The Basics of Money Management and Personal Finance
Maybe you're a young professional who is just starting to make money and you
want to know what to do with it. Perhaps you are in your thirties or forties and
you know that now is the time to finally get serious about your finances. Or
maybe you're just crawling out of bankruptcy or repairing your bad credit, and
now you want to start over on the right foot. Regardless of your situation, the
fact that you're reading this article now shows that you're taking the first
step towards better management of your personal finance.
But if this is truly your first step, you might be intimidated by some of the
terminology used by personal financial planners and other financial pros. If you
don't know a 401(k) from an ETF or a mutual fund from a municipal bond, this
article is for you.
Certificates of Deposit (CDs)
CDs - not the kind that play music, of course - are certificates ofdeposit.
They are offered by practically every bank, and they pay a set rate of interest.
For example, you might "buy" a three-year CD that yields 6% interest for
$2,000. At the end of the three-year period, your CD will mature, and you
will be paid $2,382. The $382 profit is the compound interest the bank
will pay you for the privilege of using your money for three years.
CDs are extremely safe. Their interest rates are almost always fixed (not
subject to change), and your return on principal is guaranteed (meaning that it
doesn't matter if the bank turns a profit or not, you are still owed your
money). Even if the bank that issued the CD goes out of business, your
certificate of deposit is insured by the Federal Deposit Insurance Company, or
FDIC. This means that the U.S. federal government guarantees that you
will not lose your principal (the amount you pay for the CD).
Basically, there are only two risks that a buyer of CDs faces -
inflation risk and interest rate risk. Inflation risk is the risk
that inflation will significantly cut into your returns. For example, inflation
has been at about 2-3% per year for the past couple of decades, so whether you
know it or not, you make economic decisions every day that take this into
account. But if inflation suddenly spiked to, say, 10%, then your CD would
actually be a losing proposition. You would still get $2,382 back, but in the
meantime, that $2,382 would have just $1,747 of purchasing power compared to
when you bought it (assuming 10% inflation for three consecutive years). This is
an exaggerated example - it is highly unlikely that inflation would spike to 10%
and stay there for three years - but inflation going beyond the 2-3% expected
range is a risk that CD buyers need to consider.
Interest rate risk is the risk that interest rates in general will go
up after you buy your CD. You will not lose any money if this happens, but you
will lose the opportunity to buy a better CD. For example, if you spent $2,000
on a three-year CD yielding 6%, but then a month later the bank issued a
three-year CD that yielded 8%, you would no longer have the $2,000 to spend on
the better-yielding CD. Could you turn in your 6% CD and buy the 8% one? No,
because CDs are non-negotiable - you cannot turn them in (at least not without
major penalties) until they mature. This is why CDs pay a higher interest rate
than savings accounts. The bank knows that when you give it money for a CD, it
will have the money (to lend to other people) until the CD matures. With your
savings account, you can take money out at any time, so banks are unwilling to
pay high levels of interest on savings deposits.
The Basics of Bonds
Pretty much everyone has been given a savings bond by their grandma or aunt
at some point in their lives. But few of us have ever stopped to think just what
exactly a bond is. As it turns out, a bond is actually a loan to its
issuer. So when your grandma bought a U.S. savings bond for you, she was
actually making a loan to Uncle Sam. You, as the holder of the bond, eventually
received both the principal and interest on the "loan" when you cashed in the
bond.
Savings bonds are a bit confusing because they are unlike most other bonds.
This is because savings bonds are bought at a discount to the face
value, and then mature at face value. For example, your grandma might
have purchased a $50 savings bond for your eighth birthday. If the bond was a
10-year bond yielding 5%, she would not have paid $50 for it, but instead $21.20.
Then, on your eighteenth birthday, it would mature at the $50 face value.
Like I said, most bonds don't work this way, and since most everyone is
familiar with savings bonds, it's important to draw the distinction between them
and most other bonds. For example, corporate bonds - bonds issued by companies
like General Motors - are purchased from the issuer at face value. They then pay
interest every six months until the bond matures, at which point, the face value
is paid back to the bondholder.
This clearly illustrates how bonds are really
loans to the issuer - GM will actually "rent" your money from you, pay a "rental
fee," and then finally return your cash to you at the specified time. For
example, say you bought a $10,000 bond from GM that yielded 9% and had a
ten-year maturity. You would pay GM $10,000, and then six months later, you
would receive your first interest payment (also known as a coupon payment)
of $450. You would continue to receive payments of $450 every six months (which is
$900 per year, or 9% of your "loan" value) until the bond matured ten years
later, at which point, you would be paid back your $10,000.
However, the good thing about corporate bonds - unlike CDs or even savings
bonds - is that they're marketable. This means that you don't have to wait ten
years to get your money back if you don't want to. In fact, you probably won't
buy your bond directly from GM - you're more likely to buy it on the secondary
market from another individual. This presents interest rate risk. After all, if
you have a bond that's yielding 9%, and GM issues a new bond yielding 11%, no
one is going to pay you $10,000 for your 9% bond when they could buy one
directly from GM that yields 11%. If you want to sell yours, you will have to do
so at a discount. Conversely, if GM issues new bonds that yield only 7%, the
value of your 9% bond will go up. Of course, this will not affect the interest
payments you receive from GM or the price that GM pays for the bond at maturity,
but the market value of your bonds can go up or down in the secondary market.
Another risk of corporate bonds is that the company could go bankrupt - just
ask anyone who bought Enron bonds! So if you hold a GM bond, and GM starts to
look a little shaky (which they are now), then the market value of your bonds can go
down. Again, this will not affect your interest payments (unless the company
becomes unable to make them!) or the redemption value of your bond at maturity
(unless the company is unable to pay it!).
Stocks
Stocks are shares of ownership in a company. If you own one hundred shares of
Wal-Mart stock, then you are actually part owner of Wal-Mart. Of course, since
there are several billion shares, your fractional ownership doesn't give you the
authority to do much, but you can vote in director elections, and directors are the corporate officials who ultimately run the company.
Some stocks pay dividends. Dividends are cash payments made to shareholders
on a per-share basis. For example, if you owned one hundred shares of Wal-Mart
and the directors announced a $0.25 dividend, you would receive a cash payment
of $25. But most stocks - especially high-flying ones like Google - don't pay
any dividends at all - so why would you want to own them?
The answer is that companies like Google are still growing. Rather than using
their money to pay dividends to shareholders, companies like Google use it to
make their companies bigger and better. Theoretically, they will eventually pay
dividends. All that matters to you is that as more people want the stock, its
price gets higher. Typically, more money is made from capital gains (selling
stocks at a higher price then you bought them for) than from dividends.
Mutual Funds, IRAs, 401(k)s
So what are mutual funds? Are they an alternative to CDs, bonds, and stocks?
Not really. Mutual funds are professionally managed portfolios that might
contain stocks, bonds, and cash (like CDs). For example, the Rollin Capital
Growth Fund might contain shares of Google and Wal-Mart; bonds from GM; cash;
and stocks and bonds from dozens of other companies. Mutual funds allow you to
automatically diversify your investments.
Similarly, many people believe that an IRA or a 401(k) is a type of
investment. They are not. They are types of accounts. For example, you
could hold stocks, bonds, cash, CDs, and mutual funds within your IRA
(Individual Retirement Account).
A 401(k) is similar to an IRA, but it is employer-sponsored, whereas IRAs are
set up by individuals. You may be able to have both an IRA and a 401(k).
Regardless, 401(k)s are set up by businesses, and they often limit your choices
as to what investments you hold within your 401(k). But the 401(k) itself is not
an investment - if you have a 401(k), then it contains investments (such as
cash, stocks, and bonds) within it.
In Conclusion...
You don't need to have a Harvard MBA or a stockbroker's license to get
started managing your personal finances. But a basic level of understanding is
important. Knowing a stock from a bond and an IRA from a mutual fund gives you
confidence to ask more questions and pursue more answers. This site is designed
to be your one-stop shop for all matters financial, so browse around to build
your knowledge base and you will soon be ready to take action.
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