Introduction To Investing Basics

By | April 10, 2006

What is Investing?

The idea behind investing is that money is put to use in such a way that it is likely to turn into more money. This could happen because someone is willing to pay interest to use the money or because the value of whatever security the money was used to buy increases during the period of ownership. Destinations for invested money include savings accounts, stocks, bonds, mutual funds and numerous other investment options.

It is important to note that because money can be invested, the value of a given amount of money changes over time. The longer that a given amount of money is under your control, the longer you have to invest it and make more money from it. For this reason, it is almost always preferable to have money sooner rather than later. The name given to this concept is the “time value of money”; that is, the idea that a dollar now is worth more than a dollar in the future, because a dollar now can accrue value through interest or other appreciation until the time at which the dollar in the future would be received.

At the same time, there is a penalty associated with not investing the money that you already have. Because prices tend to rise over time, the value of money gradually decreases. This effect is called inflation. Money that is not invested or that is accruing value at a slower rate than the rate of inflation is becoming worth less and less as time passes. Therefore, investing is not only an opportunity to make more money, but it is the only way to protect the money that you already have.

Another spectacular benefit associated with many investments is compounding. Money that is earning interest grows at a constant rate, paying the same amount of interest at the end of each time period. However, if that interest is added to the principal that began earning money originally, there is more money earning interest. In this way, interest causes money to increase in value exponentially over time. As more and more money earns interest, more and more interest is earned. This scenario is constantly playing out in bank accounts, CDs, and any other investment that offers compound interest. The more frequently the interest compounds, the bigger the payoff because, on average, more money is earning interest at any given time.

At this point, it is important to distinguish between investing and gambling. Earning interest and taking advantage of compounding may not produce the immediate jackpot that comes with winning the lottery, but the risk of ending up with nothing is often far worse than waiting for a safe investment to pay off. Pouring a great deal of money into one stock is very similar to gambling. It could pay off, but if it doesn’t the potential losses are great. Safe and diverse investments may slow the pace of returns, but they also prevent the bottom from falling out and leaving you with nothing. For a further analysis of the distinction between gambling and investing, read “What is the Difference between Gambling and Investing?

Getting Started

As soon as you begin to bring in enough money so that a portion of it may be set aside for investing, a plan is necessary to take full advantage of that money. The amount of money available to invest also plays an important role in what investments can be purchased. Some investments are subject to limited access because they require certain minimum amounts. More generally, investing a greater amount of money opens the door to a portfolio with more risk and potentially greater returns. However, despite the importance of investing to your overall long-term financial situation, money for health, auto and life insurance and retirement plan contributions should be a higher priority, and should be budgeted for before beginning to invest. Additionally, investing should begin after high-interest debt, especially credit card debt, is paid off. Because after-tax returns will probably not exceed the interest rates paid on credit card debt, paying off the debt first will increase the amount of money you have each month.

After subtracting out essentials and debt, the first division to make within available funds is between savings and funds to invest. Savings allow for access to cash without the fees and lost opportunities associated with removing money from investments ahead of schedule. They should be highly liquid and will usually be located in a savings account, CD or other safe low-yield investment vehicle. Savings should include an emergency fund and funds for any major near-term purchases. To create a sufficient emergency fund, you should amass enough cash to pay bills for a couple of months in the event of unemployment or cover the costs of major auto repairs or similar unexpected major expenses.

Once those emergency savings are set aside, you can make decisions about where to invest the remainder of your money. These funds differ from emergency savings because they will be expected to outpace inflation, taxes, and other drains on finances to serve as a source of income and security over the long term. In order to achieve higher returns, your money will be subject to a somewhat higher level of risk than for the emergency funds you put in the safe but low-interest investment. One of the most important aspects of investing is determining time horizons. Put simply, it is crucial to know when you will need the money. Common time horizons are based on large future expenses, such as retirement, college, houses or cars. Knowing when money will be needed allows for the most effective investment strategy to be tailored to fit the specific goals that have been outlined.

When funds for investing have been earmarked, it is time to decide how those funds will be augmented in the future. There are a variety of plans to maintain a steady pace of contributions to investments. Of course, the amount invested will have to be adjusted periodically as income and expenses fluctuate, but developing the habit of putting away some amount of money each month is an important part of building a successful portfolio.

Financial Planning

Many people believe that long-term financial planning is only important for the wealthy, or that it’s a task best left to professionals, but in reality there are many steps that the average investor can take to solidify his financial future. The first step in the financial planning process is to determine net worth. An investor’s net worth will serve as a jumping off point to begin thinking about his financial future.

Net worth is simply the sum of an investor’s assets minus the sum of his debts. Assets include all of an investor’s assets including real estate, securities, valuables and cash. The value to use in the calculation is the amount that all of these items could be sold for at the present time. Debts include mortgages, car loans and credit card balances, and should be subtracted from the assets to determine net worth.

Once this financial snapshot is detailed, you can address your specific goals. Always remember to think about both assets and liabilities. It is always nice to acquire new assets, but if assets are appreciating more slowly than debt is growing, net worth is decreasing. It is important to strike a balance between building assets and managing debt.

The goal of financial planning, then, is simply to find ways to increase net worth at a steady pace. Saving money, allowing assets to appreciate, and paying down debt will all contribute to this goal. Incoming cash minus expenses will reveal how much money is available to an investor at the end of a given time period. If this value is negative, expenses are outpacing income, and the difference will have to be paid from savings, decreasing net worth. This is obviously dangerous because if the situation doesn’t change, eventually the reserves will run out. If income sufficiently outpaces expenses, it might be time to start contributing to net worth in earnest by acquiring assets and eliminating debt.


One thought on “Introduction To Investing Basics

  1. None

    First I’d say STAY AWAY COMPLETELY from ING Direct.

    Back in September 2001 I opened an account with $10K. Within 2 months I added another $10K to the account. Then I tried to get my money out 18 months later and for over 3 months ING DIRECT kept sending me in the postal mail system a notice saying “Invalid Account Number”. Even though I called them numerous times to correct the problem, ING Direct continued to site the “Invalid Account Number” excuse and sent rejects via mail even though ING DIRECT had both my work and home numbers (both with answering systems attached). The folks at 1-888-ING-0272 were of no help. Mostly excuses and more excuses but they never solved the problem.

    I had to write them two checks for one dollar to finally get my needed money. The first check resulted in the account number being updated according to the letter but when I requested the transfer I got the “Invalid Account Number” excuse again. The whole thing took a second check for a dollar (with a letter from my new lawyer) before they got me my money 6 months after I needed it. (We lost the house because I could not get the down payment out of ING DIRECT from my account.)

    Then in 2004 I emptied the account down to $40.00. I changed my will to include the ING DIRECT account as a gift to my granddaughter when she turns 65, she is 8 now and was 5 then. I left the account in my name so that I was responsible for the taxes on interest until my death. Then I proceeded to forget about the account and talk to anyone I hear talking about ING DIRECT out of doing business with ING DIRECT. I think I am mostly successful in my attempts even today.

    This month I received a letter from ING DIRECT out of the blue. Since September 2005 ING DIRECT stopped sending me quarterly statements.. In the letter ING DIRECT states account was closed. The statement says “Since your Orange Savings Account has had little to no activity it looks like we weren’t able to help you save. As a result we closed your account.” Yet on the same statement the “Year to date interest” is $1.10 at an “Annual Percentage Interest Yield” of 4.47%. So it has had activity through 3 quarters of the year.

    So now an 8 year old girl lost her future account. The almost $50.00 was transferred to my checking account and now I have to go back to the lawyer to remove the account from my will. Yet THEY NEVER GAVE ANY WARNING or ATTEMPTED TO CONTACT ME before closing this account. I’d have easily transferred as much as necessary to keep it open. And I have a great credit score so I know they could not have decided to can me due to bad credit rating.

    ING DIRECT has no concern for you as a customer, they just want your $25.00 to start and then more. But if you don’t keep adding to it ING DIRECT will just throw you out without any warning at all.

    My advice to one and all, STAY AWAY FROM ING DIRECT!!! Go to any other on line bank and you will be much better off.


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