This post was written by Nathan Richardson the founder of ComplexSearch. Nathan enjoys blogging deals and help consumers save money.
One of the basic rules of investing is this: Don’t invest in something that you don’t understand. The violation of this rule is one of the reasons that we ended up with a financial crisis that threw the entire world into economic recession. However, this does not mean that investing is bad. Indeed, you will probably need to invest in order to build up enough wealth to get you through your later years. But before you invest, consider the basics.
Most people invest in cash, bonds and stocks. It is a good idea to have an understanding of the risks associated with each of these financial products.
Cash
Most people do not think of cash as an investment. Many financial planners and investment professionals simple speak of “cash products.” However, cash does provide a return. It is usually a rather small return, but your money is working for you then it is in cash products nonetheless. You can put your cash in a high yield savings account or build a CD ladder to help boost the returns you get from cash.
The main reason that cash offers such low returns is due to its safety. It is practically impossible (although actually possible in theory) to lose money when you are dealing with cash. The main way that people lose money with cash is through inflation. If you are only earning 2% annually on your cash, but inflation is at a 3% annual rate, you are really losing money, since your purchasing power is eroded. However, in terms of losing your dollars, it is not very likely – especially since many cash products are FDIC insured, guaranteeing that you get your principal back (up to $250,000 an account), even if the bank fails.
Bonds
Generally, bonds are considered riskier than cash. They are not FDIC insured, and there is a real chance that you will lose some of your principal. Bonds, at the most basic level, represent a loan to some organization. When you invest in bonds, you are providing capital to a government organization or company. In return, that entity pays you regular interest, and then returns the principal to you when the bond matures. The main risk is default on the repayment of the loan. You still have the interest that has been paid up to that point, but you could lose out on principal you fronted to the organization.
As with most investments, the riskier something is, the higher its potential returns. A U.S. government bond offers a very low risk of default, and so the interest paid is lower. Emerging market governments, though, offer a higher chance of default, so when you invest in those bonds, the interest you are paid is greater. Companies range in chance of default from small to great, and if you are willing to take a chance, there are bond investments that can help you beat inflation and end up with a tidy little return. There are agencies that rate governments and companies so that you can get an idea of the risk of default (although these ratings agencies may not be wholly accurate).
Stocks
While a bond represents a transaction similar to a loan, a stock share represents ownership in a company. When you purchase stock shares, you are purchasing a small bit of the company. As a result, when the company does well, so do you. Stocks are bought and sold on exchanges, and when a company’s stock is in demand, its share price rises to reflect its desirability. On the flip side, though, when a company is perceived as being in trouble, its price drops. If you sell a stock when its price is lower than when you bought it, you lose money.
Because stock prices are driven largely by perception, they can be volatile. Something that is doing well one day may do terribly the next. Investing in individual stocks – especially those from new companies – can be quite risky. As a result, you could see better returns than what is seen with cash and bonds. However, with that increased earning potential is a chance for bigger losses.
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