subject: Choosing The Right Investments For You [print this page] Many people are interesting in making investments in order to establish and increase wealth, yet for those without a sound understanding of the conventions of investing, what types of investments are available, and how they work, investing can seem like an elite private club to which they will never be granted access. A Quick crash course in investing and the use of a helpful analogy can answer these questions and help demystify investments.
There are three main investment categories into which most investments fall; short-term investments, stocks and bonds. Let us use the example of Jim's lawn mowing business to illustrate the difference between them.
Jim needs some money to start his lawn mowing business, so he borrows $100 from his father. Jim writes an IOU to his father for $100 to be repaid in a year, plus 5% interest. This paper becomes what is called a bond. When Jim's father loaned Jim the money, he essentially invested in Jim's lawn mowing business by purchasing a bond, and will receive his $100 back, plus 5%.
Jim still needs some more start-up cash, so he sells half of his lawn mowing business to his friend Jack for $50. Jim puts the transaction in writing; "Jim's Lawn Mowing Service will issue 100 shares of stock. Jack will buy 50 shares for $50." Jack just bought stock in Jim's business, and is now considered a shareholder, or a partial owner of the business.
Jim's Lawn Mowing Service has a great month and earns $500. The costs for establishing the business were $150, and Jim pays himself $100 for the hours he worked. This means Jim's Lawn Mowing Service made $250 in profit.
At the end of the year, Jim pays back his father $100 plus $5 interest from the $250 profits. He pays $20 to Jack and himself as shareholders. Jim decides to put his $20 in the bank in a savings account, which is a short-term investment.
This example covers all three basic types of investments in simplified form. Of course, it is important to understand that there are advantages and disadvantages to each of these investing options. Stocks have historically outperformed other investments, which has made them a popular choice among serious investors. Stock holders also have a say or voting rights in the direction of the business, where bondholders and bank depositors do not. However, the values of stocks fluctuate often, and there is no guarantee that a stockholder will make a return on his investment.
Bonds have the advantage of carrying a higher interest rate than short-term investments, meaning that they are worth more over time. They are also a less risky investment than volatile stocks. But selling bonds before they are due can result in losing money, and if the business issuing the bond goes bankrupt, you lose the entire value of the bond.
Short-term investments are considered the most secure of the three because they are guaranteed by the federal government. However, short-term investments have very low interest rates, and can actually lose value once they are adjusted for inflation.
Once people understand how these different types of investments work and the risks they involve, they can then choose the investment, or combination of investments that work for them.
