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Now that you know how to budget, let’s start growing that extra money you have! Everyone knows the term “investing,” but what does it really mean?
Investing is the act of setting aside resources, usually money, in an effort to generate profit or income, according to Investopedia. For personal finances, I’ll be focusing on the “generating income” part of that definition and on increasing that income section of your budget.
To understand why it’s important to do some form of investing, one must first understand inflation. Inflation is the rise in price levels relative to the amount of goods and services in the economy, and it results in a decrease in the purchasing power of each dollar. Basically, what you can buy for $20 today will be more than what you can buy for $20 in 10 years. Inflation happens when the economy is growing, and it averages around 1-2% annually.
The Federal Reserve typically targets an inflation rate of 2%. But with its new low-rate strategy, we will likely be seeing lower rates through 2023. So if you’re keeping your money in a checking account or in cash, you’re losing purchasing power — and essentially losing money — over time.
Your money grows through interest, and interest rate is the rate at which your money grows or multiplies. Compound interest is a powerful concept in which your money multiplies as you gain “interest on interest.”
At the end of your investment period, much of your gains will be composed not of your original investment but of compounded interest over the years. Free money! Sounds good, right?
So, what’s the catch? Risk. The higher the interest rate, the higher the risk. There are a variety of ways to manage and minimize risk, but in short, diversification is key. Don’t put all your eggs in one basket. Here’s some different “baskets” you can choose from:
- Bonds: By purchasing a bond, you’re essentially extending a loan to the federal government through treasury bonds or to a company in exchange for a fixed coupon rate, or interest rate. The riskier the bond, the higher the coupon rate will be, but the chance that you may lose your initial investment if the company goes bankrupt will also be greater. Treasury bonds are essentially risk-free because they’re backed by the federal government. Rates for treasury bonds and bills are typically lower, and they’re great options for someone who is risk-averse and looking for a long-term investment. Bonds have a set lifetime, typically of three, six or 12 months or as long as 10 years.
- Stocks: Stocks are investments made through purchasing partial ownership of a publicly traded company. Stocks tend to be riskier because the value of your stock can fluctuate with little predictability. Some stocks can give dividends paid out to you annually. The amount you purchase the stock for will likely not be the amount you sell it for. The goal is to buy low, sell high. The stock market, especially during a pandemic, can be unpredictable, so the risks and returns for stocks are highest of all the listed options. You can keep stocks for as long or as little as you’d like.
- Savings account: Savings accounts are possibly the simplest method of investing. This method involves opening a high-yield savings account at your chosen bank and depositing your desired amount of savings. The difference between a savings account and a checking account is that a high-yield savings account will limit the number of withdrawals permitted per month. For example, American Express limits the accounts to 9 withdrawals per month. This is a great option to place emergency funds.
- Roth IRA: A Roth IRA is a retirement account that’s most beneficial to young savers. The greatest benefit of a Roth IRA is that your gains are tax-free. The historical interest rate on a Roth IRA is also 7-10%, with very minimal risk. The minor drawbacks to a Roth IRA are that there are only specific scenarios in which you could withdraw your money without penalties, including paying student loans or taking a mortgage. The minimum deposit amount to start a Roth IRA is $1000, and the maximum annual contribution is $6000. If you’re able to, opening a Roth IRA account when you’re young will allow you to reap the full benefits of compounding interest. When accepting a full-time job, take full advantage of employer matching to Roth IRA and 401k accounts. It’s free money!
All in all, don’t work for your money, make your money work for you. As always, if you have any additional questions or would like to further explore different investment options, make an appointment with me or any Smart Money Coach at the Office of Financial Literacy through Orange SUccess!
Andrea Lan is a junior finance major. She is a Smart Money coach in the Office of Financial Literacy. Her column appears bi-weekly. She can be reached at [email protected].
Published on October 4, 2020 at 10:08 pm