Most individuals work 9 to 5, get pay check every 1, 2, or 4 weeks. A lot of it is spent but the wise do not spend it all. They also make sure there is enough set aside for sudden unexpected events like the car not starting in the morning. But those who are even more careful, actually put away the money in either 401K before they get their pay check and save in the pay check every month or two months. Money loses it’s value because of inflation. A one dollar bill could buy a gallon of gas in 1990, could only by a quarter gallon today. If instead of just leaving it in cash, imagine you invest in low risk certificate of deposit (CD) at 2% in 1990. Today that would be roughly $1.58. If you invested in US treasury bonds at say 5% a year, that would have been worth $3.07. On the other hand if you invested in an index mutual fund that returned 8.2% a year, $6.13. What if you bought Apple company stock in 2000 at say $25. Today Apple stock is selling at $500 (It’s actually around $570 but to make calculations easy I chose $25 and $500). Today you will have $20. That’s a 2000% reward on your investment. If you put $500 in Apple, in 23 years, you would have been a millionaire. 2 years ago, you would have had $1.4 million instead of just $1 million. The reason for this is 2 years ago, Apple stock was trading at $700. In general, individual stocks fluctuate more than overall stock market itself. Stocks fluctuate more than bonds. CDs are safe and are protected by Federal government up to certain amount ($250000 per account per bank). So a very general rule is that the higher the reward, greater the risk. This is a general rule but low rewards does not mean low risk. Investing in individual stocks also takes specialized skills in being able to understand the company, stock valuation and obvious and hidden risks involved.
Investments can also be categorized by the availability of funds in case you need them. This is called liquidity. Most liquid investment is cash. But it also depreciates in value over years. In case of CD or Bonds the money is locked up for a longer period and liquidating might involve penalties or reduced return on investment. Stocks could be more liquid but the value fluctuates more and when you need the money it may not be the right time to sell.
So what’s a simple investor to do? Decide how much of your savings is for rainy day, keep it in cash or if you don’t need it immediately, keep it in CD. The money you are saving for children’s education, getting married etc. that you can’t afford to lose invest in treasury bonds or municipal bonds. The money that you want to grow for a longer term investment, should be put into stocks. This is the money that you are willing to take bigger risk for higher return.
This type of strategy is called diversification. You need to understand the risk/reward profile for the various types of investment classes and choose those that best suit your needs. Make sure you consider your house (real estate) in your list of investment. It’s not as liquid as other investments.With you are able to include in your plan more than 10 different investment options (cash/cd, core stocks, large cap, small cap, europe stocks, treasury bonds, municipal bonds which are tax-free, investment grade corporate bonds etc.) and study the effect of diversification on your portfolio returns. You can also include real estate investments you have, add ‘buying’ and ‘selling’ events for houses.
Mofinto provides you with tools to learn about your own personal finances like never before. Planning is being better prepared. Try out different plans and take charge of your savings.