As you start to earn money and set it aside, it’s important to understand the difference between “saving” and “investing” and what sorts of vehicles are most appropriate to each. You can think of saving as putting your money aside for short or medium-range goals–goals you will mostly be funding with your own cash. If you wish to buy a car, take a vacation, or scrape together the down payment on a home within a one to five-year time-frame, you have a savings objective. “Investing” on the other hand means putting money aside for long-term goals–your child’s college education, for instance, or your own retirement. Long-term investing means committing your own cash as well, but it relies most heavily on the principle of compound interest–the idea that the money you make on your money (interest) gets reinvested and continues to grow or compound over time.
When you have a shorter time horizon, you can’t afford to take as many risks with your money or you may lose part or all of your principal. This is why many people choose to stash their savings in a brick-and-mortar bank or online savings account, a money market fund, a CD, Treasury bills, or bonds. Whatever interest you earn through these vehicles will make little difference in reaching your goal–what’s important is that you are setting money aside regularly and matching or beating inflation with the interest that you do earn.
When you have a longer time horizon, you can afford to take more risks–and potentially enjoy greater rewards–with your investments. Greater risks are incurred because the value of your investment vehicles will fluctuate more than with traditional savings vehicles. The greater time horizon of your investments, however, should protect you from short-term fluctuations in their value, which should (theoretically) rise over time. Investment vehicles typically include things like stocks, bonds, and mutual funds. Stocks, or equities, basically represent a share in the ownership of a company and a claim on the company’s assets and earnings. This doesn’t mean you’ll rate a corner office or parking space at that company–you’ll simply be one of many shareholders who own a stake or share in that business–shares that the company issues in return for capital to grow or invest in itself. A company can also raise money by borrowing it, either directly from a bank or by issuing bonds. Bonds differ from stocks in that bondholders act as creditors or lenders to companies and are therefore entitled to interest on their loan as well as repayment of their principal. Creditors or bondholders typically receive legal precedent over other stakeholders if a company files for bankruptcy, while shareholders are usually the last in line to be repaid. Bonds are often considered safer because they involve less risk, though bondholders are only entitled to receive returns based on an agreed upon interest rate. Stocks are considered riskier because their value can fluctuate much more, though shareholders can enjoy greater returns as a company’s profits soar. Historical annualized returns for stocks have averaged 8-10% while bonds have averaged 5-7% or less.
You can buy individual bonds or shares of stock, but researching individual companies can take a lot of time and effort. An easier route is to invest in a mutual fund. A mutual fund pools the resources of many investors to collectively purchase stocks, bonds, or other assets. For instance, you can purchase a mutual fund that invests in small, medium, or large companies (also known as small, medium, or large-cap funds), a fund that invests overseas, or a fund of short or long-term bonds. This allows you to assemble a portfolio geared towards meeting your investment objectives and your tolerance for risk. A portfolio can be actively managed by fund managers (a load fund) or it can simply be a pool of assets or other funds that belong to a certain index or fund class (like the S&P 500). This later type of “index fund” typically features lower fees. Regardless of where or how you begin to save and invest, it’s important to distinguish between your short-term and long-term goals and the best means of achieving both.