Investing just means to put money away for the future. Period. You can invest in your under-the-mattress fund if you want. But it’s not the best place to invest because the risk doesn’t equal the reward. The reward is nothing. You will always have what you put under the mattress and nothing more. But you have the risk of fire or theft. You also have inflation risk. As things get more expensive your money under the mattress stays the same. So you have less buying power as time goes on. For example: if you saved 1 month’s rent 10 years ago, it’s not going to pay the rent today. Things get more expensive over time.
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So there are better places to invest. You could put your money in a savings account for example. This provides a much better risk vs. return. You have no risk of loss and a little bit of return. That’s much better than the under-the-mattress fund. Your risk here is inflation. You probably won’t get enough interest to cover the rise in prices. A savings account is a great place for short term savings and emergency funds.
At your local bank there are other savings options like Certificates of Deposits (CDs) and money markets. Money markets are very similar to savings accounts except they tend to get slightly better interest rates. CDs work a little bit differently. The money you put into a CD is locked up for the life of the CD. The longer you agree to lock up your money, the higher interest rate you can get.
Retirement is usually the next thing people start saving for after they have funded their emergency funds. You could save for retirement in a savings account. I mean, who says you can’t? All you have to do is put money in a savings account with the plan to use it to pay expenses when you are retired. But it’s not the best place. The reason is because you don’t get very much growth, for one. The second reason is taxes. In a savings account you have to pay taxes on the money you earn each year. This takes a little bite out of your growth every year.
If you want to save for retirement you can do so without paying taxes on the growth at all. This is called a Roth IRA (Individual Retirement Account). The name Roth IRA is just a label you put on your savings account. This tells the government you plan to use this money for retirement. The government will give you an amazing tax break for this. In a Roth IRA you put money into your account after you pay taxes on it (just like in a savings account), but the growth is tax free. Even when you start using the money in retirement you never have to pay income taxes on it. EVER. What a nice gift from the government. However, the government doesn’t give gifts with no strings attached. In exchange for this gift they have put some rules on the account. Rules like how much you can put in the account each year and when you can take it out. You can read more about Roth IRAs here.
There is another kind of retirement account. A Traditional IRA. Accounts with this label are taxed slightly differently than Roth IRAs. In a Traditional IRA account you put your money in before you pay taxes on it. (Or, more realistically, you get a refund for any taxes you paid on your deposits that year.) The money then grows tax free until you retire. When you take the money out in retirement you pay income taxes on ALL of your withdrawals, both what you put in and the growth. This type of account also has limits on how much you can save each year and when you can withdraw money. You can read more about Traditional IRAs here.
Now, I said there were two reasons why IRAs are better than savings accounts for saving for retirement. Growth and Taxes. I’ve just addressed taxes, so now let’s talk about growth. When you are saving over a long period of time, like for retirement, you want to not just beat inflation, but to actually out pace it. This means that if you save one month’s of expenses now, in time you will actually have 1.5, or 2, or 10, or 100 months’ worth of expenses. To do this you will have to put your money in something riskier than a savings account. You can put your money into just about any kind of investment you want. Most people use stocks and bonds.
A stock is just a piece of a company. A slice of the pie. If the company does well, their stock goes up and you make money. If the company does poorly, their stock goes down and you lose money. There are great rewards to be earned, but there is also risk. You can get a variety of risk levels within the world of stocks.
A bond is a loan. You can buy government bonds, which is a loan to the government. Or you can buy corporate bonds, which is a loan to the company. Organizations “sell” bonds to raise money. A local college just sold a group of bonds and used the money to update their facilities. Over time, as the bonds are redeemed they will pay back the money with interest. The better credit rating of the organization selling the bonds the less risk there is and the less money to be earned on the bond.
Experience taught me a few things. One is to listen to your gut, no matter how good something sounds on paper. The second is that you’re generally better off sticking with what you know. And the third is that sometimes your best investments are the ones you don’t make.
– Donald Trump
