This handout does not include every investment opportunity available to you. Instead, this handout explains the more common investment opportunities present in financial world today.
How can I make money by investing money?
To answer this question we must understand an underlying concept of economics. THERE IS NO SUCH THING AS A FREE LUNCH. In other words, nothing in life comes free. Whenever you borrow money to buy furniture, a car, or a house you have to pay what is called INTEREST? You can think of interest as the cost of borrowing money. Banks and other financial lenders stay in business by loaning out money and receiving the interest that borrowers pay to use the loaned funds. If you are a borrower, interest is not a good thing. There is, however, a bright side to the concept of interest if you become an investor.
As an investor, you become the person who benefits from interest. By investing in a savings account, Certificate of Deposit, or Bond you are loaning your money in return of promised financial returns. One important rule to remember is that riskier investments return higher interest rates and yields and safer investments return lower interest rates and yields. Keep this in mind as you read about the following investments.
Short-Term Investments
The following investments should be considered if you will need your money in the near future. The near future is usually defined as with in the coming year. Short-Term investments do not have the potential large financial returns seen with Longer-Term investments.
1. Savings accounts: These accounts provide a safe place to store money. Most people use savings accounts to store emergency funds or short-term savings for items such as furniture or a down payment on a car. Banks pay interest on savings accounts because they use your money to loan to other borrowers. Savings accounts usually pay 1-2% in interest.
2. Certificates of Deposit: CDs tend to offer higher rates of return than savings accounts. One negative of CDs is that you must keep you money invested for a pre-set time period. For example, if you buy a one year CD, you can not touch your money for at least one year. If decide you need your money before the year is over you will have to pay a penalty. CDs generally pay a 3-4% yield depending on the length of time your money will be invested. Longer term CDs will usually pay more than short-term CDs.
Longer-Term Investments
These investments should be considered if you have money available that will not be needed for a long period of time. People who are trying to build a nest egg for retirement or a college savings account will look to these investments to meet their goals.
1. Bonds: Many corporations and the government issue bonds to borrow money. In return for lending your money you will receive an interest payment that is usually pre-determined. Bonds are a little more risky because there is a chance that your money will not be repaid. As a bondholder, you DO NOT get part ownership in a company. Bonds usually return yields of 4-6%. The following is a list of common bonds.
Ø Corporate Bonds- Sometimes companies will use bonds to raise money quickly. If you choose this type of bond you should be confident that the business is in good shape and capable repaying your loan with interest. (5-6% yield)
Ø Municipal Bonds- These bonds are issued by cities, counties, states, and school districts to pay for projects such as government building, roads, schools, etc. This type of investment is generally safe because it is backed by the government and interest is paid out of tax revenue. (4-5% yield)
Ø Treasury Bonds- Essentially the same as municipal bond expect that the funds are used for federal projects. Again, this type of loan is safe and backed by the Federal Government. ( 4-5% yield)
Ø Junk Bonds- Companies that are in bad financial shape and need to raise cash will sometimes issue these bonds. Junk Bonds get there name because they are very risky investments. Companies that issue Junk Bonds have a higher risk of going out of business and therefore will not pay back your loan. Due to the level of risk, these bonds return a higher interest rate. ( 7-10% yield)
2. Stocks: People who invest in stock are buying part of a company. The part they own is known as a share. Stocks do not pay interest. When the value of the stock increases, investors make money. You may be wondering what determines the value of a stock. Stock value is determined by the laws of supply and demand. When many investors desire a certain stock (increase in demand) the value of the stock will increase. The opposite is also true. When many investors want to sell their stock (decrease in demand) the stock value will decline.
You might also wonder why the demand for a certain stock will rise and fall. There are
many reasons, but the most common factor that determines stock value is the level of performance by the company that investors own stock in. If a company is performing poorly then investors will shy away from its stock. On the other hand, investors will look for companies that are profitable and performing well. Stocks are better suited for long-term investors because of the dramatic price swings that can occur. In the long run, stocks have the highest return. (8-10% increase in value).
Example:
Let’s assume you were to purchase 10 shares of educate interactive stock at $5 a share.
10 shares x $5 = $50 total investment
Let’s assume that three years later educate interactive stock is trading for $20 a share. You may decide that this is a good time to sell your stock.
10 shares x $20 = $200 total return
Congratulations you made $150. This is known as a capital gain.
3. Mutual Funds: Mutual funds consist of a variety of stocks and bonds. Mutual funds allow investors to own many stocks and bonds and in doing so allow investors to become more diversified. Mutual Funds diminish the risks of the stock market to a degree because investors do not have to worry if one or two stocks decrease significantly. This does not mean that mutual funds are without risk. Mutual funds will experience the ups and downs of the market. However, a long term investment in a mutual fund is more than likely going to receive a significant return. (8-10% increase in value)
4. IRA and Roth IRA: IRA stands for individual retirement account. These accounts were designed specifically for creating a retirement nest egg. When you set up an IRA, you choose where you want your money to be invested. The main advantage to an IRA is that it is tax deductible. This means that whatever amount of money you put into an IRA will not be taxed by the government. Look at the following example.
Lets assume Frank and his wife earn $74,000 in 2005. You already learned in part one that the standard tax deduction for married couples is $10,000. This means that Frank and his wife will have to pay taxes on $64,000.
Let’s also assume that Frank invested $4000 in his IRA. When Frank files his 2005 income tax return he will be able to deduct $4000 from his taxable income. This means that instead of paying taxes on $64,000 dollars, Frank will only pay taxes on $60,000.
When Frank retires and withdraws money from his IRA he will have to pay taxes.
The IRA is a great plan for building a retirement nest egg. There is, however, another retirement plan that is even better. It is called a Roth IRA. With a Roth IRA you DO NOT get the extra tax deduction today. This means that if Frank invested $4000 in a Roth IRA he would not get to deduct it from his taxable income. He would still have to pay taxes on his $64,000. Now, you might be thinking that a Roth IRA seems worse than a regular IRA. With the information provided so far it does seem like the regular IRA is better. Keep reading and you will see why the Roth IRA is better.
Reread the last line from the example above. Notice that when Frank retires he will have to pay taxes anytime he withdraws his money from his IRA. When you invest in a Roth IRA you pay the taxes today. That is why you do not get a tax deduction. When you retire, however, any withdrawal you make from you Roth IRA is TAX FREE. The Roth IRA sounds like a good deal now doesn’t it? (8-10% return)
Benefits of Long-Term Investing
You might be wondering about the benefits of long-term investing. To better understand these benefits we will look at a couple of examples.
1. Cindy (23 years of age) recently graduated from college and was offered a job by an accounting firm. Cindy understands the importance of saving for the future so she decides to set aside $2500 a year to place in a Roth IRA. Cindy plans on retiring at the age of 60 and will continue investing $2500 every year until she reaches retirement.
2. Bob (also 23 years of age) recently graduated from college and was offered a job as a financial analyst. Bob has very expensive tastes. He bought a brand new sports car, a large house, and a ski boat. Bob earns enough to pay for these luxuries but it doesn’t leave much money leftover at the end of the month to save. Bob figures he can begin saving in a few years and catch up on creating a retirement nest egg. At the age of 30 Bob decides to begin saving $4000 a year until he retires at the age of 60.
Who do you think will have the most money at the age of 60?
If you said Cindy you would be correct.
Ø If Cindy invested $2500 a year in a Roth IRA that earned 10% interest on average every year, she would have $907,609 at retirement.
Ø Bob, who invested $4000 a year in a Roth IRA that earned 10% interest every year, would only have $773,774 at retirement.
Not only did Cindy end up with more money, but she invested less than Bob over the years.
Ø Cindy: $2500 a year for 37 years = $92,500 total investment
Ø Bob: $4000 a year for 30 years = $120,000 total investment
You can do your own calculation on the web. Go to any search engine such as google.com or yahoo.com and type in
Roth IRA Calculator.