Welcome to Frugal Fridays where we share money saving tips, discuss living frugally and generally talk about personal finance issues. Today I want to discuss some basic concepts your should know about savings and investing. When you start out looking for investment information, you can be swiftly overwhelmed by folks who crawl out of the woodwork to offer opinions and advice. Often they use confusing jargon and make claims and assertions that sound great, but you have no idea if they are telling the truth or not. So here, free of charge and with no obligation to you, I'm going to explain some of the fundamental concepts and terminology of investing so that you may better understand the potential benefits and consequences of the choices you make.
Despite my best efforts, this discussion comes out pretty dull and dry, but this is important stuff, really If you are an investing neophyte, pour yourself a big cup of coffee, prop your eyelids open with toothpicks and follow me below the fold.
Disclaimer: I am not a financial professional. I'm just a consumer who tries to be educated. Take anything I say with a grain of salt.
Saving vs. Investing
A few weeks ago, in my diary on how to make a budget, I suggested that people should try to save at least 10% of their pre-tax income. One of the commenters replied something to the effect of, "don't save, invest!" and I thought, "what we've got here is failure to communicate." Saving is the act of not spending your money. What you do with your savings is investing. Whether you are stuffing it in your mattress, funding your 401K or paying off your mortgage, you are investing your savings in one form or another. Yes, even stuffing it in your mattress could be termed investing. It is investing in cash. It's really unlikely that investment will ever show a positive return, but it's a choice some people have made.
Liquid vs. Solid
In investing an instrument can be both liquid and solid. I'm sure that offends the sensibilities of the physicists who are reading this, but these terms mean something different than what you may be used to. A liquid investment is one that is easily exchanged for another instrument. Cash is the most liquid of all instruments, while real estate is among the least liquid forms of investments. A solid investment is one that has relatively low risk (see below for more information on risk). A savings account at a bank that is FDIC insured is an investment vehicle that is both liquid and solid at the same time.
Principal vs. Earnings
The principal is the amount you originally invest while earnings are the amount you get back in excess of the principal. Sometimes you don't realize any earnings until you sell your investment. Sometimes you get earnings before you liquidate in the form of interest, dividends, rent, etc.
Risk vs. Return
Every investment has a certain level of risk. Whenever you give your money to someone else there is a chance they won't give it back. Even your mattress has risks, as many a house fire victim can confirm. If you are looking for the most risk free investment, look for something that is guaranteed by a government that is itself stable. For example, FDIC insured bank accounts or US Savings bonds are pretty safe. As long as the US government is still around, you will not lose your principal.
The rate of return is the earnings divided by the principal. A negative rate of return means that your principal actually shrunk and you have less money than you started with. For very safe (low risk) investments, your rate of return will be pretty low, but it is guaranteed to not go negative. If you want to increase your rate of return, you will need to be willing to take on more risk. Unfortunately, sometimes risky investments don't pay off, but that's why they call it risk. Before you enter into any investment, you should be aware of the potential downside, as well as the upside. If anyone offers you a "no-risk" investment with a great rate of return, run, do not walk, to the nearest exit. They are trying to scam you.
Taxable vs. Tax-Deferred vs. Tax-Free
When you earn money from an investment, that gain is usually subject to some sort of income tax, whether that gain comes in the form of a capital gain, interest payment, dividend, or what have you. These are called taxable investments. However, there are retirement accounts that most people have (or should have) that aren't immediately taxable. Some (such as standard 401Ks and IRAs) are tax-deferred. This means that gains that you make in that account are not taxed when you realize them. For example, say you have an IRA that you invest in the stock market. When you sell a stock held in that account, you owe no tax on the gain. Under these rules, your balance in the tax-deferred account will grow much faster than the balance in an equivalent taxable account if you do any trading. If you just buy a single stock and hold it for 20 years, both accounts would grow at the same rate. The drawback with an IRA account is that when you finally do retire and take withdrawals from the account, those disbursements are taxed at your ordinary income tax rate, which is probably higher than the capital gain tax rate you would pay for gains in a taxable account.
There is a second type of IRA (and 401K) available known as a Roth accounts that are tax-free. Once you put the money into the account, you will owe no taxes on any gains you make and any withdrawals you eventually take. There are a bunch of restrictions with these accounts limiting how much you can put in, and when and how much you can take out, but for most people, if you qualify, you should definitely open and fund these accounts.
IRAs and 401Ks are not the only tax-free or tax-deferred investment opportunities out there. They are just the ones most people will encounter. There are also tax-free bonds and other tax-free or tax-deferred types of accounts such as 529 Plans or Coverdell Plans that can be used to save for college or other education expenses.
Net Worth vs. ??
I wanted to define this one last term, but I couldn't think of anything to compare or contrast it to. Your net worth is the sum of your assets minus the sum of your liabilities. If you add up the worth of all the things you own (your house, car, stocks, bank accounts, pension fund, etc.) and then subtract what you owe to every creditor, you come up with your net worth. Most people start off their adult lives with a negative net worth (due to student loans, usually) and gradually work themselves out of the hole. If you are in a hole, don't be discouraged, but do be aware that you need to turn that situation around before you will be able to retire.
Finally, I'll leave you with my new motto (that I stole from Mr. Sallycat, but he doesn't read this, so he'll never know):
A dollar not spent is better than a dollar earned...it's not taxable!
Further Resources
If you want to read even more, here are some good resources I've found:
- BankRate has good advice articles, calculators for various financial purposes and is also a great source for finding banks that offer the best investment return rates for IRAs, CDs, Money Market Accounts, and other types of accounts.
- Investopedia is another site with a very good glossary where you find the definition of many other confusing terms you may encounter and advice articls.
- Dinkytown has a ton of financial calculators for almost every conceivable scenario.
Frugal Tip of the Week: You can get free directory assistance from your phone by calling 1-800-GOOG-411 (1-800-466-4411). I played with this a little and it is really easy to use and fast. It has one big downside, it doesn't have residential listings. For those, you can use 1-800-FREE-411 (1-800-373-3411). With this service, you have to listen to a couple ads, but there is no charge for the call. Unlike the Google service, I had a hard time searching by business category for my local area with this one. It kept trying to give me suggestions that were farther away, but that they obviously were paid to list. Also, unlike the Google service, it is not entirely voice driven so it doesn't work for hands free operation.