Investing, as with many things in life, benefits from an early start. The sooner you begin making your money work for you, the greater your potential return on investment. Otherwise, if you keep your life savings in cash, you’ll never have more than the literal bills you put aside. You might not even keep up with the cost of inflation, which means not learning about how to invest money could actually lose you money in the long run.
Conversely, getting into investing when you’re young — even if you’re under 25 — is a great idea. With time on your side, you have the ability to recover from risks that don’t pay off. You can develop spending habits that align with your financial goals. And there’s also a little thing called compound interest that we’ll talk about — and it’s your money’s best friend.
It’s never too early or too late to educate yourself on investing. It’s never too early or too late to increase any financial knowledge, for that matter. Since we’ve all got to start somewhere, let’s start with these essential terms when it comes to being smart and successful with your investing.
A stock is a type of investment that represents a share in the ownership of a company. Why would a company sell shares of its ownership? Usually, to raise money and as an alternative to having to borrow from lenders.
You have certain rights as a stockholder, but these rights depend on the type of stock you own. Most investors focus on common stock, and this gives you the right to receive dividends — if the company pays dividends — as well as the right to vote at annual shareholder meetings.
Stock prices change every day with the demands of the market, so the value of your stock varies as well. You might buy a stock because you believe in the long-term success of the company. If a company is successful over time, then its stock will usually rise in value. You might also buy a stock for the goal of short-term profit and focus primarily on share prices. The former is known as investing, the latter is known as trading.
While the idea of investing might be intimidating, few other investments match the potential return on investment (we'll touch on this term in a bit) that stocks offer.
Liquidity describes the degree to which an asset can be converted to cash. Assets that can easily be converted to cash — such as stocks, bonds, and mutual funds — are known as liquid assets. As you could probably guess, cash is considered to be the most liquid. Other assets, such as real estate, fine art, and collectibles, are considered illiquid, as it can take months, if not longer, to find a buyer.
Liquidity can also describe the number of assets you have that can be easily converted to cash. If you have moderate liquidity, you have a moderate amount of very liquid assets. In other words, the more assets you have that are easily converted to cash, like cash in a checking or savings account, the higher your personal liquidity.
3. Compound interest
Albert Einstein is said to have called the power of compound interest “the most powerful force in the universe.” While there really isn’t any evidence he actually said that, it doesn’t negate how powerful compound interest is. Compound interest is the interest you earn on your initial balance, as well as the accumulated interest from your balance over time. In other words, it’s the interest on interest.
Say you deposit $1,000 in a high-yield savings account that pays a 2.5% interest rate. In a year, you would earn $25 in interest. But what happens in year two? That’s where compound interest comes in. You’ll still earn 2.5%, but your account now has a balance on $1,025. At the end of the second year, you would earn $25.63 in interest, and your new balance would be $1,050.63. With time, you can watch your money grow at an ever-accelerating rate.
A 401(k) is a retirement investment account offered by an employer that gives eligible employees a tax break on money they invest for retirement. These plans offer a great way to passively save for the future because contributions are automatically withdrawn from your paycheck and invested in the fund of your choosing. Some employers even match your contribution up to a certain amount.
Your contributions to a 401(k) are known as “pre-tax” contributions, which means the money is taken out of your paycheck before it goes to the IRS for Uncle Sam to take its cut. This reduces your taxable income and, thus, the income taxes you have to pay that year.
That doesn’t mean you never pay taxes on this money, though. Taxes on your contributions are deferred, so they’ll be due once you begin distributions in retirement. 401(k) distributions are taxed as ordinary income at the rate for your tax bracket in the year you make the withdrawal.
A bond is an investment where you lend a government or business money for a certain period of time, with the promise of repayment with interest. For a balanced investment portfolio, bonds can be a great place to start. While stocks may provide a higher return, they’re also much more volatile. Bonds, on the other hand, help balance out risks. You’ll generally see a lower return, but bonds are considered a safer investment.
Bonds, like all investments, still carry risks though. For instance, the company you purchased a bond from can go bankrupt before paying off the debt and you don’t get your money back, much less the interest. Just how safe the investment is depends on the bond issuer. Bonds from the U.S. Treasury are considered the safest investment, as they’re backed by the “full faith and credit” of the United States.
6. Mutual fund
A mutual fund is a pool of money from several investors to buy a large group of assets, such as stocks, bonds, or other securities. Investors don’t actually own any shares in the companies the fund purchases, but rather share equally in the profits or losses of the fund’s total holdings.
Mutual funds can be selected based on your financial goals, as each fund may differ in what it invests in. For instance, you can put money into a small-cap mutual fund that invests in smaller companies. You could also choose to invest in a bond mutual fund that might invest solely in bonds.
No matter the type of mutual fund, a licensed investment manager will watch over the fund and decide which companies to invest in (or which bonds or other securities to purchase). Because of this, investing in mutual funds is simple, affordable, and a great way to diversify your portfolio.
7. Initial public offering
An initial public offering, or IPO, refers to the process of offering shares of a private company to outside investors such as institutional investors and individual investors. Through this process, a privately held company emerges as a public company.
Initial public offerings are underwritten by investment banks and can be used to raise money for companies, as well as to give liquidity to employees, company founders, and private investors who held private stock before going public. An IPO makes it easier for these early investors and stockholders to cash out.
8. Return on investment
Return on investment, or ROI, is a performance measure used to evaluate the gain or loss of an investment relative to the investment's cost. In other words, it tells you how profitable an investment is.
ROI is usually shown as a percentage. For example, say you invest $1,000 in company XYZ in 2018 and sold your shares for $1,200 one year later. To calculate your return on investment, you would divide your profits ($1,200 - $1,000 = $200) by the investment cost ($1,000), for a ROI of $200/$1,000, or 20%.
9. Roth IRA
A Roth IRA is a type of retirement savings account that offers tax-free growth on your contributions and investment earnings. Unlike a traditional IRA, your contributions are taxed at your tax rate at the time of contribution, allowing you to take tax-free distributions of your money in the future.
Roth IRAs aren’t investments themselves, but rather hold your investments. You can open a Roth IRA at a brokerage or bank, then select what you want to invest in, such as stocks, bonds, mutual funds, etc. Roth IRAs make for great investment vehicles for young investors who expect their tax rate to be higher at the time of retirement.
10. Money market account
A money market account, or MMA, is a type of deposit account that banks or credit unions offer that typically pays higher interest rates than what you’d find with a traditional savings account. MMAs usually offer check-writing and debit card privileges as well.
The interest rates on MMAs are variable, so they rise and fall with inflation. MMAs also generally (but not always) come with caveats like higher account minimums, limitations on the number of withdrawals you can make, and higher fees.
Inflation is the increase in the prices of goods and services over time, and it indicates a decrease in the purchasing power of your money. Because of inflation, if you put your money aside as cash and don’t invest it, then your money will actually be worth less tomorrow than it is worth today.
The only way to come out on top is if you can earn a return on your money greater than the rate by which inflation devalues it. So, for instance, if the current rate of inflation is 2%, you need to earn a return on your money greater than 2% or you effectively lose money. Your money is constantly battling inflation, whether you invest it or not, but investing provides one of the best potentials for maintaining and increasing the purchasing power of your money in the future.
Bottom line on brushing up on your investment terms
There are lots of different investing terms and you’re not going to become an expert overnight, but the sooner you educate yourself, the easier investing will be for you moving forward. Begin learning now, because by investing as early as possible you can set yourself up for greater financial success in the future.