Whenever you turn on the news these days you hear about the stock exchange hitting new heights. Records are being broken and it seems like everyone is getting rich except for you. It’s very tempting to jump in, but how do you start?
Let me warn you right now: Reading one or two articles will not turn you into an investor. A good investor learns new things all the time, and even the best make some mistakes.
There are many types of investments available in the market. Some of the most popular are bonds, stocks, mutual funds and options. I will try to explain the basics of each of these types of investments.
Bonds are basically loans that you make to a company, a municipality or even to the treasury. When a company needs money sometimes it will not go to a bank for a loan. Instead it will offer the public to loan it the money for a certain interest rate. For example, it could offer 5%. If you buy such a bond you give the company a $100 loan, and receive $5 every year for the life of that bond, which is defined in the beginning, say 5 years. After 5 years you get your $100 back.
Sounds very simple and safe. In fact, there could be complications. What if the company you loaned your money to can’t pay? Well, unfortunately the answer is simple: you lose your money.
The bond market is also strongly influenced by interest rates. If the government now offers 7% interest rate, and you suddenly have to sell your 5% interest bond, why would anyone buy it from you? They will buy it, but they will not pay $100 for it. They will pay less.
Stocks and the stock market are usually what comes to most people’s mind when they want to start investing. A share takes a moment to define, investing takes a life time to master. When you buy a share, well, you buy a share of the company. If the company earns more your share is worth more, if the company earns less the opposite happens. The problem is that the value of a share depends not only on the past performance of the company, but on the expectations people have for its future, and this is very difficult to predict. Factors like the economy and the mood of the market effect the values of stocks just as much as the numbers.
Mutual funds are managed by professionals in investment that invest your money for you. Being professionals they have the ability to make good decisions. Mutual funds specialize in certain types of investments. Some invest in foreign currency, others emulate a certain index or specialize in a certain type of companies. It is not enough to look at the past performance of a fund to decide if it’s right for you. You need to understand the level of risk of each fund. You also need to check what they charge to manage your money. These professionals don’t work for free.
The last type of investments I mentioned is options. Options are considered a more sophisticated and risky type of investment. They do not necessarily have to be risky, but you do need to know what you are doing. The easiest way to explain how an option works is an example. Imagine stock ABC is now selling for $100. I believe it’s going to go up, but for reasons I will not go into I prefer to buy an option. I can pay someone $10 for the option to buy the share for $120 a year from now. In a year, if the share trades for $140 I exercise my option, buy it, an make a nice $10 profit (I payed $10 for the option + $120 for the share). If in a year it costs $119 I just don’t exercise my option, and the seller of the option made $10.
Options can be traded during this year and here is the temptation about them. What if 11 months after I bought the option company ABC is trading for $140? I can surely find someone who Will pay almost $20 for the right to buy it for $120. The share went up 40%, but the value of the option doubled! On the other hand, if the share lost even 1%, or simply didn’t go up as much as expected, the value of my option can go to zero! And there’s another side of options we haven’t discussed here – “Put options” that can be even more dangerous. Options are not for beginners. They can be very profitable, but you need to know your strategies.
From this short primer you probably understand that there is much more to learn even about these basic types of investment. Bonds, shares, mutual funds and options are just the tip of the iceberg. Keep reading and learning before you invest your money.