Dear Karen,
We've talked about the need to keep some money handy for expenses, and some more where I can get to it in case of an emergency. So what do I do with Bucket #3. I'm still a little uncomfortable with the idea of investing. It seems like the stock market has been a bad place to have your money pretty often over the last few years.
Your Young Friend
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Dear Young Friend,
You've just zeroed in on the difference between saving and investing. With savings, we usually have some assurance that we won't lose our money, such as FDIC insurance on bank accounts or NCUA insurance on credit union accounts.
But when it comes to investing, there is risk that your investment could lose value. There could even be a risk of losing all of your money.
The potential reward is the reason we choose to take that risk – the potential to earn much greater returns than we can get on our savings, and the opportunity to have our money grow faster than inflation. But those returns don't usually come in an orderly fashion . You might see significant losses in one or two years, and then spectacular gains for a year or two, followed by almost no change.
You just don't know what will happen in any given year with investments. in the short term, you have no idea whether the value will go up or down. That's why you only invest money that you don't expect to need for a number of years.
Over longer periods of time, you're more likely to see positive returns that are better (maybe significantly better) than from savings vehicles. And there are basic investment techniques, such as diversifying, that protect you from losing all your money.
The Securities and Exchange Commission sums it up nicely on their Investor.gov webpage:
Why Invest?
A few people may stumble into financial security. But for most people, the only way to attain financial security is to save and invest over a long period of time. You just need to have your money work for you. That's investing.
The basic building blocks of investing are stocks and bonds. You may never own a stock or a bond directly. You will likely invest in mutual funds, and the mutual fund will own stocks or bonds inside of it. But you still need to know the basics of how stocks and bonds work.
Bonds
Bonds are IOUs issued by corporations or municipalities, who sell the bonds as a way to generate cash. Bonds have a maturity date and usually a fixed interest rate. Think of a loan with interest-only payments, and a balloon payment at the end.
The owner of the bond gets those periodic interest payments until the maturity date, and then they get their investment (the principal) back. In the meantime, they could sell the bond to someone else. How much the bond is worth at that point depends on how the bond's interest rate compares with current rates.
Let's say you (or your mutual fund) have a bond from ABD Pharmaceuticals that was issued a few years ago, and it pays 6% interest. But bonds being issued today are paying 8%. You'd have to sell yours at a discount (meaning, you'll sell it at a loss) to make it competitive. If current interest rates have dropped, you could sell your bond at a profit. You don't have to sell it before maturity; you can just hang onto it and keep getting those 6% interest payments until maturity, when you'll get your original investment back.
There is a risk that you might not get those interest payments, or get your principal back. That's called default. Junk bonds are bonds of companies that experts think are more likely to default.
Stocks
Stocks are shares of ownership of a company. When you own a stock, you own a piece of the company. If the company does well, then your share of it should appreciate, or become more valuable. If the company does poorly, the value of your shares will drop. If the company goes out of business, your shares could become worthless.
Many companies share their earnings with stockholders, through payments known as dividends. These may look like interest payments, since the amount is often consistent and they are usually paid quarterly. But it's not interest, it's your share of the company's profits.
Mutual Funds
Rather than buying individual stocks and bonds, you can put your money into a mutual fund, where it is pooled with money from other investors. The mutual fund purchases stocks or bonds, or a combination, according to the fund's guidelines. By investing through a mutual fund, you can be diversified and indirectly own stock in many different companies even though you only have a small amount of money to invest. You can even choose target date retirement funds that own stocks, bonds, and perhaps cash in a proportion appropriate for someone in your age group.
A Perspective on Risk
Since 2000, the US stock market has had two of its biggest drops in value since the Great Depression. So I understand that it may seem like a risky place. But during those same 14 years, the stock market had annual returns of more than 30% once, between 20 and 30% twice, and more than 10% another five years (Stern School of Business, NYU). By the end of 2014, the stock market had gained 46% compared to the end of 1999 – probably double what you could have earned on a savings account during the same time, despite those years with horrible returns, but certainly with more risk.
What will the next 15 years hold? Personally, I don't think anyone can predict. But my take is, they're still the best choice for my long-term money.
Next up - why you might want to use an IRA or a Roth IRA for your long-term money.
Karen
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This post continues a series based on conversations with a young friend of mine about the financial decisions and challenges of being an independent young adult in today's world. You can find other posts in the series by clicking Organizing Finances in the Category list on the right side of this page. ~Karen