Day 24: Compound Interest & Investments

Now that we’ve talked about our emergency fund and other saving goals, it’s time to talk about investments. I’ll be honest — investments kind of scare me. Do they scare you? So much money and so many different companies and corporations and funds and oy! Just a lot to think about, right?

I really should divide this post into multiple posts, but there’s no time for that my friends. I have other fun things to share with you this week. So today is going to be extremely text heavy and boring, but stick with me and maybe it will lessen the fear of investments a bit. :)

Compound Interest:

Why don’t you just keep your money sitting in the bank? What’s the big deal about investments? Compound interest. Y’all — compound interest is awesome. Basically you’re giving a company or a government entity some of your money to borrow, they add interest to it, and then continue to add interest on the amount you put in (aka “the principle”) and also the interest that they’ve already paid.

Ok let me give you an example.

If you invest $1,000 with a compound interest of 10% return (pretty rare to find these days, but stick with me), then that year you will get $100 in interest. The next year, you will still get 10% interest, but this time it will be on $1,100 because that interest from the first year was added and untouched, so that brings your Year 2 total to $1,210. After 10 years or not touching it at an interest rate of 10%, you will have $2,593.74 sitting in your account. Pretty sweet, huh?

Now imagine that you continued to add $100 to it each year. After 10 years the amount would be $4,346.86 after just putting in $2,000 for the 10 years. Isn’t that awesome? I think so.

Here’s a link for you to test out more compound interest calculators in your free time.

Types of Investments:

Stocks:
Stocks are pretty baller. When you purchase a stock, you essentially own a slice of the business. So, if you own a stock in Apple (kuddos), you are part-owner of the Apple corporation (albeit, a very small part). You can earn what’s called “dividends” on the profits. So if the company does well, you do well. If the company tanks, sadly so does your investment.

Pros & Cons: The earning potential for stocks is relatively high. Lately the stock market hasn’t been that great, but it isn’t uncommon that some stocks can yield 8% to 12% return on your investment. However, stocks fluctuate in value on a daily basis and you aren’t guaranteed anything. You could put in your $1,000 and at the end of your ten years get nada, and the company owes you nothing because that is the deal when you invest in stocks.

Bonds:
Bonds are the conservative investment in the mix. When you buy a bond, you’re essentially lending your money to a company or government for a specific period of time at a specific interest rate. They agree to give you interest on your money and eventually pay that back to you at the end of the period.

Pros & Cons: They are very low risk, but generally have a low return.

Mutual Funds:
Mutual Funds are the happy medium between stocks and bonds because it has, well, both!  When you buy a mutual fund, you’re basically adding your money with other investors to purchase a pool of stocks and bonds. It allows you to pick and choose stocks and bonds based on your strategy. For example, you can do a mix of large stocks, small stocks, government bonds, stocks in certain countries, domestic or international stocks, and on and on. Mutual funds allow you to tailor your investment to get the right about of risk that you want.

Pros & Cons: They allow you to tailor your investments to get the right amount of risk that you want. It is not always guaranteed, however, because sometimes the reward

So there you have it! A quick and dirty run of investments and why they’re important.

 

This is post #22 of a 31-day series on Financial Freedom. Click here to see all of the other posts. And thank you for reading!

(photo credit)

  • Reader

    Not trying to nitpick, but your post has a couple of inaccuracies. When you own a stock, you aren’t necessarily entitled to dividends. When a company makes a profit, the Board of Directors may decide to pass it onto the shareholders and declare a dividend. As a shareholder, you would then be entitled to a cash distribution. Alternatively, the company could post a profit and not declare a dividend. As a shareholder, you would then have stock that (hopefully) is higher in value, but no cash.

    Secondly, bonds are not all “virtually risk free.” ALWAYS ask your broker for a prospectus, read it and make sure you understand it before purchasing a fixed income instrument. Not all bonds are alike and just because a bond received an investment grade rating doesn’t mean that it’s risk profile is appropriate for everyone.

    Love your blog. If you’re really interested in personal finance, you might want to look into becoming a CFP.

  • Reader — thank you so much for clarifying some of the mistakes I made about stocks and bonds! It’s greatly appreciated. I made some of the corrections in the post above. And I have considered becoming a CFP but I’m not sure if that’s the career for me… at least not now! We shall see what happens down the road. :) Appreciate your comment!

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