As we were growing up, we were probably exposed to ways to save money more than we were exposed to ways to invest our money. Parents buy their kids piggy banks to put coins in at a young age. Banks advertise incentives for opening a savings account with them and provide interest rates for letting your money sit there long term. Retail stores look to consumers and provide deals to save money on various items. There are even people who participate in “bedside saving” or the adult level of piggy bank banking and they stuff money in a mattress. Whatever the method you use, you’ve known about it for years and pretty clear on how it works. But what about investing? What exactly is investing?In all honesty, I call it glorified gambling.
On Wall Street, you take risks. You look at a company given as much historical information, news and analyst predictions that’s available through various sites like Yahoo! Finance or Google Finance and you make a prediction on the future success of a company. If you think it will do well you invest, otherwise you may pass up that company or short sell it (future blog post).
But whether you invest in the stock market, your child’s education, real estate or pursue venture capitalism, there is a level of risk that you take on as an investor similar to the way a bank does when someone asks for a loan. When banks are deciding to give an entrepreneur a loan, they are analyzing how much of a risk that person is and how risky the business that the person is trying to conduct is. And based on the risk tolerance the bank has, they can chose to accept it by taking on the loan with an appropriate interest rate assigned. For example, if I was trying to get a loan to start a smoothie stand, the banks would consider the location I’ll be working in, the fact that I wont need any deep frying or heavy duty kitchen appliances and the fact that this stand is mobile so I can move to different locations for new business if necessary. They are more likely to give me a loan for that than giving me a loan for a business that was less stable and unproven to succeed or if my business plan was not well written.
This general concept of perceived risk and risk tolerance are two factors that are very important when deciding to invest. A third consideration is the duration of time in which you want to invest. When analyzing companies to invest in you have to know the type of risk you are willing to take and understand the business of the company that you are investing in. It also helps if you have a time horizon in which you intend to actively or passively invest.
Just in a nutshell, here are a few key differences between saving and investing.
|Saving is what you do so that you’ll have money at a moments notice. (Rainy day/emergency funds)||We invest with the mindset that we wont be needing that money for the next couple years.|
|Savings account reflect what you put in them, along with low interest rates. (generally < 1%)||A portfolio of stocks may lose value.|
|Safe bet you’ll get what you put in.||Potential for higher rate of returns and dividends, but higher risk of losing money|
In my Friday post, we’ll be diving in deeper into how to measure your personal risk tolerance.