Finance 101: Long Term Investments
The world of finance can be an intimidating place, especially for those with little exposure or understanding. Terms like return-on-investment, 401K, inflation and 'mutual funds' are enough to make anyone's head spin. While daunting, matters of money can be boiled down to easy concepts, making the world of finance much more approachable.
One of the most common questions I hear is about investing: if you've managed to save up a sizable amount of money, what should you do with it? What's the best way to manage its growth? Questions like this can keep you up at night, wondering if you're losing out on potential earned income.
Pretend you have $10,000 in your pocket to do with as you please. That's a pretty nice start. But what now? You could go on a shopping spree... pay off your credit card debt... but for the sake of this scenario let's say you want to save that money. There are plenty of ways to invest, some will protect your money and some will help your pile grow. Let's look at the most common saving and investing options and see what can happen to that money 10 years down the line.
Option 1: Stuff it in your mattress
If you don't trust anyone but yourself with your money, you may opt to keep it hidden in your home. In 10 years, when you remove the money from your mattress... or whatever other non-interest earning location you might consider ... you will be left with the exact same amount of money (and a very old, used mattress). No surprises there.
Option 2: Put it in a savings account
A bank savings account is one of the safest places to keep your money. In return for storing your money in the bank, you receive interest, which is the bank's way of paying you to deposit the money in their bank. Why would a bank pay you to keep your money? The bank does not simply let your money sit in an account. They take your money and lend it to others, collecting a higher interest rate. Essentially, they are making money from your money. A typical bank will pay you an interest rate around 0.06% each year. If you kept $10,000 in a savings account with a 0.06% interest rate, in 10 years, you will end up with $10,616. That's right, you earned $616 for doing absolutely nothing.
Option 3: Put it in a savings bond
Think of a savings bond as a small loan. When you buy a bond, you are lending money to a company or government for a set amount of time, with an agreement that they will pay you interest on that loan. When you purchase a 10-year bond to the US government, this simply means you are lending your money to the government for 10 years. The government is then obligated to pay you back the entire amount of your loan with interest at the end of the 10 years. Currently, buying a 10-year government bond will earn approximately 2.5% in interest each year. At that rate, if you buy $10,000 in US bonds, you will have approximately $12,800 in 10 years.
Option 4: Put it in the stock market
Although unpredictable, historically, the stock market has been a lucrative place to invest. The average yearly percentage increase is around 8% when averaged over the lifetime of the market. If you choose to invest in the stock market, each year, on average, your money is worth 8% more than the year before. In 10 years, if you averaged an 8% return each year, your $10,000 investment would be worth $21,589! Of course, this does not prove to be true every year, and there are years when the market will go up or down by a much higher percentage than 8%. But if you are a long-term investor, 8% per year is not unreasonable. If you are concerned about needing the money in your savings in the short term, the stock market may not be the best option for you, simply because of its volatility.
When saving money, another important concept to consider is risk. Every type of investment has some amount of risk of losing money. In most situations, the higher the risk, the larger the possible reward on your investment. Putting your money into a savings account or shoving it in your mattress has virtually no risk, and thus a lower return on investment since the interest rate is low. On the other hand, the ebbs and flows of the stock market proves it is a risky place, but the average return on investment skews higher.
Your money and what you choose to do with it is all a matter of understanding your financing options and how they can impact your bottom line. The bottom line: before you do anything with your savings, make sure to research and fully understand all of your options.