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In the first post of the Investing Guide for Beginners series, I covered the basics of investing. The previous post should have given you a few essential rules you should follow before you invest. However, we did not include details about how to invest in financial instruments.
It is time now we cover more investing details. In this post, I am going to cover the most important financial instruments that you can use to invest: Cash, Bonds, and Stocks.
All these instruments are quite different from one another. They are all important. If you are serious about investing, you should know about them. We are going to see the advantages and disadvantages of each of these instruments.
By the end of this post, you should have a better understanding of them. And you can always ask questions for more information!
Cash is the primary form of money. You need cash. I am not necessarily talking about hard cash in notes in your wallet. I am talking here about money that is directly available if you need it. It can be the cash in your purse, in your checking account, or your savings account. We are going to cover all these forms.
If you have no cash available, you will not be able to make any purchase. You will not be able to handle emergencies where you need a significant amount of cash. Therefore, if you do not have cash, you should start by accumulating a few months of expenses in cash. This money is called an emergency fund.
We will cover this in more detail in the series later. I keep three months of monthly expenses in cash. It depends on many things. If your job is very stable, you probably will not need more than three months. But some people need or want more. If you are close to retirement, you probably want to store more cash.
You should not let it sit under your mattress. Most of your cash is probably in a checking or savings account. Savings accounts will generally give you more interest. But your money will be locked for some time. There is usually a limit in the number of withdrawals you can do from a savings accounts. Be careful to keep some money in a checking account for monthly expenses.
In these accounts, your money is earning some interest. It means that each year, you will make some money. If you are in Switzerland, the interest rates are close to zero. If you are in the U.S., you can easily find accounts with more than 1% interest. It is good, of course. Who does not want to get more money? And it is safe.
However, there is one big problem with bank accounts: Inflation
Inflation is the increase of prices in the economy for goods and services. Since the 1950s, Inflation has almost always been positive. That means that each year, the average price of goods and services is going up. Of course, this highly depends on the countries. Here is the inflation rate in Switzerland since 1956:
For instance, in Switzerland in the last 20 years, inflation has been quite low. It only went once to more than 2 percent after the financial crisis of 2008. And we even had several years of negative inflation. In the United States, inflation has been much higher:
It has seen several years are more than 2-3 percent in the last 20 years.
Investing and inflation
What does inflation have to do with investing?
Inflation increases the prices of goods and services. That means that each year of positive inflation, your money will get you less than the previous year. That means that inflation is reducing the value of your money. Every year your money is worth less than it was the year before. Inflation is very important to know and understand. Many people do not realize this.
In most countries, interest rates are now lower than inflation. Let’s consider an average of 1% inflation. In Switzerland, interest rates are very low, around 0.1%. That means that each year, you are losing 0.9% of your money. This loss will not be reflected on your account, but your money will get you 0.9% less each year!
This concept is very important! If your interest rate was higher than inflation, you could still increase your buying power each year in a bank account. Around ten years ago, interest rates were higher than inflation. However, this is not possible anymore. It may come back. Unless you find a very high-interest rate account (please tell me about it!), checking and savings accounts are not worth it anymore. You should still use it to store the cash you need. But you should invest the rest to fight inflation.
How to beat inflation?
How to find better returns than inflation?
Beating inflation is where investing starts to be a bit more complicated. But do not worry, it is not very complicated either! To fight inflation, you have to invest in bonds or stocks.
For me, details and examples on inflation, read my guide on currency inflation, and how to fight it.
The second financial instrument is to invest in bonds. While everybody had cash, not many people hold bonds.
A bond is a debt. In financial investing, you are lending money to a government, a municipality, or a company. You are lending some amount of money to them. In return, they are giving you some interest on your money. You may think it is the same as what your bank is offering you. But in fact, the bank offers a much lower interest rate than bonds. The reason is pretty simple. They are themselves using bonds as an investment. And they are getting most of the profit! What you want is to have a bond yourself and get the profit.
A bond works like this. You lend the issuer money for a certain amount of years. The issuer of the bond will then pay you some interest on the principal. The interests will be paid annually or semi-annually. At the end of the duration, the bond will mature, and you will get your principal back.
Why not use bonds?
If it is better than a bank account, why does not everybody use bonds?
For two reasons! First, for most people, it is not as convenient as bank accounts. You can get a bond directly from a company, municipality, or government. You can also get them from a broker or a bank. But you need to know what you are looking for. And secondly, there is some risk!
If the bond issuer goes bankrupt, you will not get your principal back. Some issuers are very safe, for instance, treasury bonds from the U.S. government bond. However, their yield is not incredible. Generally, the lower the risk is, the lower the interest rate. If you want a very high yield, you need to take on some risk.
Historically, you can expect around 2% of Swiss bonds. However, now, Swiss bonds are terrible investments. They have a negative yield. It means that each year (or month), your money is going down. Thanks for the Swiss government. Fortunately, you can also get bonds from other countries. In this case, do not forget about the risk of currency exchange.
You have another option to invest in companies. You can directly buy some stocks from them. By owning stocks (or shares) of a company, you own a part of it.
A stock is a share of a company. It is a part of the company that you own. If you own some shares of a company, you own some part of the company.
There are several advantages to stocks. First, if the company goes well, the price of the stock should go up. And as such, your investment should go up as well. Second, most companies pay some dividends to their shareholders. You will receive, generally quarterly, some money for each share you own. Finally, you own a part of a company. If you like a company very much, it would be good to own part of it. And if you own enough shares of the company, you can be a part of the company’s decisions.
How good are stocks?
So, stocks are the best investment?
It is a good investment, but not a perfect one. Even though the stock price is generally going with the financial health of the company, it is also based on the market. The price is driven by demand and offer. If a lot of people want to buy one specific stock, it will drive the price up. There are some trends in stock investing. That means that the companies that you are likely to be interested in are likely to be overpriced. Moreover, sometimes even a very healthy company’s stock will fall.
Historically, stocks have returned around 8% per year. Some years you can expect much more, and some year you can lose a large part of your investment. Until now, in the long run, stocks have been an excellent investment. But you need to be ready to take on some risks. Do not sell at the first time of loss!
How to choose stocks?
And owning stocks from a single company is a bad idea. If you only invest in one company and it goes bankrupt, you lose everything. And if the company you are investing in does not keep up with its competitors, you are missing on a lot of growth. You should own stocks from many companies. Generally, experts recommend owning stocks from at least 20 companies. But this is only a rule of thumb.
But choosing the companies you want to own is a difficult choice. You need to look at all the financial characteristics of a company to try to guess its future. How much debt does it have? How much potential for growth? What are the policies of the company? And so on. And answering these questions is not easy.
Even finding all the financial information about a company is not trivial. It is a job to find the best companies to invest in. Some people are very good at it, like Warren Buffet. Some people are terrible at it and lose a lot of money. To put it simply, choosing a company to invest in is like gambling.
Diversification in the stock market
If you want to invest in the stock market, you need to invest in a lot of companies. You should probably invest in every possible company. The idea is to replicate the performance of the entire market. With this, if the market goes up, your investment goes up as well. Since nobody can consistently beat the market returns over a long period, you are better off with the market returns.
However, that is highly impractical. You surely do not have enough money to buy one share of every company in the stock market. If you do, you probably are not reading this blog ;) And even if you had enough money, it would be a lot of work. And a lot of trading fees.
However, there is a solution for you. Instead of buying all these shares, you can invest your money in a fund. A fund is a collection of stocks. You only purchase some shares of the fund itself. And via the fund, you own a part of all the shares of all the companies inside the fund!
In the next installment of this series, we are going to cover funds in detail. Funds are what I am using to invest!
Now, you should have a better understanding of the main financial instruments you can use to invest.
As we saw, cash only gets you so far. The returns are very low, and inflation is eating most, if not more, of your profits. You can use bonds to lend money to companies or governments. Bonds offer better investment returns, but you take more risks. And stocks allow you to own a part of a company. They will generally return more than bonds but also expose you to more risks.
The biggest problem with bonds and stocks is to pick them. How can you choose the best stocks in a portfolio? You need many of them to diversify. Fortunately, there is something called funds. There are bond funds and stock funds. Investing funds is the way I recommend to invest.
To continue learning about investing, read my article about mutual funds, and index investing.
Do you have any questions about these financial instruments? Did I miss something?