There's one golden investment rule that you should always keep in mind: Never invest money that you can't afford to lose. Learn why this rule is important, and how to protect your assets from risk and volatility.
- Saving is a low-risk strategy of putting away money in a secure account until you need to use it, even though it will not earn much interest.
- Investing is a higher-risk strategy of putting money in vehicles like stocks, bonds, and mutual funds in order to receive interest or dividends or a gain in value.
- To avoid investing money that you can't afford to lose, first focus on building up your savings to cover general and emergency expenses for several months.
- You can minimize investment risk by creating a financial portfolio that includes savings, insurance, retirement accounts, and real estate.
Saving vs. Investing
There's a significant difference between saving and investing. Saving is setting money aside in a safe place, where it stays until you want to access it, whether that's in a few days, a few months, or even several years. It might earn a little interest, depending on where you put it, and it will be there for you in case of an emergency or to achieve the goal you're saving for.
Common savings vehicles include:
- Savings accounts: These accounts are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA), which means that each account is protected up to $250,000. They tend to have very low interest rates, especially at brick-and-mortar banks.
- Certificates of deposit (CDs): With these accounts, you leave your money in the CD for a period ranging from months to years. The interest rates are low but typically better than with regular savings accounts. You can withdraw funds before the CD matures, but you would lose some or all of the interest you've earned.
- Money market accounts: These accounts allow you to spend funds using checks or a debit card. They pay relatively low interest.
All of these accounts have virtually no risk, but you receive minimal interest.
Investing is the process of putting your money to work for you. It can typically make more money for you than the interest you might earn in a savings account or CD when done properly. But with reward comes risk. If you make poor choices, or if things beyond your control go wrong, you could lose that money. It might not be there for you in case of an emergency.
Common investment vehicles include:
- Stocks: With these, you invest in a company and share in its profits and losses.
- Bonds: With a bond, you're lending money to a company or government entity. Bonds typically pay fixed interest rates. Government bonds are considered relatively low-risk and may pay low interest rates, depending on economic conditions. While bonds are relatively safe and could be used as savings vehicles, they do have some risk, depending on the type of bond.
- Mutual funds: These are investment vehicles managed by money managers. They may include stocks, bonds, or other assets. Buying shares in a mutual fund is a simple way to diversify your investments, and you can find mutual funds that reflect a wide range of interests and investment goals.
There are many more investment options, including collectibles, index funds, hedge funds, and annuities.
The Challenges of the Investment Rule
If you remember the "Never invest money that you can't afford to lose" rule and never violate it, you shouldn't have to worry about running out of funds during retirement. You'll have the funds to handle something potentially catastrophic that occurs, like job loss or illness. The key is to build up your savings before you start to invest. You shouldn't invest money that you need to meet other responsibilities.
There's a natural human tendency to want to overreach, put in more money than you can afford, and go for a huge payout. This trait tends to become magnified in the face of losses. This is referred to as the "sunk cost fallacy"—the belief that you've invested too much to walk away. Rather than selling in the face of losses, someone might hold on to a stock that's underperforming or, worse, buy more.
Guarding Against Investment Risk
You shouldn't just look at your portfolio as the stocks you own. A portfolio encompasses so much more—your emergency cash reserves, your insurance coverage, your funded retirement accounts, your real estate holdings, and even your professional skills that determine the income you could earn if you were to lose your job and have to start over.
You can avoid the pitfalls of what's called "the refrigerator problem" by keeping your eyes on the big picture. This means you need to spend more time researching complex financial decisions, even if they are harder for you to understand, as you would with something that is part of your everyday life.
For example, the same folks who spend weeks studying Consumer Reports ratings for a new stove or refrigerator will sometimes put all of their savings into a stock or other investment that they don't entirely understand. Investments can be complicated, and a good financial plan includes factors like your retirement plans and goals, your other financial goals, and your risk tolerance. It's unlikely that investing in just one vehicle will meet those goals.
When deciding how to invest in your portfolio, your first goal should always be to avoid major losses. You can do that through patience, keeping your management costs low, and seeking the advice of qualified, well-regarded advisors.
Frequently Asked Questions (FAQs)
Why is investing important?
Investing is a key aspect of personal finance. It's one of just two ways to make money—the other being earned income from working a job. Most people hope to retire at some point, and if they want to continue making and spending money in retirement, then they need to save up money to invest.
What does investing do?
Investing is putting your money to work. It can be tempting to spend money and get something you want immediately, but if you can delay that gratification, then you may be able to use your money to make more money. When you invest money, you're giving it to someone else who has a more immediate need for it.
For example, in the case of stocks, the money is used to finance a business. In the case of government bonds, the money is used to pave roads, keep street lights on, and fund government programs. In both cases, if all goes according to plan, the investor will eventually be able to withdraw more money from the investment than they initially put into it.