The term investing is thrown around fairly loosely. Many times people talk about investing when they are really saving or even spending. Knowing the difference is important, because putting your savings in investments or your investments in savings can lead to bad results.
Saving is when you put money aside for later use. Realize that money is just a storage vessel for past work that was done, so putting a few hundred dollars under your mattress from a paycheck is a way to store the value of the work you did until you are ready to redeem it for work or goods others produce. Most of the time other methods are used to save money than simply keeping cash, such at putting deposits into a bank account. Bank accounts, money market accounts, and checking accounts are all appropriate places for keeping savings since the money will be readily available when needed.
The important aspect of savings is that the stored for use in whenever needed. Ideally savings would maintain its value indefinitely. Unfortunately, because governments often print money to pay for things without creating something of value in exchange, money stored in cash bills will decline in value over time, typically at a rate of about 3-5% per year. This is known as inflation. Lately the US government has been printing a lot of money and doing things like buying government bonds and mortgage securities. A wave of inflation is sure to follow.
Typically, no matter what rates are being paid, the interest earned from bank accounts will be less than inflation by a little bit. This means that savings will be declining in value each year; therefore, money should only be saved when it will be needed within a short period of time – maybe 1-5 years in the future. Over this period of time the amount lost to inflation will normally be fairly small and worth the security of knowing the funds will be available.
Value to be held for long periods of time must be protected from inflation. The only way to save for more than ten years is to convert the money into a commodity such as gold. Ironically, holding gold is very risky for short periods of time since the value can change rapidly but very safe if held for tens or hundreds of years since the relative value will be maintained – unless someone finds a way to make gold from scratch.
In investing, money is put at risk in order to produce more money. Examples of investments are stocks, real estate, and bonds. A purchase such as a car can be an investment if the car is used to generate income (for example, driving to work or making deliveries). Only the amount of the car purchase needed to perform make an income is an investment, however. Buying a $40,000 SUV to get to work when a 5-year old Chevy Sprint will do the trick is spending, not investing.
Investing involves risk but that risk, meaning that the actual nominal value of an investment can decline in value. The risk of losing money in an investment is reduced dramatically when an investment is held for a long period of time. This means that the chances of losing money from an investment over a long period of time are well offset by the certainty of losing value if the money is saved instead.
For example, if one puts $1000 a mutual fund and then sells it after six months, the chances that the fund will be worth $1200 are about equal to the chance that the fund will be worth $800. If one puts money into a fund and sells it after 20 years, chances are very good that the fund’s value will have doubled two or three times, while the purchasing power of the same $1000 left under the mattress would be equivalent to $800 or less.
A final concept is a speculation. With speculation, the longer it is done the more likely it is that the individual will lose money (and a substantial amount of money). For example, the longer one day trades stocks, the more likely it is that one will lose money. This is because the odds are against the speculator – often substantially – while they are with the investor. A speculator plays roulette and may make money in short spurts but will lose money over time. An investor buys a casino and may have a few bad nights, but will see large profits over months and years.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.