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.