How does investing work?
Putting money aside as you’re able is a great way to cushion against the unexpected and make progress toward bigger financial goals such as retirement. How most people do that takes two forms: saving or investing.
You probably get how saving works. But how does investing work and how can you select your investments?
What is saving vs. what is investing
Saving is usually reserved for short- and intermediate-term goals—an emergency fund for car repairs, for example.
How investing works is you put your money in an account or fund with the goal of making a profit. Investing comes with the potential of greater rewards (which can include more risk) over time. That’s why some people use investments to reach long-term goals such as retirement.
|Savings account||Investment account|
|Where money goes||An account in a financial institution, such as a bank.||Financial products such as stocks, bonds, mutual funds, and annuities, the value of which is held in an account.|
|How money grows||Steadily but slowly. The higher the interest rate, generally the higher required minimum balance.||Account value shifts as investments such as stocks gain or lose value. The potential for growth is higher, but not guaranteed. You may also sell investments for gain (or loss) or receive dividends with stocks or interest with bonds.|
|Risk and flexibility||Low risk, some flexibility, little variability. Generally insured up to $250,000 per institution. Many have fees and transfer limits. Interest earned is typically taxable.||Generally fairly flexible to purchase or add to; may be penalties for early withdrawal on retirement accounts. No growth is guaranteed, so there’s more risk. Some are tax advantaged.|
How investing works in investment accounts
The term investment account refers to how the money you use to purchase stocks, bonds, mutual funds, or some combination, is held. There are three different types of investment accounts:
1. Retirement investment account
There are two main types:
- A 401(k), which is provided through your workplace and often supplemented by employer contributions.
- An individual retirement account, or IRA, set up by you as an individual to put money aside for retirement.
For both, you choose, based on predetermined limits, how much to deposit. If you have a 401(k), funds are deferred from your paycheck. With both, you may decide how you want to allocate your investments (see below). Learn about the tax advantages to both 401(k)s and IRAs.
2. Education investment account
Savings and earnings in these, such as a 529, are used to pay for qualified educational expenses. You can choose the allocation in funds that contain products such as stocks and bonds, and there are tax advantages as well.
3. Brokerage investment account
You as an individual transfer funds to a brokerage firm; you choose individual investments, such as stocks. Your money has no guarantee against loss and there are no tax advantages, but there may be more flexibility for withdrawal than a retirement investment account.
How to select investments in your investment account
When you start saving in an investment account and select your investments, you don’t buy stock in just one company. You’re investing in a fund that in turn is invested in a range of companies. There are hundreds of different types of these funds, and the choices can be overwhelming. That’s why most people with investment accounts select investments based on age or risk tolerance. For both, it’s important to understand the role of risk and diversification in your investment selections.
Investment account risk
Investment funds are generally classified based on risk, from conservative to aggressive. The riskier the investment, the more potential for growth or loss. If you have more time before you need your investments, you may be able to withstand more risk. The closer you are to retirement, the less able you may be to tolerate risk.
Investment account diversification
Each investment fund includes a diverse array of companies; if one company does poorly in a year, another might do well, which offers balance in loss and growth. Funds might also allocate their assets (i.e., your money) in diverse ways, putting a certain percentage in stocks, another in bonds, and the rest in cash. Both are an example of diversification, which can help to spread out the risk.
The investing rule of thumb
Invest as soon as you can, for as long as you can. The more time your money works for you, the more opportunity it’ll have for growth (otherwise known as the magic of compound interest). Here’s an example:
|Age of opening investment account||Initial investment||Average return||Account value at age 651|
1 This is for illustrative purposes only and does not represent actual or implied performance of any investment option. Past performance does not guarantee future results. Market and economic conditions could have material effects on the results portrayed. Performance shown does not reflect any product from Principal®. For illustrative purposes only. Does not represent any investment strategy or reflect the impact of fees, taxes, or expenses.
Investing involves risk, including possible loss of principal.
Asset allocation and diversification do not ensure a profit or protect against loss.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel, other financial professionals or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products and plan administrative services provided through Principal Life Insurance Company®. Securities offered through Principal Securities, Inc., 800.547.7754, member SIPC. Principal Life and Principal Securities are members of Principal Financial Group®, Des Moines, IA 50392.