Everything You Should Know About Investing
From the Perspective of Someone Who Isn’t a Financial Advisor
Below you will find a bunch of terms relating to Investing that I believe are core to anyone trying to increase their Financial Literacy
Time Value Of Money & Compound Interest
Imagine someone giving you the option of receiving $10,000 today or $10,000 a year from now. Intuitively most people would choose the $10,000 today, but beyond the reasoning that they don’t want to wait another year, most people may not understand the time value of money. The time value of money, also called TVM in finance, is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the meantime. This money is only worth more today if it’s invested and not stagnant somewhere. If you were to hide the $10,000 in a mattress for three years, you would lose the additional money it could have earned over that time if invested. If you do nothing with the $10,000 it will have less buying power when you finally retrieve it because inflation has reduced its value.
“All returns in life, whether in wealth, relationships, or knowledge, come from compound interest “ — Naval Ravikant
Now let’s say you took that initial $10,000 on day 1 and invested it into an account earning 5% annually. One year later you now have $10,500 instead of the $10,000 should you have left it under your mattress. Now flash forward another year and you’ll have $11,025 in that same account that once had $10,000 without investing any additional money. Over time, the interest you earn is added to the principal which then earns you more interest. This is the power of compound interest. After 30 years, your $10,000 investment compounding annually at 5% would be worth over $40,000.
Stocks & The Stock Market
Imagine you shop at this bakery regularly and you realize they’re making a killing and you want a piece of the pie (literally and figuratively). So you ask to invest in the bakery. Instead of purchasing the entire bakery, you buy shares of it, much like buying slices of a pie. The more slices (shares) you own, the larger your ownership in the bakery. The value of these slices (shares) can change every day depending on how well the bakery is doing, how popular it becomes, and other factors. This is where supply and demand come into place. If more people want a slice of the bakery (high demand), the price of each slice goes up meaning your initial slice is worth more. Conversely, if people aren’t as interested in the bakery’s pies (low demand), the price could drop.
Investors in the Stock Market aim to buy slices (shares) when they’re affordable and sell them when they become more valuable. They watch the news, analyze not just one but multiple bakeries’ performances, and keep an eye on overall market conditions to make informed decisions all while hoping to make a profit.
You can think of the Stock Market as the main financial venue where investing happens. It’s a collection of all the places where matches are made between buyers and sellers trading slices (shares) of public companies. Through the Stock Market, companies are also raising money by selling ownership stakes to investors so it works both ways. These equity stakes are known as shares of stock. By listing shares for sale, companies get access to the capital they need to operate and expand their businesses without having to take on debt.
NASDAQ VS NYSE
Whenever someone talks about the stock market, two terms usually come up at one point or another and those are the New York Stock Exchange (NYSE) and the Nasdaq. The two exchanges collectively account for the bulk of stock trading in North America and internationally. They differ in their operations and the types of equities they list. Historically, the Nasdaq is known for technology and innovation and is home to digital, biotech, and other companies at the cutting edge. As such, stocks listed on the Nasdaq are considered growth-oriented and more volatile. In contrast, companies that list on the NYSE are perceived as more stable and well-established. NYSE is known for trading blue chip companies which are nationally recognized, well-established, and financially sound companies that have a large capitalization and trade on a major stock exchange.
SEC
The SEC or Securities and Exchange Commission regulates the stock market in the United States. The SEC was created after the passing of the Securities Act of 1933, following the stock market crash of 1929. The SEC’s mission is to protect investors, maintain orderly and efficient markets, and facilitate capital formation. Because of the SEC rules, public companies that trade on the stock market must tell the truth about their business, and those who sell and trade securities must treat investors fairly and with honesty.
Wall Street
Wall Street is a street located in New York City at the southern end of Manhattan. It is often used synonymously with the Stock Market or just the financial industry in general. The connotation has its roots in the fact that so many brokerages and investment banks historically have established their headquarters in and around Wall Street and are also the home of the New York Stock Exchange.
What is a Stock Market Index?
A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. Investors follow different market indexes to gauge market movements. The three most popular stock indexes for tracking the performance of the U.S. market are the Dow Jones Industrial Average (Tracks 30 large, blue-chip companies trading on the NYSE), the S&P 500 Index (Standard & Poor’s 500 index that tracks 500 leading publicly traded companies in the U.S.), and the Nasdaq Composite Index (Index consisting of 3,500+ stocks listed on the Nasdaq stock exchange).
Stock Brokers
Stock brokers are people or firms licensed to buy and sell stocks and other securities via the stock market exchanges on behalf of investors. Decades ago, the only way for individuals to invest directly in stocks was to hire stock brokers to place trades on their behalf. Nowadays most people open a brokerage account with online brokers rather than working with an individual person.
IPO
Chances are you’ve also heard of the term IPO, or Initial Public Offering, which marks the debut of the company’s stock on the public market. When a company goes “public”, it offers to sell shares of its stock to outside investors on an established stock exchange, like the NYSE.
How Do You Make Money?
The primary reason anyone owns stock is to earn a return on their investment. That return generally comes in two possible ways:
- The stock’s price appreciates, meaning, it goes up and becomes more valuable. You can then sell the stock for a profit if you’d like
- The stock pays dividends. Not all stocks pay dividends, but many do. Dividends are payments made to shareholders out of the company’s revenue, and they’re typically paid quarterly. Some brokerage accounts automatically reinvest your dividends into buying more stock too
Over the long term, the average annual stock market return is around 10% which falls between 7% to 8% after adjusting for inflation. That means $1,000 invested in stocks 30 years ago would be worth over $8,000 today (Time Value of Money & Compound Interest)
Treasuries: Bonds, Notes, and Bills
Treasury bonds, notes, and bills are U.S. government debt securities that mainly differ in their duration, the interest they pay, and the amount of interest rate risk they face. A Treasury is a type of investment that the U.S. government issues. You are essentially loaning the government money by purchasing a Treasury and earning interest in return. Treasuries are considered low-risk because they’re issued and backed by the U.S. government but also don’t have the greatest returns.
Bonds
Treasury bonds are the longest-term U.S. debt security with maturities of 20 to 30 years. They’re also known as T-bonds and pay a fixed rate of interest every 6 months. Although they may yield lower returns on average than stocks, T-bonds offer stability and liquidity if that is what you are seeking.
Notes
Treasury notes are short and intermediate-term debt securities with maturities of 2, 3, 5, 7, or 10 years. Like bonds, notes pay a fixed rate of interest every 6 months.
Bills
Treasury bills are the shortest-term government investment and mature in four weeks to one year. Treasury bills are also known as zero coupon bonds, meaning unlike bonds and notes, they don’t pay a fixed interest rate. Instead, bills are sold at a discount rate to their face value. Bills are assigned a face value, which is what the bill is worth if held the full length and you purchase it at a discount. You ultimately profit from the difference at the end of the term.
401(k)s & IRAs
You can think of 401(k)s and IRAs as retirement savings accounts and are often grouped when talking about investing. These types of accounts tend to invest in things like mutual funds which will be explained in the next section. The main difference between 401(k)s and IRAs is that a 401(k) is offered through an employer, whereas IRAs are opened by individuals through banks or brokers.
The following sections break down the differences:
401(k)s
401(k), or 401(k) retirement savings plan, is named after a section of the U.S. Internal Revenue Code, specifically Section 401(k). A 401(k) is sometimes offered through employers as it can be tax deductible for the company. As of 2023, They have a contribution limit of $22,500 ($30,000 for those 50 and older), and most employers offer a match of around 3% on these plans. This means, that if your salary is $50,000, your employer will contribute $1,500 as long as you also contribute at least $1,500 in the given year. Some employers will give you an option of a Traditional and Roth 401(k) which will be explained later.
IRAs
IRA, or Individual Retirement Account, is a type of retirement savings account that individuals can set up on their own. They come in two different types: Traditional and Roth IRAs each with their own rules and tax benefits which will be explained in the next section. In 2023, the combined contribution limit for all of a Traditional and Roth IRA is $6,500 or $7,500 if you’re 50 or older.
Traditional 401(k) or IRA
A Traditional 401(k) or IRA is a type of retirement savings account where you contribute pre-taxed income. Traditional Accounts lower your current taxable income, but when you withdraw from the account down the road you will be taxed as ordinary income. You’d generally want to choose a Traditional Account if you want a tax deduction now, you expect to be in a lower tax bracket in retirement, or you want to maximize your current cash flow. Generally, you can start withdrawing money from a Traditional account without penalties at the age of 59 1/2 and these withdrawals are subject to income tax.
Roth 401(k) or IRA
A Roth 401(k) or IRA is a type of retirement savings account where you contribute post-taxed income. You’d generally want to choose a Roth Account if you want tax-free withdrawals in retirement, you want flexibility with withdrawals, you anticipate future tax rates to be higher, you plan to leave an inheritance, or you don’t need a tax deduction now. Generally, contributions to a Roth IRA can be withdrawn at any time without penalty because you’ve already paid taxes on that money but any earnings cannot be withdrawn without a tax or penalty until the age of 59 1/2.
Generally, if your employer offers a 401(k) with a company match, it is recommended to contribute the minimum required to get the match before putting any money into an IRA. After getting the match, try to max out an IRA for the year before contributing more to the 401(k) if this is your main source of investing. You can read more details about both here.
Mutual & Index Funds & ETFs
If you’ve talked to anyone about investing, it’s very likely the terms mutual or index funds have come up. They’re often cited as a good choice for beginning investors, but you might want to know why. This section aims at answering questions about both as well as ETFs.
Mutual Fund
The definition of a mutual fund is really in the name itself. Instead of investing in one individual security, you are pooling your money into a variety of stocks, bonds, etc. When you buy a mutual fund you get a more diversified holding than you would with an individual security.
Mutual funds give small or individual investors access to professionally managed portfolios. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.
Most mutual funds are part of larger investment companies such as Fidelity, Vanguard, T. Rowe, etc. A mutual fund has a fund manager, sometimes called its investment adviser, who is legally obligated to work in the best interest of mutual fund shareholders.
Exchange-Traded Fund (ETF)
An Exchange-Traded Fund (ETF) is a type of pooled investment security that operates similar to a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way a regular stock can.
Index Fund
An Index Fund is a collection of stocks that aims to mirror the performance of an existing stock market index, such as the S&P 500 index. A market index is made up of companies that represent a segment of the financial market and offers a look into the health of the economy as a whole. At its core, an Index Fund is a type of Mutual Fund with a portfolio constructed to match a specific index.
The main difference between a Mutual and Index fund is that a mutual fund is trying to beat the returns of a benchmark index. Beyond that, mutual funds usually have more expensive fees as they are actively being managed by someone. Lastly, it should be noted that history has shown it’s extremely difficult to beat passive market returns (aka indexes) year in and year out. According to the S&P 500 index vs. Active (SPIVA), only 6.6% of funds outperformed the S&P 500 in the last 15 years.
All of these terms can be easily mixed up and I’ve even seen notable investing websites even go back and forth on their definitions. At the end of the day, these three funds are diversified into many types of investments and professionally managed by someone or something else which is the key thing to grasp here.
These types of investments are considered a good choice for investors and good for beginners as you don’t need to actively manage the account. Legendary investor Warren Buffet has recommended index funds as a haven for savings for the later years of life and that they make more sense for the average investor. If you want to find out more info you can check out this article by Vanguard here.
Checking & Savings Accounts
If you haven’t heard of any of the terms listed in this article so far, chances are you’ve at least heard of a checking or savings account and probably have one of these yourself. Below are the two explained in simple terms
Checking Accounts
A checking account is a deposit account that lets you keep your money in a secure place while still allowing you to easily pay for daily expenses. When you use your debit card at a store, the money is typically withdrawn from your checking account. The same can be said if you use checks
Savings Accounts
A savings account is another deposit account for when you want to save money for the future. Regulation limits the number of transfers on a savings account to six per month or statement cycle so day-to-day access isn’t as feasible as a checking account. The average savings account across all financial institutions is 0.42% according to the FDIC. Meaning, $10,000 in a Savings Account today would be $10,042 at the end of the year. This time last year the average savings account rate was 0.10%.
You may be wondering, “Where do banks then get the money to give people these interest rates?” Well, they come from multiple sources, but one of the primary sources of income for banks is the interest they earn from lending money to borrowers, such as individuals, businesses, and governments. Banks charge borrowers a higher interest rate on loans than they pay to savers on savings accounts. The difference between these rates, known as the interest rate spread, is a key source of income for banks, and a portion of this spread is used to pay interest to savings account holders.
Checking and savings accounts in the United States are insured up to $250,000 per account holder by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA) for credit unions. This insurance provides protection to depositors and promotes stability in the banking system.
Money Market & High Yield Savings Accounts
Money Market Accounts and High-Yield Savings accounts typically come with higher interest rates than standard savings accounts. These types of accounts function similarly to regular savings accounts and may limit the number of withdrawals you can make in a month. They’re also FDIC insured covering your account up to $250,000 if the bank were to fail.
Money Market Accounts
Money Market Accounts are interest-bearing accounts at a bank or credit union. Most Money Market Accounts pay a higher interest rate than regular savings accounts and often include check-writing and debit card privileges. They may also come with restrictions that make them less flexible than a regular checking account.
High Yield Savings Accounts
High Yield Savings Accounts are a type of savings account generally available through online banks that offer higher rates (up to 10 to 12 times the national average) of interest than traditional bank savings accounts.
Both Money Market Accounts and High Yield Savings Accounts are said to be suited for individuals who want to earn more interest than they would with a savings account with short-term goals in mind. For these accounts, banks and credit unions generally require customers to deposit a certain amount of money to open an account and to keep their account balance above a certain level. Look into your current bank today and see what options you may have!
Saving Strategies
There are loads of savings strategies out there and if you want to read up on some of the most popular (like Zero-Based Budgeting) you can check out this article here. I’m going to cover the one I try to follow which is the 50/30/20 Rule.
The 50/30/20 Rule states that (if possible) try to set aside 50% of your after-tax income for needs, 30% on wants, and 20% on savings.
50% Needs
Needs would include any bills that you absolutely must pay and are necessary for survival. If you are spending more than half of your after-tax income on needs you may need to try and cut down on wants or downsize your lifestyle. This could include: eating out less, carpooling, or cutting back on those sneaky streaming services that prices always seem to be going up. Examples of “needs” could include groceries, minimum debt payments, utilities, and more.
30% Wants
Wants are all the things you spend money on that are non-essential to survival. You may instantly think wants would be a new pair of shoes, but what they also include are things like gym memberships, eating out, and vacations. These things add up quicker than you realize and that is why it’s as high as 30%. Anything that you don’t need falls into the want category.
20% Savings
Last but not least, you should be trying to allocate 20% of your net income to savings and investments. A lot of experts recommend you have at least three months of emergency savings in case you lose your job or an unforeseen event occurs. From there, focus on putting money into things like retirement accounts, money markets, mutual funds, and everything else we listed above. The other huge thing you can do with this 20% is make debt repayments above the minimum payment in your plan. This can reduce the total amount you’ll pay in the long run due to interest.
Depending on your spending habits and random occurrences throughout the year these numbers can be interchanged. Have an unexpected expense? Try and reduce your wants that month. Receive a substantial End-Of-Year bonus? Try to push that into your savings. Finally, the other biggest recommendation that can be made when it comes to budgeting is to take a month and track where all of your money is being spent. Then you can create these percentages and see for yourself where you can improve.
Lastly…
I want to reiterate that I am not a financial advisor, but rather someone passionate about investing and learning the ins and outs of financial literacy. If you are seeking advice based on what to do with your own personal finances I’d suggest consulting with an expert. Just remember, the sooner the better