The Basics of Investing (Stocks, Bonds, Mutual Funds, and Types of Interest)

Most people have heard that investing is the best  way to accumulate wealth. Investment is the act of redirecting resources from being consumed today  so that they may create benefits in the future. More precisely, investment is the use of assets to  earn income or profit.

The wealthiest individuals in the world became wealthy through successful  investment of their assets. Let’s go over the basics regarding common ways that people invest. Stocks and bonds are two of the most common forms of investment.

A stock is a representation  of ownership in a public company. They can be risky to purchase as their prices can change  dramatically and unpredictably, but often the bigger the risk, the bigger the potential reward.  There are two ways for stockholders to make money: dividends and capital gains.

Dividends are  profits paid out four times a year to all shareholders. The size of the dividend depends  on the profit of the company. Capital gains are when a stockholder simply sells their stock for  more than they originally paid for it.

If the stockholder made a profit, it’s a capital gain.  If they lost money, it’s a capital loss. A market for buying and selling stock is called a stock  exchange.

Brokerage firms are businesses that help stockholders trade stocks and sometimes  even deal out stocks. These days, anyone can easily access the stock exchange on their phone  through apps that offer brokerage services. A bond is essentially an IOU issued by a  corporation or by some level of government.

When you buy a bond, you are loaning money  in return for a guaranteed payout at a later date. Bonds are usually a more stable investment  than stocks. There are three components of bonds: their coupon rate, maturity date, and  par value amount.

The coupon rate is the interest rate that a bond issuer will  pay to the bondholder. The time at which payment to a bondholder is due is called  the bond’s maturity. A bond’s par value, assigned by whoever issues the bond, is the  amount to be paid to the bondholder at maturity.

In order for investment to take place, an  economy first must have a financial system, which is the network of structures and mechanisms  that allows the transfer of money between savers and borrowers. As we learned in the previous  tutorial, when people save their money, they often are actually lending funds to others.  Savers and borrowers may be linked directly through what’s known as financial intermediaries. 

Financial intermediaries are institutions that help move funds from savers to borrowers.  They include banks, which we learned about in the previous tutorial, but they also include  mutual funds, hedge funds, and pension funds. A mutual fund pools the savings of many  individuals and invests this money in a variety of stocks, bonds, and other financial assets.

A  hedge fund is a private investment organization that employs risky strategies that can often  make huge profits for investors. In general, these investors already have tremendous  wealth and are knowledgeable about investing. A pension fund is income that some retirees  receive after working a certain number of years or reaching a certain age.

In some cases,  injuries may also qualify a working person for certain pension benefits. Employers set up  pension funds by collecting deposits, and pension fund managers then invest those deposits  in stocks, bonds, and other financial assets. In general, the best way to invest your money is  to put it in a diverse range of securities.

This reduces risk, especially when stock or bond  prices drop. Therefore, people often invest some of their money in more risky ventures but  invest the rest in more stable funds. It is also better to invest money earlier in life.

This  is because one of the greatest assets is time. The longer your money is invested in securities,  the more it will grow. Put another way, you make more money on the money your money already makes.

When investing money, it’s important to consider the two types of interest, simple and compound.  Simple interest is based on the principal amount of a loan or deposit. Compound interest is based  on the principal amount and the interest that accumulates on it in every period.

Thus, it can  be regarded as “interest on interest. ” Simple interest is only calculated on the principal  amount of a loan or deposit. The formula looks like this: A = P(1 + rt) where A is the final  amount, P is the initial principal balance, r is the annual interest rate, and t is  time, usually in years.

Compound interest is calculated based on both the principal and  interest accrued. The formula looks like this: A = P(1 + r/n)nt where A is the final amount,  P is the initial principal balance, r is the interest rate, n is the number of times interest  is applied per time period, usually in years, and t is the number of periods elapsed. Let’s look at an example.

Say you loaned $10,000 to a friend and they agreed to  pay it back in five years with an annual simple interest rate of 5%. After five years, the  amount of interest you would get would be $2,500, as the total amount they would repay would be  $12,500, which is the original principal plus the interest. Now say you loaned $10,000 to a  friend and they agreed to pay it back in five years with an annual compound interest rate of  5%.

Because you really want to make some money, you also make sure that interest is compounded  monthly, or 12 times a year. After five years, the amount of interest you would get would now  be $2,833. 59, and your friend would have repaid you a total of $12,833.

59. This example serves to  illustrate that compound interest is far superior to simple interest when investing your money. Whenever consumers evaluate an investment, they must balance the risks involved with the  rewards they expect to gain from the investment.

In general, the higher the potential return  on an investment, the riskier that investment is. In the next tutorial, we will look at one of  the riskiest ways to borrow money, credit cards.