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FINRA Investor Education Modules: Preparing to Invest

Preparing to Invest

1. Introduction: Saving and Investing

People save and invest to have enough money at some point in the future to pay for the things they want or need. While you might hear these two terms used interchangeably, saving and investing are overlapping, yet distinct concepts that involve different processes. Stated most simply, saving is the act of putting aside for another day some of the money you earn or receive as gifts, while investing is what you do with those dollars, including choosing products and strategies to make money grow or to preserve the assets you’ve accumulated.

If you have specific financial goals that will cost money such as purchasing a car or a home, paying for college or building a secure retirement accumulating assets and building wealth through saving and investing are the keys to achieving those goals.

Saving for the Future

There are various ways to save. One way is to open one or more deposit accounts, such as a checking or savings account, in a bank or credit union or what you’ll sometimes hear described as a savings institution. Deposit accounts give you ready access to your money, and your account balances are typically insured by the federal government up to a set limit.

Insurance for bank accounts is provided by the Federal Deposit Insurance Corporation (FDIC), while insurance for credit union accounts is provided by National Credit Union Share Insurance Fund. The insurance currently protects individual, joint, business and trust accounts up to $250,000 for each depositor in a participating bank or credit union. As a result, when you put money into an insured bank or credit union account, you don’t risk losing any of your money neither the amount you put in, which is your principal, nor the amount you earn in interest. Retirement accounts in those same institutions are insured up to $250,000 for each depositor, provided all the money is in bank accounts.

Another way to save is to purchase U.S. savings bonds either through an online account with Treasury Direct (www.treasurydirect.gov), at a bank or sometimes though a program where you work. Savings bonds are backed by the federal government, so your money is safe. While maturity dates differ depending on the type of bond you buy and when you buy it, most saving bonds continue to pay interest for at least 30 years from the date of issue. Series EE savings bonds pay a fixed rate of interest, while Series I savings bonds pay interest linked to the rate of inflation.

You can’t cash a savings bond for a year after you purchase it, and you’ll lose three months’ interest if you cash it in within the first five years. After that, you can cash it any time without penalty and collect the interest that has accrued.

Earning Interest

Every savings institution tells you the interest rate it is paying, expressed as both a nominal, or named, rate and an annual percentage yield (APY). If the APY is larger than the nominal rate, even by a little bit, that means the interest is paid more frequently than once a year, and that the interest earnings are added to the principal (or amount on deposit) each time they are paid. This process, called compounding, creates a bigger base on which future earnings can accumulate.

Banks and other financial institutions use a complex formula to calculate how interest compounds over the years. But you don’t have to be a math whiz to see how your money can grow. The Rule of 72 is a shorthand way to figure out how many years it will take for compounding to double your money at a particular interest rate. What you do is divide the interest rate you’re earning into 72.

For example, let’s say you have $1,000 and you want to know how long it will take to double your money. If you earn 6 percent interest each year on your account, you divide 72 by 6:

72 ÷ 6 (representing 6 percent interest) = 12 (years to double your money)

At the end of 12 years, you will have just over $2,000 in your account.

Remember, this illustration only focuses on the impact of compounding on your initial deposit of $1,000 and does not take into account any additional deposits you might make over time. If you were to deposit $100 each year to your account, it would take only six years for you to have $2,000.

The true magic of compound interest is that you earn interest not only on your principal, but also on the interest you accumulate each year.

Learning About Bank Products

Savings institutions offer different types of accounts, sometimes described as bank products, which pay different interest rates. In general, the higher the rate paid on an account, the more limitations there are on access to your money. These are the most common types of accounts:

  • Basic savings accounts usually pay interest at a lower rate than other bank offerings, though some institutions may pay higher than average rates, especially when they are competing for customers. You can withdraw or make additional deposits any time you like.
  • Money market accounts usually pay a somewhat higher rate than basic accounts, but typically limit the number of withdrawals or transfers you can make each month. These accounts may impose fees or stop paying interest, or both, if your balance falls below a certain minimum.
  • Certificates of deposit (CDs) pay the highest rates, but require you to leave your money in the account for a specific term, or period of time, to earn interest. If you take your money out before the CD matures, or reaches full term, you may forfeit some or all of the interest you expected to earn. Generally, the longer a CD’s term, the higher the rate of interest it pays.
  • Seeking Growth Through Investing

    If you are willing to take a certain amount of risk with the money you have saved, you can use it to make investments that you expect to be worth more in the future or to pay you regular income over time at a rate higher than you usually can earn on a bank account or both.

    Two of the key ways in which investments differ from savings accounts are: (1) investments are not insured by the federal government and can lose value, and (2) investment earnings are not guaranteed. If you choose your investments carefully and if the financial markets perform in your favor, your return or what you get back on the amount you invest can be higher, sometimes much higher, than you could earn on an insured savings account.

    Higher expected returns are accompanied by risk. By investing, you take the risk that the investments you choose may not live up to your expectations, or that troubles in the marketplace may depress investment prices. You can have a loss if you sell your investment for less than you paid for it. In a worst-case scenario, your investment might lose all its value. You can limit your risk, however, by not putting all your eggs in one basket and by choosing a well-diversified mix of investments.

    While there are many things of value that you might choose to buy because you expect them to provide a profit, the term investment is usually used to describe products that are traded in an organized and regulated marketplace. The best known investments include:

  • Stocks, or equities, which give you ownership shares in a corporation.
  • Bonds, or fixed income, which promise (but usually don’t guarantee) repayment of the money you invest plus interest for the use of that money.
  • Mutual funds and exchange-traded funds, which are pooled investment vehicles that invest in stocks, bonds or other financial instruments.
  • Cash equivalents, which include U.S. Treasury bills and other short-term interest-paying investments, such as money market mutual funds (as opposed to money market deposit accounts at a bank).
  • Other types of investments include listed options, which are contracts to purchase or sell a stock at a set price in the future, and real estate investment trusts (REITS), which invest in properties or, less often, in mortgages on properties. Purchasing shares in a REIT is very different from the direct purchase of real estate. The latter can be considered an investment in the sense that a house or property can increase in value and may provide income if you rent it out to a person or company. An important difference, though, is that real estate is not traded on an organized market where there is almost always a buyer when you want to sell. In fact, while real estate may sell quickly in some periods, it may sell very slowly in others.

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