This is the seventh post in a multi-part series on how to manage your finances so you can build up your savings, have a safety net, and still live comfortably today without having to live paycheck to paycheck. Click here for part 6, which discusses your insurance needs.
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Growing your money
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By this point, you’re familiar with all of the boring parts of personal finance. Unfortunately, you need to have all of that boring stuff taken care of before you can get to the really exciting parts – how to use the money you have to make more of it, or how to “make your money work for you.”
Believe it or not, one of the worst things you can do is to let all of your money sit in a savings or checking account. That’s why in Part 2 of this series, we told you to only keep as much as you needed for your average expenses (plus a buffer) in your checking account. At first glance, this may not make sense. Why shouldn’t you keep all of your money safe and sound in bank deposits?
Well, the main reason is, that money could be making you even more money if you used it the right way. If you leave it in a savings or checking account, it won’t be doing that for you.
How does it work?
If this is a new concept for you, don’t worry, we’ll go through how this works, and we’ll even give you a few resources to help get you started.
You’ve probably heard the expression “it takes money to make money.” Well, it’s true. Companies have to pay their employees so they can provide a product or service that their customers will buy. Banks take the money you deposit with them and use it to provide loans. And everyday workers use their hard-earned salaries to invest or trade. That last point is what we’ll focus on in this article.
As an individual investor or trader, your best bet at getting rich is to slowly and steadily grow your money through the power of compounding. Sound scary? It’s not (and as an up-and-coming trader, you’re going to learn to love it). All it means is that over time, you can use the money you’ve made to make even more money. Essentially, compounding is a wonderful thing that helps you grow your money faster and faster and faster. All you have to do is help get the process started, and stay consistent.
Risk
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Before you can get started, though, you have to know about risk. Why risk? Well, it’s the most important consideration in growing your money – the more “risk” you take, the more money you can earn or lose. If you put your money in no-risk investments, you won’t lose it, but you also won’t make a lot. If you put your money in higher risk investments or trades, you stand to make a lot more, but you could also lose a lot more too, so part of learning how to grow your money is figuring out what you’re comfortable risking.
With that said, it’s very important to not put any money in risky trades or investments if you can’t afford to lose it. This article is for people that have taken care of their basic expenses, have saved for emergencies, and are have a solid payment plan in place for their debt.
The choices at your disposal
Now lets go over some of the different choices you have, how risky they are, and how much money you can expect to make from them.
Bonds (fixed income)
Bonds are essentially loans from you to someone or something else. When you buy a bond, you’re loaning money to a company, town, city, state, or country in exchange for the promise that you’ll get paid back more than you lent out. You can buy a bond that will pay you back in as little as a few days, or as long as a few decades. The amount you get back depends on a few things – the interest rate in the economy, the chance that whoever you lent the bond to goes bankrupt, and when your bond is set to repay you.
Stocks
Everyone has heard about stocks. Even if you have no idea what they are, you’ve seen plenty of stories about the “markets” rising and falling, new companies going public, and stock shares. Stocks (and funds, which you’ll read about next) are some of the most popular financial instruments for everyday people to grow their money.
Mutual funds
One of the problems with owning individual stocks is that it’s too easy to lose money. One bad headline in a company that you own and the stock could go down 30%, wiping out your capital along the way. That’s where mutual funds, or plain old “funds”, come in. Funds are groupings of stocks that are combined together to form a single investment. When you buy into a mutual fund, you’re actually buying into many different stocks at once. The idea is that a combination of many different stocks can help to offset losses in any one, particular stock.
401(k)s
If you work for a company, chances are you have access to a 401(k), which is essentially just a retirement account that invests in mutual funds. The company that administers the 401(k) will give you a choice of a few funds, and you can control how much of your money goes into which funds.
Options
Options are our favorite financial instrument, and they’re what we specialize in. Options are an incredibly flexible class of securities that are known as “derivatives.” What this means is that they’re only valuable because they tie back to a security that actually has real value (like a stock). Said differently, their value is derived from the value of something else. You can have options on all sorts of different underlying securities, but on this site, when we talk about options, we mean stock or stock index options.
Other advanced financial instruments
Options aren’t the only derivatives out there that you can trade. There are also futures, swaps, CDOs, and a variety of other exotic instruments that big banks create. In addition to derivatives, you can also trade commodities (things like corn, soybeans, or coffee), as well as precious metals (like gold and silver). Learning how to trade each of these is similar to trading options – if you do decide to get into them, learn how the markets work, understand the little quirks that go along with each instrument, and practice, practice, practice.
Real estate
Real estate is a tougher investment to do properly. Many people used to think that the price of a house could never go down, so as long as you continued to borrow money from the bank to buy and sell houses, you could make money forever.
Getting started
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Now that you know what’s available to you, how do you get started? First off, you’ll need a broker – someone that can execute your trades and take care of the logistics. They’ll charge you, so make sure to find the cheapest broker that you can find that still provides you with the level of service you’re looking for.
You should also start familiarizing yourself with whatever it is you want to invest in. Interested in bonds? Read up about their peculiarities. Interested in options? Figure out how puts and calls work. Want to build up long-term wealth with minimal effort? Find out which mutual funds are the best fit for you.
Once you’ve learned what you need to get started, go slowly. If you’re investing in stocks or bonds, figure out the right asset allocation and don’t go beyond that. If you’re trading options, figure out a strategy that works for your trading style and try some virtual trading before putting real money in. In any case, be consistent, and don’t get discouraged from a few losses. It’s all part of the process of growing your money.
That’s it for the personal finance series. In the next, and final post, we’ll wrap it all up, give you some good resources to learn more, and get you on your way to achieving financial stability so that you can then go on to be a trader and achieve financial independence. Read on!
