Investing in markets can sometimes feel like reading tea leaves and just hoping for the best. We know we need to invest, we want to understand it at a basic level, but there’s just so much information.
Magic of Compounding
Remember in high school when one of your teachers shared that if you saved $1 per day you could easily be a millionaire? That’s the magic of compounding. Compounding is the simple formula of using your savings to earn interest and saving the interest, therefore the investment compounds and grows at a faster rate because you are making money off your base investment AND the interest.
Compounding is a long term strategy where you build growth off the growth of your investment. This is the reason why we are encouraged to invest when we are young. The magic of compounding earns us even more money because we have a long time frame.
Stocks versus Mutual Funds versus ETFs
Okay, you decide to invest, now what? There are lots of choices when deciding what to invest in and much of it can depend on your personal risk level (Check out article here). Here are some basic definitions:
- Stocks – these are individual investments in single companies. By purchasing stock you are investing in that single company and it’s financial performance will determine the value of the stock.
- Mutual Fund – these are a collection of stocks professionally managed. The performance of the mutual fund is determined by the performance of the underlying stocks. Professional managers create a mix of stocks based on the goal of the mutual fund (stability versus growth).
- ETF – Exchange Traded Fund – is a mix between stocks and mutual funds in that the individual fund invests in stocks and imitates the growth of certain sectors of the market.
Depending on your strategy (short term versus long term) and your personal risk levels will help determine the type of investment you should consider. When investing within a retirement account through your employment most only offer mutual funds and ETFs. Single stock investment are considered the most risk because the investment’s performance is dependent on a single company versus mutual funds and ETFs take the performance of a group.
One of the benefits of investing in mutual funds or ETFs is diversification, investing in multiple companies within a single investment. This allows investors to mitigate risks due to poor financial performance of major disaster from one single company. Diversification is the simple task of spreading your investment over multiple companies therefore reducing the risk of your overall investment.
Continue the conversation about Investing 101 with Terry Savage, writer, author, speaker on the Savage Truth About Money.