This week’s word is: Investing. I chose this word for a couple of reasons. First, I have been having an ongoing conversation with my husband about why he hasn’t rolled over his 401K to his current job yet--to me, it makes sense to have it all in one place, he says that there may be value in the additional diversification that comes from having a 401K with two different companies (that, and he doesn’t know how to roll it over...). Second, I have been thinking more and more about preparing to send my girls to college and know that the investment options (the 529 or the Coverdell plans) make a lot of sense (and I should probably get something started before they are college age).
So, for those of you who don’t know (or have hidden in the blanket fort with your kids whenever the subject of investing has been brought up), the idea of investing is actually pretty simple. Investing means putting your money to work for you. The long-standing idea of how you earn money, by working and getting a paycheck, is true, but has limitations-the number of hours you can work, the probability of raises, etc. Investing is a way for people to get around those limitations and earn money without having to be physically present and without the limitation of employers setting a wage.
Maybe you’ve heard the term “investment vehicles?” These are the ways to invest and include stocks, bonds, mutual funds, real estate, starting your own business, etc (i.e. these are places where you put your money with the expectation that it will grow over time). And all of these work on the same basic principle-compounding.
In basic terms, compounding says, if you invest $100 with a 6% annual interest rate, at the end of a year you will have $106. Investing works because you don’t take that extra $6.00 out and spend it, rather you leave it alone and start year two with $106 dollars and earn the 6% on your initial investment AND on the money you earned the previous year. If you do that year after year, your initial investment will continue to grow. The same is true with starting a business, if you invest $100 to get your business off the ground, and see a 6% return in the first year (i.e. you make $106 dollars in sales your first year) and then reinvest that $106 dollars in your business for added advertising or product development, then you can expect a higher return in year two and each successive year.
I want to clear up one thing before we go any further, there is a lot of confusion around investing when people start talking about risk, specifically the comparison between investing and gambling. Trust me when I say this, investing is not gambling. Gambling involves a blind hope that luck will turn the odds in your favor even though you know that the odds are against you winning anything. Investing, on the other hand, involves research and planning, and only involves an investment of capital after you have determined that there is a reasonable expectation of profit. There is risk in both, but the risk in investing a calculated and mitigated by the long-term nature of investments, while the risk in gambling is often unknown and constant.
I really want to continue the discussion of investment vehicles, but most of them require more a whole article all to themselves, so I will stop here. Hopefully that clears up a little of the confusion about investing as a broad concept. Come back next week and dig a little deeper into one investment vehicle-Mutual Funds.
Alisha- Kirby Roo Mom and Slayer of Scary Words
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