What Is Investing and Why Is It Important?

FT Contributor  | 

If you want to be a wealthy individual, you have to do a bit more than earn a paycheck and move some of those funds into a savings account. Investing is a long-term strategy that allows your money to grow over time. As an investor, your money can help you acquire things that offer profitable returns. Fortunately, you don’t have to become an expert at investing to reap the benefits. There are simple ways to invest and watch your money grow. Learn more about why people invest their money and the types of returns certain investments can bring.

Why People Invest

Everyone has different reasons for investing their money, but most people do it to reach certain financial goals. These include retirement funds, wealth accumulation, or paying off debts. By investing your money in vehicles that have the potential to earn strong rates of return, you’re able to increase your financial worth. Investing does come with risks, but if you invest wisely you’re more likely to gain money than if you never invest at all.

Advantages to Investing

Sometimes, a savings account is not enough. Without investing, your financial growth will eventually plateau. There are many advantages to investing, like compound interest in stocks. With enough time, compounding investments can allow you to turn a single penny into millions of dollars. Investing also allows you to reach personal financial goals you set, like buying a home or starting your own business. Certain investment options, like an employer-sponsored 401(k), allow you to capitalize on pre-tax dollars.

Challenges With Investing

There are many moving variables in investments, which can make it challenging to invest. It’s easy to become overwhelmed with information when you’re looking at where to invest. Avoid contradictory advice on the internet. Instead, turn to the strategies used by successful investors. One of the many challenges associated with investing is dealing with the unknown risks that seemingly simple investment strategies come with. Again, being as informed as possible helps negate this challenge.

Investing is also a fast-paced environment — things can change quickly and those who invest need to constantly check in on their investments. Inaccurate information and rushed decision making can cause a misstep in your investment strategy. With constant information flow in the financial markets, it’s important to confirm the accuracy of the information you receive before making any investment decision.

Another challenge associated with investing is becoming over-diversified. Many investors feel the need to invest in everything to better protect themselves from risk, but this can significantly stunt your portfolio’s growth. Invest most of your portfolio in two or three investment options to ensure your money continues to work for you.

Types of Investments

As an investor, there are many ways to invest your money. It’s important to weigh each option carefully so that you can make the decision that’s best for you. Investments are generally categorized as stocks, bonds, and cash equivalents, and there are many ways to invest within each bucket. Here are some common ways people choose to invest their funds.

Mutual Funds

Mutual funds allow you to purchase a large number of investments at once. Pooling money from different investors, a professional manager then invests those funds in stocks, bonds, and other assets. These investments follow a careful strategy. Ultimately, how risky the mutual fund is determines the investments included in the fund. One mutual investment might invest in specific stocks or bonds while another fund invests in both stocks and bonds. When a mutual fund makes money, a portion of that is distributed to each investor in that fund. When your investments increase in value, the fund increases as well and you can sell your shares for a profit. To be involved in a mutual fund, you must pay an annual fee, called an expense ratio.

Bonds

Bonds are a type of loan you make to a company or government. These institutions borrow your money and pay you back with interest. While they’re considered to be safer than stocks, bonds offer lower returns. Bonds are a fixed-income investment that collects interest once or twice a year. They come with a maturity date that determines when the total principal is paid off, but bonds will continue to collect interest for a certain amount of time, depending on the type of bond you have. As with any loan, there is a risk that the issuer can default, but government bonds are backed by the “full faith and credit” of the United States, eliminating that risk.

Stocks

Stocks are investments in a specific company that sells shares to raise cash. Purchasing a stock entitles you to a small piece of a company’s earnings and assets. Certain stocks offer high returns, but at a higher risk than other types of investments. Companies can go out of business or decrease in overall worth, which affects your investment. When the value of a stock goes up, however, you’re able to sell it for a profit. Certain types of stocks also pay dividends, which are regular distributions of a company’s earnings.

Retirements Accounts

There are many types of individual retirement accounts (IRAs). Each comes with its own set of tax advantages that allow you to increase the money you save for retirement. Depending on the IRA you choose, there are limits to how much you can contribute and when you can access the money. Below is a closer look at the different types of retirement accounts available to you, including 401(k), traditional IRA, Roth IRA, and rollover IRA.

  • 401(k) allows you to set money aside from your paycheck to be invested in stocks and bonds. Most employees match your investment, funding your account dollar for dollar and allowing you to make more money for retirement. You decide how much of your paycheck goes into your 401(k), but you’re limited to $19,000 of what you earn. If you are over 50, you can contribute up to $25,000 of what you earn. The money can’t be accessed before you are 59-1/2. Anything taken out before then is charged a penalty.
  • Traditional IRA is a tax-favored investment that allows you to invest in stocks, bonds, mutual funds, ETFs, and other assets. You can make investment decisions yourself or hire someone else to do so. This type of retirement fund is popular for people with an employer that won’t match 401(k) contributions. As with 401(k) funds, you are penalized if you access your funds before age 59-1/2.
  • Roth IRA allows you to invest after-tax contributions and earn tax-free dollars. When you withdraw your funds at retirement, they are tax-free if you meet the requirements of a Roth IRA.
  • Rollover IRA accounts are created when a retirement account, such as a company-sponsored 401(k), is rolled over into another. When you switch jobs, you can roll the money in your 401(k) account into a rollover IRA.

Index Funds

Index funds are a type of mutual fund that passively tracks an index as opposed to paying a manager to oversee your investments. In essence, index funds attempt to mimic the performance of another type of investment. These investments tend to cost less because you’re not paying someone to physically manage your assets. The risks associated with index funds depend entirely on the types of investments within the fund. Index funds allow you to earn money from dividends or interest. As with stocks, you can sell your share for a profit. While there are fees for expense ratios, index funds tend to cost less overall than the fees for investing in mutual funds.

Exchange-Traded Funds

Exchange-traded funds (ETFs) are a type of index fund that tracks a benchmark index and attempts to mimic that index’s performance. They’re not actively managed, which means they’re often cheaper to invest in than mutual funds. The difference between an index fund and an ETF is how they’re purchased. Mutual and index funds are priced once at the end of a trading day. ETFs are bought and sold at various price points throughout the day. Ultimately, people choose to invest in ETFs because they have more control over the purchase price. The hope is that the fund increases in value and you can sell it for a profit. Some ETFs will pay out interest and dividends to investors, too.

Options

Options are one of the most flexible types of investments. An option is a contract to buy or sell a stock at a set price, but as the name implies, you have the option to do so or not. Buying an option is buying a contract, not the stock itself. Most option contracts are for 100 shares of a stock. When the time comes, you can buy or sell that stock at the agreed-upon price, sell the contract to another investor, or let the contract expire. Options are a complex investment, but essentially, you purchase an option with the hope that you’re investing in a stock that will increase in value. Options provide you with the benefit of purchasing stock for less than the going rate. If the stock decreases in value, you can forego the purchase altogether and you only lose out on the cost of the options contract.

With the many types of investment vehicles at your fingertips, you could set aside money and potentially walk away in a better financial situation if and when these vehicles appreciate in value.


Image Source: https://depositphotos.com/