Now that you know why you're investing and how to get started, it's time to dig deeper and pick some investments. As you may have noticed, there are several categories of investments, and many of those categories have thousands of choices within them. So finding the right ones for you isn't a trivial matter.
The single greatest factor, by far, in growing your long-term wealth is the rate of return you get on your investment. There are times, though, when you may need to park your money someplace for a short time, even though you won't get very good returns. Here is a summary of the most common short-term savings vehicles:
Short-term savings vehicles
- Savings account: Often the first banking product people use, savings accounts earn a small amount in interest, so they're a little better than that dusty piggy bank on the dresser.
- Money market funds: These are a specialized type of mutual fund that invest in extremely short-term bonds. Unlike most mutual funds, shares in a money market fund are designed to be worth $1 at all times. Money market funds usually pay better interest rates than a conventional savings account does, but you'll earn less than what you could get in certificates of deposit.
- Certificate of deposit (CD): This is a specialized deposit you make at a bank or other financial institution. The interest rate on CDs is usually about the same as that of short- or intermediate-term bonds, depending on the duration of the CD. Interest is paid at regular intervals until the CD matures, at which point you get the money you originally deposited plus the accumulated interest payments. CDs through banks are usually insured up to $100,000.
Fools are partial to investing in stocks, as opposed to other long-term investing vehicles, because stocks have historically offered the highest return on our money. Here are the most common long-term investing vehicles:
Long-term investing vehicles
- Bonds: Bonds come in various forms. They're known as "fixed-income" securities because the amount of income the bond generates each year is "fixed," or set, when the bond is sold. From an investor's point of view, bonds are similar to CDs, except that the government or corporations issue them, instead of banks.
- Stocks: Stocks are a way for individuals to own parts of businesses. A share of stock represents a proportional share of ownership in a company. As the value of the company changes, the value of the share in that company rises and falls.
- Mutual funds: Mutual funds are a way for investors to pool their money to buy stocks, bonds, or anything else the fund manager decides is worthwhile. Instead of managing your money yourself, you turn over the responsibility of managing that money to a professional. Unfortunately, the vast majority of such "professionals" tend to underperform the market indexes.
A number of special plans are designed to create retirement savings, and many of these plans allow you to deposit money directly from your paycheck before taxes are taken out. Employers occasionally will match the amount (or a percentage of that amount) you have withheld from your paycheck up to a certain percentage of your salary. (Pssssst ... that's what we affectionately call "free money.") Some of these plans let you withdraw money early without a penalty if you want to buy a home or pay for education. If early withdrawals are not permitted, you may be able to borrow money from the account, or take out low-interest secured loans with your retirement savings as collateral. Rates of return vary on these plans, depending on what you invest in, since you can invest in stocks, bonds, mutual funds, CDs, or any combination.
- Individual retirement account (IRA): This is one of a group of plans that allow you to put some of your income into a tax-deferred retirement fund -- you won't pay taxes until you withdraw your funds. Withdrawals are taxed at regular income-tax rates, not at the lower capital-gains rates. All IRAs are specialized accounts (not investments) that allow the account holder to invest the money however he or she likes. If you qualify, some or all of your IRA contribution may be tax-deductible.
- Roth IRA: This retirement account differs from the conventional IRA in that it provides no tax deduction up front on contributions. Instead, it offers total exemption from federal taxes when you cash out to pay for retirement or a first home. A Roth can also be used for certain other expenses, such as education or unreimbursed medical expenses, without incurring a penalty -- although any earnings that are withdrawn are subject to income taxes unless you are more than 59 ½ years old. Not all taxpayers are eligible to contribute to a Roth IRA. You may be able to qualify if you participate in corporate retirement plans and don't qualify for deductible contributions to the conventional IRA.
- 401(k): A retirement savings vehicle that employers offer. It's named for the section of the Internal Revenue Code where it's covered. Given the tax advantages and the possibility of corporate matching -- those cases when your employer matches part of your contribution -- the 401(k) is well worth considering.
- 403(b): The nonprofit version of a 401(k) plan. Local and state governments offer a 457 plan.
- Keogh: A special type of IRA that doubles as a pension plan for a self-employed person, who can put aside significantly more than the contributions allowed for an IRA.
- Simplified Employee Pension (SEP) plan: A special kind of Keogh-individual retirement account. SEPs were created so that small businesses could set up retirement plans that were a little easier to administer than normal pension plans are. Both employees and the employer can contribute to a SEP.
Investing in stocks
It's worth taking a closer look at stocks, because historically, they've had much better returns than bonds and other investments. Essentially, stock lets you own a part of a business. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor becomes a part-owner of the company. That ownership is represented by stock -- specialized financial "securities," or financial instruments -- that are "secured" by a claim on the assets and profits of a company.
Common stock is aptly named -- it's the most common form of stock an investor will encounter. This is an ideal investment vehicle for individuals, because anyone can take part; there are absolutely no restrictions on who can purchase common stock -- the young, the old, the savvy, the reckless. Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company -- a stake in a real, living, breathing business. By owning stock -- the most amazing wealth-creation vehicle ever conceived (except for inheriting money from a relative you've never heard of) -- you are a part-owner of a business.
Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.
Because they own a part of the business, shareholders get a vote to elect the board of directors. The board is a group of individuals who oversee major decisions the company makes. They tend to wield a lot of power in corporate America. Boards decide whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock. Top company management will give some advice, but the board makes the final decision. The board even has the power to hire and fire those managers.
As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value. They could even end up being worthless if the company goes bankrupt.
Different classes of stock
Occasionally, companies find it necessary to concentrate the voting power of a company into a specific class of stock, in which a certain set of people own the majority of shares. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control and has, say, 10 votes per share of stock, while they sell another class of stock that only has one vote per share to others.
Does this sound like a bad deal? Many investors believe it is, and they routinely avoid companies with multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.
When there is more than one class of stock, they are often designated as Class A or Class B shares.
We hope this hasn't been the most painful thing you've had to read this week. You're now conversant enough in stock market matters to impress those who are very easily impressed. Although knowing the terms and general workings of the stock market is just the first step in your investing career, it's useful to know that each share of stock represents a proportional share of a business, and that the potential rewards are great, but that stocks are also riskier than putting money in the bank.
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