Does the idea of investing scare you? Does it seem like one of those things that only sophisticated experts with advanced degrees in finance can really understand? Does the stock market seem like a horribly complex system from which no average person can hope to benefit?
If so, you’re certainly not alone. The reality is, however, investing is not just for the experts! With some basic understanding of a few simple concepts, you will on your way to making some serious money for the long haul.
Let’s jump right in.
First, let’s start off with the concept of stocks. When you buy a stock, you are essentially just buying a piece of ownership in a company. Each unit of ownership is known as a “share.” You are paying some amount to share ownership of the company. As a result, the company you invest in is able to use your money to grow the company. It can be a win-win for you and the company if it does well. They get to use your money to grow and your piece of the company pie increases in value.
But, isn’t it risky to invest in a stock? Absolutely. When you invest in a single stock, you could make an incredible amount of money. If you had invested $5000 in Amazon when it first started, you would have well over a million dollars today (check out this Business Insider article to see how much $1000 invested in various large companies would be worth now). But, if you had invested your money in Pets.com, an exciting stock during the tech bubble of the late 1990’s-early 2000’s, you would have seen your money disappear faster than Lindsay Lohan’s career.
Wouldn’t it be best to stay away from the stock market altogether, then? Why not just keep all your money in the bank?
The problem is that even though this sounds like a safer bet, you have to consider another type of risk that will catch you from behind: inflation. According to Wikipedia, the infallible source of all things credible, “inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services.” In other words, your dollar will be worth less next year than it is worth today. The average rate of inflation is about 3% in America, so every year you’re losing 3 cents out of every dollar. Add to this the problem of compound interest working against you, and your money sitting in the bank will actually be losing value exponentially with every passing year. Even the online bank I use with one of the best interest rates around only earns 0.75%, meaning I lose 2.25% to inflation every year.
While individual stocks are risky, the stock market as a whole earns an average of about 8-10% per year. One measure of the overall stock market is called the Standard and Poor’s 500 (S&P 500). The S&P 500 is a list, also known as an index, of the 500 largest companies. This index of companies serves as a representative sample of the stock market as a whole, and is well-regarded for doing so quite effectively.
The whole idea behind taking advantage of the high returns of the stock market is to diversify your investments. Instead of investing in 1 or 2 stocks which could skyrocket or plummet, you want to invest in a large number of stocks which will balance each other out. The easiest way to achieve this diversification is to invest in a mutual fund.
A mutual fund is like a basket of stocks. Imagine you pool your money with hundreds of other people who want to invest in stocks. You put this money in a huge pile and let a skilled manager pick tens or hundreds of solid stocks with excellent proven history. This type of mutual fund is known as an actively managed fund because a portfolio manager, a brilliant expert who spends every day analyzing research on companies, manages the portfolio of stocks which you as a big group of investors are investing in. Another type of mutual fund is an “index” fund. One of the most common types of index funds is the S&P 500 index fund, which simply invests money in the 500 companies that make up the S&P 500. This type of mutual fund is easy to invest in, requires minimal knowledge of investing, and actually outperforms most actively managed funds, anyway. In fact, Warren Buffett, the second-richest man in the world, recommends this type of mutual fund for the average investor.
In the next post, we’ll discuss what to look for in a mutual fund and how to actually start putting money in one. I can assure you, it’s a lot easier than you think!