Learning how to invest money the best way can be hard. Between all the different investments competing for your dollars, the financial industry fighting to sell you their services, and an entire internet full of hucksters looking to take advantage of you, it can seem overwhelming. But it’s still one of the most important things you can do to secure your future, and doing it well can lead to huge wealth.
Keep reading to learn how to invest money effectively and safely.
What is investing?
Merriam-Webster defines investing as “to commit (money) in order to earn a financial return.” This may seem obvious, but it’s important to differentiate between investing and saving. Saving and investing are both very important, but serve two different fundamental purposes.
Saving is essentially the accumulation of leftover income, kept as cash or a cash-equivalent such as a certificate of deposit (or CD). This money will earn very little return at current interest rates, and when inflation is factored in its spending power could actually decline.
So why save? In short, because it’s a source of predictable short-term money. This can make a huge difference if you lose your job, get injured, become ill, experience a natural disaster, otherwise, find yourself at the mercy of some unexpected expense, or to afford a major purchase within a few years. Stock prices are volatile and can gain or lose significant value in a very short period of time. Even bonds can lose value if you sell them when interest rates are going up. Alternative investments such as Bitcoin and precious metals like gold can be even more high-risk and volatile than stocks in the short-term.
So the first thing you need to do is think about what you’re trying to accomplish, and decide whether you should invest that money (longer-term growth), or save it (short-term accumulation).
Your timeframe tells you whether you should be investing or saving (and how you should invest)
Cash, stocks, bonds, real estate, and anything else you can invest in is a tool. And like any tool, it’s important to use the right one for the job. The three charts below shows exactly how making the right asset choice, based on your timeframe, can make all the difference:
There is a big lesson from this chart: The volatility of stocks can cause big losses in the short-term, but also deliver wonderful long-term returns.
Investors who bought near the market’s peak before the Financial Crisis and Great Recession took nearly five years just to break even (and plenty lost money, selling long before the market recovered). But those who stayed invested through the downturn have done very well. Even from the peak before the Great Recession, investors in a low-cost index fund that mirrors the S&P 500, like one of the three Vanguard 500 Index Funds (NASDAQMUTFUND: VFINX)(NASDAQMUTFUND: VFIAX)(NYSEMKT: VOO), have nearly doubled their money by holding long-term.
Let’s take a look at bonds, represented by the Vanguard Total Bond Market Index Fund (NASDAQMUTFUND: VBTSX)(NASDAQMUTFUND: VBMFX)(NYSEMKT: BND) over the same period:
As the table above shows, high-quality bonds are far less volatile than stocks. This is because bonds are debt — you loan money to a company (or the government) for a set period of time, get paid an interest rate, and then get your money back when it matures.
You can lose money with bonds, too, however, if you need to sell the bond before it matures, and interest rates have gone up. This is because you have to discount the value of your bond to compete against newer bonds that pay a higher interest rate than your bond. Bond prices can also fluctuate with major economic or monetary crises, such as during a major recession or inflation periods, though almost never at the same levels as stock prices. For instance, bond prices fell more than 5% in late 2008 during the financial crisis, though they rebounded within a few weeks. Lastly, since bonds are debt, you can lose money if the bond issuer has financial struggles and is unable to repay bond investors. This is generally very rare, especially with high-quality corporate and government bonds.
Let’s take a look at cash, as measured by the U.S. core inflation rate.
As the chart above shows, inflation has been generally a little less than 2% over the past decade, that is the target of the U.S. Federal Reserve, which controls monetary policy. At 2% inflation, each dollar loses about $0.02 in spending power. This lost value to inflation is offset by the interest yield paid by your bank on your checking, savings, or CD, if very little (if any) more.
This means that cash is very, very predictable in the short-term. That’s exactly what you want in the short-term, over a few months to a couple of years, when an unexpected event — like a recession — could simultaneously put you out of work, and also send the stock market falling 25% in a matter of months. You don’t want your emergency fund to lose one-quarter of its value right when you’re going to be depending on it, right? That makes cash perfect for the short-term.
But the steady erosion of inflation, combined with the minuscule yields of savings and CDs, makes cash a terrible investment for the long-term.
To sum this up, think about it this way:
- Money you may need in the next year or less is best in a cash equivalent form (because its value holds very steady).
- Money you will need in three to five years is best in high-quality bonds or bond funds (because you’ll get better returns than cash, but less risk to short-term volatility like stocks).
- Money you won’t need for more than five years in high-quality stocks or stock-based index funds.
Things you can invest in
Besides stocks and bonds (and ETFs and mutual funds that hold stocks or bonds), there are a lot of things you can invest in, including commodities like oil, natural gas, precious metals like gold and silver, industrial metals like aluminum and steel, emerging things like Bitcoin and other “cryptocurrencies”, foreign currencies, and real estate, just to name some of the most common.
It’s also very important to differentiate between long-term buying and holding of assets, versus trading. Commodities and currencies are generally traded over relatively short periods of time, even weeks or days, and often using contracts for delivery of a commodity at a specific time. Not only does this require more time involved in the act of trading, generally requires specialized knowledge to be profitable. Commodity trading can be very profitable if you know what you’re doing, but it’s an excellent way to lose a lot of money in a very short period of time if you don’t.
Investments like cryptocurrencies and precious metals can be even more volatile (and therefore wealth-destroying) since much of their value — particularly when they are going up quickly — is driven by speculators and not in the commercial value of that good. In other words, if something’s value is underpinned by speculators and not what it’s worth to the people using it for something, there’s a huge risk its value will collapse, and fast.
Stocks and bonds, on the other hand, can be far more predictable and are generally less risky investments. This is because bonds, as was discussed above, are worth their face value when they mature, and stocks are ownership in a company with assets and a business that can be valued.
Open a brokerage account and start investing your money
To start, you’ll need a brokerage account, with a discount online brokerage generally being the cheapest, easiest, and best way to go. But before you just open an account, you’ll need to open the right kind of account based on what you are investing for.
If you’re investing for retirement, you’ll want to open either a traditional IRA or a Roth IRA, which will reduce your taxes and stretch your retirement dollars even further. You’ll be able to invest in stocks, bonds, ETFs, and mutual funds, which should be the core holdings for retirement investors, with stocks (and stock ETFs and mutual funds) making up the bulk of your holdings for the best long-term returns.
If you’re investing for a child’s education, either a 529 college savings plan, or a Coverdell ESA, depending on how much you (as well as family and friends) will contribute each year, and what you plan to invest in.
If you’re not investing for either a child’s higher education or your retirement, a plain-Jane taxable brokerage account should be just fine.
Once you have opened the proper kind of account and funded it, now you can start investing!
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Jason Hall has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.