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Do you ever wonder why some people always have money in their accounts?
It’s simple – they always have their money work for them in some form of investment regardless of how small or big their income is.
You may be wondering why is investing your money important.
No one likes to talk about money and the importance of investing. I know – it’s boring and not as exciting as Trump’s tweets or Samsung’s latest smartphone.
However, in addition to making more money and increasing your income, investing is one of the best ways to grow your money on autopilot. The sooner you start, the better off you’ll be!
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In fact, according to Merrill Lynch, one of America’s biggest money regrets is not saving, earning more, and investing sooner.
If you don’t want to be eating Ramen when you get older then you need to learn the importance of studying investing today.
You don’t need to be an expert and write an “importance of investing” essay for grad school or teach investing 101. Educating yourself on the basics of investing will be enough to change your life – literally!
I wish someone told me about the importance of studying investment when I was younger so I don’t need to work as hard today.
Don’t make the same mistake as me and get ahead financially!
Objectives of investment
Before we dive into what is investing, we need to understand what your financial goals are.
When it comes to goal setting, we need realistic goals to keep us honest and motivated. Without setting goals, our effort to invest our money will be in vain.
A common goal is to save a down payment to buy our first home. If you plan on getting married, you’ll need money for that as well.
Do you want kids? Then you may need to save for little Billy’s education!
Perhaps you want to travel to your favorite destinations every year in your golden years.
Take a moment to think about your investment goals.
As you’re doing this, attach a dollar amount to each goal so you know how much you’ll need.
Your goals will likely change down the road and adjustments to your investment plan will be needed. However, never lose sight of your goals. Our goals will keep us disciplined in the world of investing where there are many temptations (i.e. hot stocks).
What is investing?
We often use the terms, saving and investing interchangeably. But there is a difference between saving and investing.
You can think of savings as a sprint and investing as a marathon.
If you treat investing as a sprint, you won’t have enough energy to finish the race and your retirement will be less than comfortable.
Saving is money left over after paying for living expenses and spending from your paycheck. When you have small and short-term goals like buying a car or going on a nice summer vacation, savings is your best bet.
People save for different reasons, but make sure you also save for emergencies. If you have an emergency fund, you won’t need to stress about going into debt to pay for unexpected car repair bills or flight tickets to your cousin’s wedding.
You can learn how to save money fast with these painless and effective strategies. They actually work and you can expect to save up to $10,000 per year with these savings tips.
What does it mean to invest money?
Investing is putting your money to work by buying assets with the expectation for a profit.
It’s perfect to help you realize your long-term goal of buying a beachfront property and waking up to the sound of waves every day. No more annoying buzzing alarm clocks! Ah… that’s just life.
What kind of assets can help make your dream come true?
The popular investment avenues are stocks, bonds, mutual funds, exchange-traded funds (ETF), and real estate.
There are many fancy investments for different kinds of investors. However, for the purpose of our discussion, we will focus on investments for individuals, not sophisticated investors.
To give you an idea of what’s out there, here are some examples of non-traditional forms of investment: futures & options, hedge funds, private equity, and commodities.
You can think of investing as getting an education. Why do our parents always nag at us to attend school and get good grades? Well, it’s because they want us to graduate and get a good job that pays well.
We invest our time and sweat in our education with the expectation that one day, it will reward us handsomely. The same applies when it comes to investing in assets.
A word of caution, don’t confuse investing with short-term trading and day trading.
The goal of short-term and day trading is to make money by buying and selling assets for a profit in a short period of time (in a matter of days or even the same day).
The allure of making fast money is hard to ignore, but keep in mind that frequently trading is very risky and not many people can make money trading short-term.
Investing requires patience and a long-term perspective.
Why is investing important?
“Failing to plan is planning to fail.”
Many people underestimate the importance of investment for individuals.
Instead of working hard for money, you can turn the tides with investing and have money work for you. By investing, you are growing an army of minions!
Your yellow minions will work hard and make money for you while you focus on more important things in life.
Things like trying to take over the world!
On the flip side, you can forgo investing and carry on with your life.
What can you do with your money if you decide not to invest it?
You could stash all your hard-earned cash under your mattress and sleep on your money. Having your money under you is great, but there are risks.
Yes, someone could break into your place and steal all of your life savings. And yes, your money could turn to ashes if a fire breaks out at your place.
You’re smarter than that so you deposit your money at banks.
Banks have many security guards, cameras and impenetrable vaults to safeguard your money. Plus, your deposits at the banks are backed by the full faith and credit of the government.
Your money is safe now, right?
Sure, it’s safe from burglars and fires.
The invisible thief (AKA inflation)
Even though your money is protected by the bank’s impenetrable vault, it is not safe from a scary invisible thief.
Like all thieves, this invisible thief goes by another name.
The king of thieves is inflation!
Don’t get fooled! Inflation is scarier than you think! It robs us of our purchasing each year.
Ever notice your grocery bills getting more expensive? Even McDonald’s cost a fortune these days!
That, my friend, is the work of the invisible thief!
We are losing real money when our money is not growing faster than inflation.
If all your savings or emergency funds are sitting in checking accounts, you are giving away your money to the banks.
According to a recent Bankrate survey, the average interest rate banks pay you for leaving your money a checking account is 0.07%. That’s practically nothing!
Now, if all you have are checking accounts do yourself a favor and open a high-yield savings account. You can earn upward of 2.45% by depositing your money in a high-yield savings account.
The next step is to invest your money in hopes to beat inflation and grow your money!
What should I invest in?
Before we start investing, make sure you have an emergency fund in place. What you don’t want is to sell your investments in order to pay for unexpected expenses.
Once you have an emergency fund set up, you can look start investing.
Let’s have a look at the popular forms of investments.
When people think about investing, the first thing that comes to mind is buying stocks.
What are stocks?
When you buy stocks, you’re buying shares of the company. You pretty much own part of the company’s assets and profits!
Your ownership of the company is based on the number of shares you hold relative to the total number of shares held by everyone else.
So before you barge into Samsung’s shareholder meeting to tell them how to run the company, make sure you know how many shares you own.
It’s also important to know these types of shares that companies issue.
How do you make money with stocks?
Stock investors can make a profit by selling the stocks for more than they what they paid for. This is also called capital gain or appreciation.
Another way to make money with stocks is to receive dividends from the company. When a company is profitable, the board of directors can choose to give money back to the investors in the form of dividends.
Why invest in the stock market?
Stock investing is one of the investments where you can earn a high return. If you bought Amazon’s stock back in March 2009, you could be laughing your way to the bank with a return of 2,200%!
But of course, investing in single company stock is a risky business. A company could go bust and your investment would be worthless. Does anyone remember Blockbuster?
No pain, no gain
Stocks can provide great returns to your investment portfolio but it also carries more risk than other investments.
Don’t forget that risk and return are inseparable. Higher returns can only be achievable by taking more risks.
However, never invest money that you can’t afford to lose.
Wouldn’t it be nice if you could make money like a bank? Where you charge borrowers interest for lending them your money?
Not just any borrower like your friend John. He didn’t even pay you for losing that bet!
Imagine, lending money to creditworthy borrowers like Verizon, Walmart, CVS, and other mega corporations!
Well, you can do exactly that by buying bonds from large corporations and the government!
What are bonds?
When you buy bonds, which are fixed income securities, you are essentially lending money to the bond issuers.
Bond issuers can be domestic corporations, the U.S. government, foreign corporations, and governments. These giant entities borrow money from investors to fund their expensive projects in order to expand and grow.
Wait a minute, why do these organizations need to borrow money from people like us when they can just get loans from their banks?
Well, it’s actually cheaper for corporations to borrow money from bond investors than banks. Banks are in the lending business and we all know that borrowing money from banks is not cheap.
How do you make money with bonds?
So what do you get for lending companies your money?
You’ll receive regular interest payments every year, usually twice a year, until the bond matures. When the bond matures, you will get back your principal (initial investment).
Let’s look at a simple example with Treasury bonds.
The U.S. government issues treasury bonds so you don’t have to worry about the government not paying you back.
When you buy a 30-year Treasury bond that pays 3% coupon. For every $1,000 face value you own, you will receive $30 a year.
Similar to stocks, you can make money by selling the bond at a higher price than what you bought it for. On the flip side, you can lose money if you sell the bond for less than what you paid for.
Can you lose money with bonds?
The simple answer is yes.
As you can see above, just because bonds are safe doesn’t mean there are no risks.
You can realize a gain or loss if you sell the bond before the maturity date.
Bonds prices are affected by interest rates. When interest rates go down, bond prices go up. When interest rates go up, bond prices drop.
There is an inverse relationship between bond prices and interest rates.
Default risk is another important factor we need to keep in mind when investing in corporate bonds. We won’t be getting our interest payments and principal if the company closes its doors.
Bonds may not be as exciting as stocks, but they are definitely safer than stocks.
Every investor should include some bonds in their balanced portfolio for diversification purposes.
3. Mutual funds
“Don’t put all your eggs in one basket.”
When investing, it is prudent to diversify your portfolio by spreading your investments to many companies from different industries.
Sure, you might get lucky and earn some great return by buying a few companies only. But you’re also exposing yourself to a high level of risk.
Many people were going crazy over technology stocks during the dotcom bubble. When the party was over and the bubble burst, those investors and speculators lost A LOT of money.
Lesson: Don’t go chasing hot stocks because you might get burned badly.
One way to diversify your portfolio is to invest in mutual funds.
What are mutual funds?
You can buy mutual funds from your financial advisors or directly with mutual fund companies like Vanguard, Fidelity, Blackrock, etc.
The prices of mutual funds are quoted based on Net Asset Value (NAV).
Unlike stocks, where the price changes throughout the trading day, the NAV price is only updated at the end of each trading day.
By buying a mutual fund, you’re pooling your money with many other investors.
Professional money or fund managers will manage the pool of money by purchasing a basket or a combination of stocks. A basket of stocks may contain as many as 90 different stocks!
Fund managers’ main objective is to maximize portfolio returns given a certain level of risk.
Types of mutual funds
Depending on the mutual fund’s strategy, fund managers will diversify the mutual fund by purchasing different types of investments.
For instance, a balanced fund (objective: provide capital growth and income) might hold stocks, fixed income securities (government and corporate bonds) and foreign stocks.
The objective is to balance the goal of generating high returns versus the risk of losing money.
Balanced funds might be more suitable for investors that want a hybrid of stocks and bonds. Equity funds invest mainly in stocks in order to get higher returns.
Young investors that can take on more risk (long investment horizon) may want to invest in an equity fund.
Fixed income funds invest in government and investment-grade corporate bonds. The primary goal of these funds is to generate regular cash flow while preserving capital for its investors.
Investors that are about to retire would be attracted to fixed income funds due to its steady stream of income.
This is only an example of a few types of funds.
There are tons of mutual funds out there to satisfy the needs of different investors.
Hence, it’s very important that you read the prospectus before you invest in any mutual funds. The prospectus will outline the important information about the mutual funds so you can make an informed decision.
How do you make money with mutual funds?
Similar to stocks, you can earn a profit by selling the mutual fund at a higher price than what you paid for. You will lose money if you sell your mutual fund at a lower price than what you bought it at.
When mutual funds receive dividends, interest and capital gains from trading financial securities, these incomes are passed back to the investors.
Money earned from these activities is called distributions.
Distributions from mutual funds are great, but keep in mind that distributions are taxable in the year investors receive them.
Nasty mutual fund fees
“There are no free lunches.”
Mutual funds are great, but they’re not cheap to buy.
When you buy mutual funds, you may have to pay for sales charges. You can think of the sales charges as commissions.
With front-end load funds, investors pay an upfront fee when the mutual funds are purchased. The fee can be as much as 5% of the initial investment!
For back-end load funds, investors pay a fee when they sell or redeem their mutual funds. However, if you invest in the mutual funds for 5 to 7 years, some mutual fund companies will waive the fee.
Some mutual fund companies have no-load funds, where investors don’t need to pay any sales fee. But the catch is that investors will likely have to pay other fees.
There’s always a trade-off, remember to research and compare different mutual funds before you invest in one.
In addition to sales charges, there are management fees and operations expenses. These fees are often referred to as the management expense ratio (MER).
Investors don’t pay the MER directly; it is paid using the money earned from the mutual funds. MER reduces mutual fund returns, which means that it’s the investors that end up paying for the fee!
The average expense ratio for actively managed mutual funds ranges from 0.50% to 1.5%. Active funds that use complex strategies to make money may charge more than 2.0% in expense ratio.
Who else is going to pay the portfolio managers to manage the fund, spend time researching which securities to buy, and wear their expensive suits?!
Are mutual funds for you?
Overall, mutual funds are solid investments that offer many benefits.
- You have a buffet of mutual funds to choose from!
- Funds are well diversified.
- Professionals will manage the fund by buying, selling and rebalancing the fund according to the investment policy.
Mutual funds are well known and easy to buy, but they are also very expensive!
If you want the professionals to do the heavy lifting and you don’t mind paying the fees, then mutual funds are perfect for you.
4. Exchange-Traded Funds (ETFs)
ETFs are very popular these days and are frequently compared to their mutual fund cousins. This is because ETFs and mutual funds share some common characteristics.
How are ETFs similar to mutual funds?
What are ETFs?
Both mutual funds and ETFs invest in a mix of assets, such as stocks or bonds and are managed by professional money managers.
When you invest in ETFs, you are getting shares of the portfolio or fund.
However, there are some differences in how the funds are managed between mutual funds and ETFs.
Most mutual funds are actively managed, where fund managers will choose the type of investments to include in the funds.
Some ETFs are actively managed, but the popular ETFs are passively managed to mimic the performance of a specific market index, such as the S&P 500 or NASDAQ. ETFs that track indices are called index ETFs.
Another difference between the two is that ETFs trade like stocks and can be bought and sold easily on stock exchanges. Unlike mutual funds, where the price is updated at the end of the trading day, ETF prices are updated throughout the day.
Although ETFs don’t have sales charges, investors need to pay commissions and management fees to invest in ETFs.
How do you make money with ETFs?
You can earn money on ETFs in a similar fashion as stocks and mutual funds.
You will make a profit if you sell your ETFs shares for more than what you bought it at. If you sell the shares for less than what you paid for, you will suffer a loss.
As with most mutual funds, ETFs pay dividends, interest and capital gains to its investors. These payments are called distributions.
It’s nice to receive distributions, but don’t forget that distributions are taxable if your ETF shares are held outside your tax-sheltered accounts.
Why are ETFs so popular?
Many investors like stocks because of the potential for high returns. However, they don’t like the idea of having to buy many stocks in order to diversify their portfolio.
Well, they can invest in mutual funds, right? That will take care of the diversification problem!
Yes, mutual funds will solve the diversification problem but it’s not cheap to buy. The sales charges and MER fees are hefty and hard to swallow!
This is where ETFs comes in and saves the day. You can have the best of both worlds of a stock and mutual fund with ETFs!
Advantages of ETFs
People love to invest in ETFs for the following reasons:
1. ETFs offer diversification benefits of mutual funds. Again, an ETF is a fund or portfolio that holds a basket of stocks or bonds. So, by buying ETF shares, you are essentially holding a bunch of different stocks or bonds.
2. Much cheaper than mutual funds. Most ETFs are created to track the performance of indices like S&P 500, Dow Jones Industrial Average, etc. It is much easier and cheaper when you are mirroring an index (passive investing) than trying to pick the best performing stock (active investing). For example, Blackrock’s IVV ETF tracks the S&P 500 and it has an expense ratio of 0.04%!
3. Trading flexibility. ETFs trade like stocks so you can buy and sell it whenever the stock exchanges are open. Mutual funds investors can only buy and sell when the trading day is over. Because ETFs trade like stocks, investors have the option to place limit orders and buy on margin.
4. Better tax efficiency. When mutual fund investors sell/redeem their shares, they trade directly with the mutual fund companies. If there is a large redemption from investors, the mutual fund will likely have to sell some of its stock or bond holdings to pay the investors. This trading activity by mutual funds may trigger capital gains distributions to the remaining mutual fund investors and these investors will have to pay taxes on the capital gain distributions. ETFs, in contrast, are traded on stock exchanges. When ETF investors sell their shares, the shares are exchanged with other investors rather than with the ETF companies. This means that ETFs don’t need to sell any of its positions to pay the sellers for their shares.
Disadvantages of ETFs
ETFs are great and all, but we also need to consider the drawbacks of ETFs. Let’s have a look at the cons of ETFs.
1. Commissions. ETFs don’t have sales charges like mutual funds, but you need to pay commissions every time you buy ETFs. Commissions can add up quickly and eat into your returns if you trade frequently. However, as competition heats up in the ETF space, some brokerages are offering commission-free ETF trading.
2. Trading flexibility. Why is ease of trading listed as a disadvantage? The fact that you can easily trade ETFs can tempt you to trade more often. If you are not trading ETFs for free, each time you trade will cost you money. More trading means more commissions and that will eat into your portfolio returns.
3. Tracking difference. Creating a portfolio to track an index is not as easy as it sounds. In fact, ETF returns will hardly be identical to the index it’s tracking. Management fees, cash holdings and index rebalancing are some examples that cause ETF returns to deviate from index returns.
Due to the popularity of ETFs, there are thousands of ETFs in the market. Index ETFs are one of the many flavors in the world of ETFs. Don’t get caught up learning every type of ETFs. Stick with the basics and you’ll do just fine.
My friend, Jane has an in-depth review of the Acrons app which helps invest your change into a portfolio of ETFs so your savings can potentially grow over the years without you realizing. She’s a regular user of the app and covers the pros and cons of it.
Once you learn what ETFs are and how they work, you can decide whether investing with Acorns is right for you. 🙂
Conclusion about the importance of investing
The hardest part about investing is not whether you can stock pick or predict the market.
It’s getting started!
You don’t need to be an expert or have a lot of money to start investing.
You can start by investing a small portion of your monthly paycheck into something simple like an index ETF that tracks the S&P 500.
As you get more comfortable investing, you can increase your investments.
You are in control of your financial success. Stop making excuses and JUST DO IT!
Readers, did you learn something new about investing in this article? Are you now aware of the importance of investing? What are you waiting for? Start investing your savings today!