Saving money is important to cope with potential emergencies… but what do you do after you have the recommended 3-6 months’ worth of wages in savings? The answer: invest. Investing is different from saving in that one generally invests to gain wealth. This means someone invests in order to receive a tangible return. This way, you can make your money work for you!
However, investing requires some risk. Everyone has their own risk level, called their risk tolerance. So why would anyone be willing to be risky with their money? The higher the risk level of an investment, generally the higher rate of return. The rate of return of an investment is calculated by dividing the total return on investment by the initial investment. If John invests $100 and his return is $5, then the rate of return (5/100) is .05, or 5%. One force to keep in mind that is working against the value of money is inflation. If there is a 3% inflation rate and the rate of return on your investment is 3%, you aren’t gaining any money! In fact, after taxes you are losing money. This is one reason people often look to investments with higher rates of return, and in turn take on more risk.
Some examples of investment (in increasingly risky order) are bonds, mutual funds, and stocks. Savings bonds are an investment where you buy say a $50 bond for $25 dollars, and after 10 years it matures and becomes worth the $50. In addition, you can hold on to it and gain interest on the bond. Mutual funds are collections of stocks and bonds put together by mutual fund managers. Groups of investors invest in them, and they are generally less risky because they include such a diverse collection of stocks and bonds. This is called portfolio diversification. It is important to have a diverse investment portfolio, because it is usually much safer.
Let’s compare a diverse portfolio to a student’s GPA. A few investments give good returns (the student gets “A’s” in those classes) and a few of the riskier investments give poor returns or no returns at all (symbolically “B’s” or “C’s”). Because the person has a diverse portfolio, the poor returns are balanced out by the good returns, just as a 4.0 GPA helps balance out a few 3.0 or 2.0’s. So how does one invest? Most investments need to be done through brokerage firms and require you to be 18 or older. However, it is possible to invest if you are under 18. Most firms will allow you to set up a custodial account, where you can invest and your parents will be custodians of it until you are 18. Every investment should take a lot of thought though, so never just impulsively purchase!