Overview: Saving and Investing Money
Overview: Saving and Investing Money
What It Means
Saving money and investing it wisely are crucial to long-term financial success. To save money one must first draft a sensible budget (a catalog of expenses and revenues) to be sure that monthly expenses do not exceed his or her monthly income. If after tallying all expenses one discovers that he or she is spending more money than he or she is making, it is crucial that the person cut back spending or earn more income rather than charging more purchases on a credit card. Maxing out credit cards (going as far into debt on the card as is permitted) and then opening lines of credit on new credit cards makes it nearly impossible for a person to allocate funds for future use.
After creating a budget a person would be wise to commit to storing some excess revenues in a savings account. Though the money in a savings account earns a small amount of interest (an annual fee paid by the financial institution to those who store money there), most people do not maintain these accounts because of the returns they provide. Rather, people maintain savings accounts so that they can have access to money needed for purchases and expenses beyond the scope of their monthly budgets. For example, the money in a savings account can be accessed if someone experiences a spell of bad health and accrues medical bills or if one becomes unemployed. Many financial advisers recommend that to see oneself through an unexpected financial crisis, a person should maintain enough money in a savings account to cover four months worth of expenses.
Investing is spending money in an attempt to generate more revenue in the future. Purchasing a home is an investment because in most cases the value of a home increases with time. For example, suppose a person buys a home for $80,000, and the house rises in value to $110,000 over five years. If desired, the person can sell the home and draw a profit of $30,000 or can choose to live in the home for several more years, during which time the home will likely continue to appreciate in value. Unlike buying a home, purchasing a car, a computer, or a television is not an investment because these items tend to lose value over time. When people buy these things they do not expect that in the future they will be able to sell them for a profit. In addition to buying a home, one can invest money sensibly by purchasing stocks (shares of ownership in a company), bonds (loans to the government or a corporation that are paid back with interest), or mutual funds (a bundle of investments including stocks, bonds, and other securities that are managed by an investment company).
When Did It Begin
Many historians believe that the practice of saving commodities and currency in banks began in 3000 bc when people stored grains and precious metals in sealed areas of temples. These first banks were located in temples because these structures were well built, frequently occupied, and therefore difficult to rob. Furthermore temples were considered a safe place to store valuables because many people figured that the potential of inciting the wrath of the gods would deter criminals from stealing. Historical records charting the beginnings of investment are unclear. Some evidence indicates that Roman investors bought shares in groups of publicani (groups of publicans, people who in modern parlance would be called general contractors, or private contractors) who collected tolls at ports, recruited for the military, and oversaw building projects. Other findings suggest that by the eleventh century in Cairo, merchants and investors had established trade relationships that resembled, in a rudimentary way, the methods of buying and selling in a stock market.
Many contend that the first formal gatherings of investors took place in the thirteenth century among Flemish commodities traders in the house of a man named Van Der Beurse in the city of Bruges. Investors throughout the Netherlands followed suit, and soon there were similar groups meeting in Amsterdam and Ghent. Elsewhere at this time, Venetian bankers were trading in government securities. The first company to issue stock was the Dutch East India Company. Shares in the company were first traded in 1602 at the Amsterdam Stock Exchange. Mutual funds were introduced much later. MFS Investment Management, formerly known as Massachusetts Financial Services, is believed to have invented the mutual fund in 1924. Sales of mutual funds curtailed during the Great Depression (1929 to about 1939) but picked up again in the 1940s. By the 1960s there were as many as 270 mutual funds, and by the middle of the first decade of the twenty-first century there were more than 8,000.
More Detailed Information
Rather than buying shares of stock in one company or putting all of their money into a single real estate venture, most investors compile an investment portfolio, which is a collection of different assets, such as stocks, bonds, mutual funds, real estate, and perhaps a collection of art or other rare memorabilia that tends to hold its value or appreciate over time. One could view a portfolio as a pie and each slice of the pie as a different type of asset. Maintaining a range of assets is called diversifying the investment portfolio. All investors are strongly urged to diversify their portfolios because no one knows how any single type of asset will perform from year to year. The average investor is also advised to buy and hold or to keep his or her money invested for a long period of time. Though the value of a portfolio will fluctuate from year to year, over a sustained period of time (10 to 20 years or more), the overwhelming majority of diversified investment portfolios will earn considerable returns, or profits. Rashly deciding to buy and sell assets based on sudden fluctuations in the market is the worst investment strategy, especially for those who cannot afford to lose money.
Diversifying a portfolio can be a complicated yet interesting process because one has so many options when investing money. A wise investor will commit different sums of money for different periods of time, and he or she will manage risk, taking some chances on stocks that may either lose value or pay high returns and investing conservatively by purchasing stocks that tend to pay smaller returns but rarely lose their value. Money market accounts are short-term investments that pay relatively low returns but often guarantee profit. For example, a certificate of deposit, or CD, is a time deposit issued by banks that pays a fixed interest rate for a predefined term, usually six months or a year. The interest rate on a CD is higher than the interest rate for a savings account; however, the investor must pay a fee if he or she withdraws funds from a CD before the account matures, or expires. Treasury bills, or T-bills, are another money market instrument. These notes, which are issued by the federal government, usually mature in a year, at which time the government repays the principal of the loan plus a fixed rate of interest. When one “buys” T-bills, one is actually lending the government money that will be paid back with interest at a predetermined date in the future. As with CDs, T-bills pay modest returns in a short period of time. Both are considered to be risk-free investments.
Mutual funds carry more risk but can pay higher returns. Because a single mutual fund consists of a bundle of assets, the amount of risk one assumes when purchasing a mutual fund depends on the nature of the assets in the bundle. (Both mutual funds and portfolios are groupings of different assets, but there is a distinction. If the portfolio is the pie, one mutual fund would be a slice of the pie. That particular slice would be further subdivided into shares of stocks, bonds, money market investments, and other securities.) Mutual funds that invest in stocks that pay potential high returns are called growth funds. Such funds pose more risk than income or value funds, which tend to pay lower returns. Some mutual funds require investors to keep their money in the funds for a fixed period of time, usually between three and seven years.
Most investment portfolios have a retirement fund, normally called an individual retirement account, or IRA. Typically investors do not have access to the funds in an IRA until age 59½. In exchange for committing their money for an extended period of time, investors usually see sizable returns in these funds, which many retired people use as income after they have left their careers. One of the most important things to consider when purchasing an IRA is the tax laws that apply to the account. In a traditional IRA an investor is not taxed on the money he or she puts into the account; however, one does pay income tax when withdrawing from the account in retirement. With a Roth IRA one invests after-tax income but later pays no taxes when withdrawing from the account in retirement.
Because investing is such a complex and risky process, many people come together in groups called investment clubs to increase their chances of maximizing their portfolios. In some investment clubs members pool their money together and compile a single portfolio. In other clubs people gather to learn more about investing and to exchange views on recent trends in the stock market and in the economy in general but maintain their own portfolios.
Recent Trends
Since 1990 household debt has grown more quickly than household income throughout the United States. On a monthly and yearly basis many families spend more money than they take in. However, in the overwhelming majority of cases, household net worth is still greater than household debt. In other words in most households the combined value of the equity in the home, the investment portfolio, material possessions, and earned income is greater than the combined value of all liabilities, such as credit card debt and the amount owed on the house, the car, and all other materials that have been financed. The increase in household net worth has been due largely to an increase in property values and the reliable performance of mutual funds. Many families are spending more and saving less because their assets are appreciating steadily. As long as these assets continue to appreciate, economists think that families will be able to sustain their debt. However, families that steadily acquire debt risk financial peril because real estate and securities markets require sustained investment in order to provide returns. If the majority of Americans continue to pay large sums to credit card companies and to banks, they will have less to invest in the stock market and real estate.
Membership in investment clubs, especially among males, rose in the 1980s and 1990s but has fallen since the turn of the century. Since that time membership among women has increased substantially. Most women prefer to belong to women-only investment clubs, with the typical member of such a club being a college-educated woman older than 50 who no longer is responsible for raising children. These women-only clubs tend to have a distinct approach to finance. Some emphasize motivational speaking and empowerment and use investing as a way to help women achieve independence. Others, with names like Girl Power and Chicks Laying Nest Eggs, deliberately mock gender stereotypes.