Most of us know that we should be investing. After all, it’s the most reliable way to build wealth. But not all of us understand how investing truly works. The world of investments can be confusing, and it’s easy to shrug off the weird terminology, trust our brokers, and hope for the best.
But we really should strive to understand the basics. It will make us better and smarter investors. Here are a few key terms and concepts that every investor should know well.
Few investing concepts are as important as compound interest. And, fortunately, few are as easy to exploit. Compound interest is the mathematical reality that is responsible for much of investing’s power to increase your wealth. Here’s how it works.
Simply put, compound interest refers to the fact that the interest that you earn grows your principal investment, meaning each successive piece of interest earned becomes even more valuable. If you earn a 10 percent return on a $1,000 investment, that’s $100 — not bad! But even better is next year’s 10 percent, which will be $110 — because now you have $1,100 invested, not just $1,000.
Over time, compound interest can be worth big amounts of money. Understanding this concept will help you understand why investing money early in your life is so important.
Types of orders
When you buy or sell a stock, you can issue different types of orders. The most common ones are market orders and limit orders. But what does that mean?
Market orders are all about the now. When you issue a market order, you express your desire to close this deal fast. You’ll get the price that the market determines right now — the buyer or seller who will give you the best deal as soon as possible.
With a limit order, you set parameters. You want to buy or sell, but if nobody meets your limit — the maximum price you’ll pay or the minimum price you’ll accept — then the deal is off.
With highly liquid stocks like those of major blue chip companies, the difference can be academic. But if you’re not careful and issue a market order instead of a limit order on a illiquid or highly volatile stock like a penny stock, watch out! This important concept could haunt you.
Saving and investing are always good ideas. But they’re even better ideas when you can reap benefits at tax time just for saving in a savvy way.
An IRA is a classic example of a tax-advantaged account. Anything you contribute to your IRA (up to the limit allowed by law) will not be counted toward your taxable income that year (when you withdraw from your IRA later in life, those withdrawals will be taxed as income, and you will pay penalties if you withdraw from your IRA before you’re of retirement age). Employee-sponsored 401(k) plans work similarly and feature higher deposit limits and, with some employers, generous employer-match programs. Also, Roth IRAs, are taxed normally but have won’t be taxed when you withdraw your earnings in retirement. Plus, there are tax-advantaged savings accounts for things other than retirement, including education costs and health care costs.
In short, you have a lot of ways to use tax-advantaged accounts to maximize your savings and profits from investing. Investing in these sorts of plans early and often is a great strategy that anyone can use.
Calls, puts, and options
Buying stocks and index funds is simple. So is selling them — you need to note some tax consequences, and that’s about it. But there you should be aware of more complex maneuvers, even if you don’t plan to make full use of them yourself.
We’re talking about options. Knowing how options work and the difference between call versus put options is important, because it helps us all remember that the market isn’t always as simple as buying and selling and hoping for growth all of the time.
Options contracts stipulate that one party may — but does not have to — buy or sell (one or the other, and the contract will say which) a given amount of a given investment from another party within a specified time frame. This means that someone can sell an option to buy (a “call” option) to another party in the hope that the underlying security actually goes down in value. Even more complex moves are possible here, such as selling different types of options on the same security or short-selling a security (that is, offering to sell something that you don’t even own yet — a risky strategy with big potential profits).