Bottom line there are two ways to make money (besides the old-fashioned way; inheriting) is by working for it and making it work for you. Here is some Investment 101 that will help you get started on your quest to make your money work.
Investment 101: Basics for Beginners
Saving and investing seem like daunting tasks. There can be a mountain of details and jargon to sift through. However, if you start with the basics, they’re actually fairly simple.
It’s going to be helpful here to think in terms of value instead of money. Saving is keeping the value you’ve earned for a later time when you need it. Investing is managing the value so the amount you have stays at least the same or grows larger by the time you need it. This growth in value is usually called a “return.”
We earn value for doing valuable things and we get paid in cash, the most convenient way to measure and trade value. The value of things relative to cash and to each other changes over time. There are some very smart people with good ideas on how to model and predict these changes. However, no one really knows with any certainty how these values will shift. Here are some major classes of investment that we use to safeguard our savings against unexpected change.
When you need money (or value) for something, you borrow some and then pay it back with a little extra on top, the “interest.” It’s called a loan. Big companies and governments do the same thing. They call it “issuing a bond” rather than “taking out a loan”. Sometimes when you get a bond, the return (interest) is paid over the course of the debt, and sometimes it’s all paid at the end.
If you need extra value, instead of taking out a loan, you can just sell something. Companies do this too. An interesting thing they can sell is stock (also called equity). When you own stock, you own a part of all the valuable things a company has, and if you own enough, you may even have a say in what the company does with those things. Owning different stocks can come with different benefits, including regular payments called dividends. Stock can be sold — hopefully, for more value than it was worth when you bought it.
Some materials, like oil, sugar or gold, are inherently valuable. We use them for different things like energy, food and medicine. Just like stocks and bonds, their value shifts depending on economic conditions.
Real Estate and Other Investments
Real estate is another common investment because (assuming you can keep your property rented) it has regular cash flows similar to bonds, and an overall value that can appreciate, similar to stock. Art, jewelry and antiques are also considered investments, but the value they store can be unpredictable. However, if you already own some, don’t discount them. Make sure to have these items appraised, because they’re also part of your portfolio.
What’s a Portfolio? Can You Hold It?
Long ago, stocks and bonds were issued officially as pieces of paper, and could be carried around in a literal portfolio. These days, ownership is kept track of electronically through an account, but we still call the combination of ownership a “portfolio”. Anything you own of value that can grow over time is considered part of your portfolio.
As mentioned, no one is quite sure about the way things will pan out, so the common sense advice in investing is not to keep all your eggs in one basket. The best way to keep your value safe is to own a combination of the investments mentioned above.
5 Reasons to Consider Bonds
The fluctuating stock market has made other investment vehicles, such as bonds, more attractive — and for good reason. Although stocks can boast an average annual growth of around 11 percent as compared to less than 6 percent for bonds, bonds provide real benefits to a wide range of investors. According to the Michigan Association of CPAs, these include safety, predictability, income, diversification, and tax savings.
Reason #1: Safety
For many investors, bonds represent capital preservation. The degree of safety varies based on the bond’s credit strength, but investors generally can be reasonably certain that their original principal will be returned in full if they hold a bond to maturity. That’s not to say that bonds are without risks. Bondholders face credit and market risk.
Credit risk refers to the possibility that the bond issuer will default. Market risk depends on whether interest rates will rise, making those bonds issued when rates were lower worth less. You can minimize credit risk by limiting your purchases to Treasury securities and to bonds with the highest ratings. It also helps to diversify your bond holding across many industries or governments. Owning bonds that have staggered durations, a practice known as laddering, can help to reduce market risk as well.
Reason #2: Predictability
Bonds offer a conservative way to fund future expenses. If you know that you will need money at a set time — to pay for a child’s education, for example — you can buy bonds that come due then and give yourself the peace of mind of knowing the money will be there when you need it.
Reason #3: Income
Conservative investors often use bonds to provide steady income. When it issues a bond, a company guarantees to pay back your principal (the face value) plus interest at a preset, if modest, rate of return. The interest they pay, known as the coupon, is typically a fixed amount. For example, a $10,000 bond issued with a 7 percent coupon generates interest payments of about $700 each year, thus the term “fixed-income investment.” Generally, bonds pay higher income than short-term investments, such as money market funds, CDs, and savings accounts.
Since different types of bonds pay interest at different times, with careful planning and purchasing, an investor can assemble a bond portfolio that offers a constant income stream.
Reason #4: Diversification
It is a well-accepted fact that an investment portfolio’s success depends greatly on its asset allocation, that is, the percentage of funds invested in stocks, bonds, and cash equivalents. By spreading across a variety of investments, diversified portfolios generally offer more reliable and stable returns over time.
Although stocks generally perform higher over the long term, stocks and bonds do well at different moments in the economic cycle. Bond prices tend to rise and fall at different times and rates of speed from stocks, offsetting the volatility of the market. It’s been said that adding bonds to a stock portfolio lowers its return — but it lowers its volatility more.
Reason #5: Tax Savings
If sheltering income from taxes concerns you, consider tax-free municipal bonds. States, cities, counties, and towns all issue bonds to finance a wide variety of public projects. In order to encourage investors to lend money to pay for these projects, interest on municipal bonds, or “munis” as they are commonly called, is exempt from federal income tax. If you buy bonds issued by your own state, they are free of state income taxes as well. Because of this advantage, munis usually pay a lower interest rate than corporate bonds, making them appeal most to investors in high tax brackets who stand to benefit the most from the bonds’ tax-exempt status.
Know what you’re getting into.
Investing in bonds can be more complicated than you might think. To learn more about how bonds can enhance your investment strategy, consult with your CPA.
You seek the expertise of CPAs at tax and audit time, of course. But CPAs also promote personal and professional financial security year round. Visit the CPA Referral Service on the MACPA website to search for a CPA in your geographical area or specific area of expertise.
This article was submitted by the Michigan Association of CPAs.