and investing,
read "What is the difference between
gambling and investing?"
Getting Started
As soon as you begin to bring in enough
money so that a portion of it may be set
aside for investing, a plan is necessary to
take full advantage of that money. The
amount of money available to invest also
plays an important role in what investments
can be purchased. Some investments are
subject to limited access because they
require certain minimum amounts. More
generally, investing a greater amount of
money opens the door to a portfolio with
more risk and potentially greater returns.
However, despite the importance of investing
to your overall long-term financial
situation, money for health, auto and life
insurance and retirement plan contributions
should be a higher priority, and should be
budgeted for before beginning to invest.
Additionally, investing should begin after
high-interest debt, especially credit card
debt, is paid off. Because after-tax returns
will probably not exceed the interest rates
paid on credit card debt, paying off the
debt first will increase the amount of money
you have each month.
After subtracting out essentials and debt,
the first division to make within available
funds is between savings and funds to
invest. Savings allow for access to cash
without the fees and lost opportunities
associated with removing money from
investments ahead of schedule. They should
be highly liquid and will usually be located
in a savings account, CD or other safe
low-yield investment vehicle. Savings should
include an emergency fund and funds for any
major near-term purchases. To create a
sufficient emergency fund, you should amass
enough cash to pay bills for a couple of
months in the event of unemployment or cover
the costs of major auto repairs or similar
unexpected major expenses.
Once those emergency savings are set aside,
you can make decisions about where to invest
the remainder of your money. These funds
differ from emergency savings because they
will be expected to outpace inflation,
taxes, and other drains on finances to serve
as a source of income and security over the
long term. In order to achieve higher
returns, your money will be subject to a
somewhat higher level of risk than for the
emergency funds you put in the safe but
low-interest investment. One of the most
important aspects of investing is
determining time horizons. Put simply, it is
crucial to know when you will need the
money. Common time horizons are based on
large future expenses, such as retirement,
college, houses or cars. Knowing when money
will be needed allows for the most effective
investment strategy to be tailored to fit
the specific goals that have been outlined.
When funds for investing have been
earmarked, it is time to decide how those
funds will be augmented in the future. There
are a variety of plans to maintain a steady
pace of contributions to investments. Of
course, the amount invested will have to be
adjusted periodically as income and expenses
fluctuate, but developing the habit of
putting away some amount of money each month
is an important part of building a
successful portfolio.
Financial Planning
Many people believe that long-term financial
planning is only important for the wealthy,
or that it's a task best left to
professionals, but in reality there are many
steps that the average investor can take to
solidify his financial future. The first
step in the financial planning process is to
determine net worth. An investor's net worth
will serve as a jumping off point to begin
thinking about his financial future.
Net worth is simply the sum of an investor's
assets minus the sum of his debts. Assets
include all of an investor's assets
including real estate, securities, valuables
and cash. The value to use in the
calculation is the amount that all of these
items could be sold for at the present time.
Debts include mortgages, car loans and
credit card balances, and should be
subtracted from the assets to determine net
worth.
Once this financial snapshot is detailed,
you can address your specific goals. Always
remember to think about both assets and
liabilities. It is always nice to acquire
new assets, but if assets are appreciating
more slowly than debt is growing, net worth
is decreasing. It is important to strike a
balance between building assets and managing
debt.
The goal of financial planning, then, is
simply to find ways to increase net worth at
a steady pace. Saving money, allowing assets
to appreciate, and paying down debt will all
contribute to this goal. Incoming cash minus
expenses will reveal how much money is
available to an investor at the end of a
given time period. If this value is
negative, expenses are outpacing income, and
the difference will have to be paid from
savings, decreasing net worth. This is
obviously dangerous because if the situation
doesn't change, eventually the reserves will
run out. If income sufficiently outpaces
expenses, it might be time to start
contributing to net worth in earnest by
acquiring assets and eliminating debt.
