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Developing and Testing Your Investing Beliefs

Praise for Eric Tyson

“Eric Tyson for president! Thanks for such a wonderful guide. With a clear, no-nonsense approach to … investing for the long haul, Tyson’s book says it all without being the least bit long-winded. Pick up a copy today. It’ll be your wisest investment ever!”

— Jim Beggs, VA

“Eric Tyson is doing something important — namely, helping people at all income levels to take control of their financial futures. This book is a natural outgrowth of Tyson’s vision that he has nurtured for years. Like Henry Ford, he wants to make something that was previously accessible only to the wealthy accessible to middle-income Americans.”

— James C. Collins, coauthor of the national bestsellers Built to Last and Good to Great

“Among my favorite financial guides are … Eric Tyson’s Personal Finance For Dummies.

— Jonathan Clements, The Wall Street Journal

“In Investing For Dummies, Tyson handily dispatches both the basics … and the more complicated.”

— Lisa M. Sodders, The Capital-Journal

“Smart advice for dummies … skip the tomes … and buy Personal Finance For Dummies, which rewards your candor with advice and comfort.”

— Temma Ehrenfeld, Newsweek

“Eric Tyson … seems the perfect writer for a … For Dummies book. He doesn’t tell you what to do or consider doing without explaining the why’s and how’s — and the booby traps to avoid — in plain English… . It will lead you through the thickets of your own finances as painlessly as I can imagine.”

— Clarence Peterson, Chicago Tribune

Personal Finance For Dummies is the perfect book for people who feel guilty about inadequately managing their money but are intimidated by all of the publications out there. It’s a painless way to learn how to take control.”

— Karen Tofte, producer, National Public Radio’s Sound Money

More Best-Selling For Dummies Titles by Eric Tyson

Personal Finance in Your 20s & 30s For Dummies

This hands-on, friendly guide provides you with the targeted financial advice you need to establish firm financial footing in your 20s and 30s and to secure your finances for years to come. When it comes to protecting your financial future, starting sooner rather than later is the smartest thing you can do. Also check out Personal Finance For Dummies.

Mutual Funds For Dummies

This best-selling guide is now updated to include current fund and portfolio recommendations. Using the practical tips and techniques, you’ll design a mutual fund investment plan suited for your income, lifestyle, and risk preferences.

Home Buying Kit For Dummies

America’s No. 1 real estate book includes coverage of online resources in addition to sound financial advice from Eric Tyson and front-line real estate insights from industry veteran Ray Brown. Also available from America’s best-selling real estate team of Tyson and Brown — Selling Your House For Dummies and Mortgages For Dummies (Tyson co-authored with Robert Griswold).

Real Estate Investing For Dummies

Real estate is a proven wealth-building investment, but many people don’t know how to go about making and managing rental property investments. Real estate and property management expert Robert Griswold and Eric Tyson cover the gamut of property investment options, strategies, and techniques.

Small Business For Dummies

Take control of your future, and make the leap from employee to entrepreneur with this enterprising guide. From drafting a business plan to managing costs, you’ll profit from expert advice and real-world examples that cover every aspect of building your own business.

Investing in Your 20s & 30s For Dummies®

To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Investing in Your 20s & 30s For Dummies Cheat Sheet” in the Search box.

Introduction

Investing offers so many possibilities and so many choices. Your young adult years, which at least for the purposes of this book I define as your 20s and 30s, are filled with so much promise and potential. Your career, your interests, your personal life, and your family and friends all compete for your time and attention.

Most folks work upward of 2,000 hours per year earning a living. Managing the money that passes through their hands is an important task, one most people aren’t trained to do.

Earning money generally takes a lot of work. Managing your personal finances and saving money take discipline and sacrifice. When you have money to invest, you want to do the best you can so you earn a decent return without ending up in failed investments.

About This Book

I designed and wrote this book to help you with the important and challenging task of investing. Your young adult years are a great time to lay the best foundation for investing wisely. After all, some of the investments you make now and in the near future will have decades to grow and multiply.

I’ve worked with and taught people from all financial situations, so I know the investing concerns and questions of real folks just like you. I’ve discovered how important having healthy and strong personal finances and investments is.

I first became interested in money matters as a middle-school student when my father was laid off from his employer and received some retirement money. I worked with my dad to make investing decisions with the money. A couple of years later, I won my high school’s science fair with a project on what influences the stock market.

During my younger adult years, I worked hard to keep my living expenses low and to save and invest money so I could leave my job and pursue my entrepreneurial ideas. I accomplished that goal in my late 20s. I hope to give you some tools to help you make the most of your money and investments so you too can meet your goals and dreams.

This book is basic enough to help a novice get his or her arms around thorny investing issues. But advanced readers will be challenged as well to think about their investments and finances in a new way and identify areas for improvement. Check out the table of contents for a chapter-by-chapter rundown of what this book offers. You can also look up a specific topic in the index. Or you can turn a few pages and start at the beginning: Chapter 1.

Foolish Assumptions

No matter what your current situation is — whether you’re entering the job market right after high school, graduating college with a large amount of student loan debt, feeling pretty well established in your career, and so on — I thought of you as I wrote this book and made some assumptions about you:

Icons Used in This Book

The icons in this book help you find particular kinds of information that may be of use to you:

tip This lightbulb marks strategy recommendations for making the most of your investments.

remember This icon points out information that you’ll definitely want to remember.

warning This icon marks things to avoid and points out common mistakes people make when making and managing their investments.

investigate This icon tells you when you should consider doing some additional research. Don’t worry — I explain what to look for and what to look out for.

Beyond the Book

In addition to the material in the print or e-book you’re reading right now, this product comes with a free access-anywhere Cheat Sheet that helps you get started with investing. To view this Cheat Sheet, simply go to www.dummies.com and search for “Investing in Your 20s & 30s For Dummies Cheat Sheet” in the Search box.

Where to Go from Here

This book is organized so you can go wherever you want to find complete information. You can use the table of contents to find broad categories of information or the index to look up more specific topics.

If you’re not sure where you want to go, you may want to start with Part 1. It gives you all the basic info you need to assess your financial and investing situation and points to places where you can find more detailed information for improving it.

Part 1

Getting Started with Investing

IN THIS PART …

Define commonly used investing jargon, including explaining the different types of investments.

Use investments to accomplish your goals, such as making larger purchases, buying a home, and investing for retirement.

Understand expected investment returns and risks.

See how investment returns are taxed and what you can legally do to minimize your taxes on your investments.

Chapter 1

Making Sense of Your Investing Options

IN THIS CHAPTER

check Comparing common investments

check Explaining investment terminology — risks and returns

check Looking at the best investment companies and the rest

check Deciphering the gobbledygook of professionals and credentials

So many subject areas and disciplines are packed full of jargon. Some of this is the result of “progress” and advances, and some of it is caused by workers in the field not going out of their way to explain and define things.

In this chapter, I give you the lay of the land regarding the enormous numbers of investment choices and foreign-sounding terminology that await you in the world of investing. I also explain the types of companies that offer investments and their strengths and weaknesses. And should you want to hire some investing help, I also detail the various professionals pitching their services to you and the common credentials they hawk to convince you of their expertise.

Growing Your Money in Ownership Investments

The most exciting thing about investing during your younger adult years is that you can be more aggressive with money that you’ve earmarked to help you accomplish long-term goals. To achieve typical longer-term financial goals, such as being financially independent (also known as retiring), the money that you save and invest generally needs to grow at a rate much faster than the rate of inflation. If you put your money in a bank account that pays little or no interest, for example, you’re likely to fall short of your goals.

Ownership investments are investments like stocks, where you own a piece of a company, real estate, or a small business that has the capability to generate revenue and profits. Over the long term, consider ownership investments if you want your money to grow much faster than the rate of inflation and don’t mind more volatility in your investments’ values.

The downside to such investments is that they can fall more significantly in value than non-ownership investments (for example, bank accounts, bonds, and so on), especially in the short term. So don’t put money into ownership investments that you may need to tap in the short term for rent money or your next vacation. To reduce the risk of ownership investments, diversify — that is, hold different types of ownership investments that don’t move in tandem.

I highlight three major ownership investments in the following sections: stocks, real estate, and small business.

Sharing in corporate growth and profits: Stocks

If you want the potential to share in the growth and profits of companies, you can gain it through buying shares of their stock. Stocks are shares of ownership in a company. You can buy stock directly in individual companies through a brokerage account, or you can buy a collection of stocks via a mutual fund or exchange-traded fund (see Chapter 10).

remember You don’t need to be a business genius to make money in stocks. Simply make regular and systematic investments, and invest in proven companies and funds while minimizing your investment expenses and taxes. Of course, there’s no guarantee that every stock or stock fund that you buy will increase in value. In Chapter 8, I explain proven and time-tested methods for making money in stocks.

Profiting from real estate

You don’t need to be a high roller to make money investing in real estate. Owning and managing real estate is like running a small business: You need to satisfy customers (tenants), manage your costs, keep an eye on the competition, and so on. Some methods of real estate investing require more time than others, but many are proven ways to build wealth.

Among the key attributes of real estate investment are the following:

  • You build wealth through your rental income exceeding your expenses and through property-value appreciation.
  • You can leverage your investment by borrowing money.
  • You must be comfortable dealing with property management, which includes finding and retaining tenants and keeping up (and possibly improving) your property.

See Chapter 12 for the details on investing in real estate.

Succeeding in small business

I know people who have hit investing home runs by owning or buying businesses. Most people work full-time at running their businesses, increasing their chances of doing something big financially with them. Investing in the stock market, by contrast, tends to be more part-time in nature.

In addition to the financial rewards, however, small-business owners can enjoy seeing the impact of their work and knowing that it makes a difference. I can speak from firsthand experience (as can other small-business owners) in saying that emotionally and financially, entrepreneurship is a roller coaster.

Besides starting your own company, you can share in the economic rewards of the entrepreneurial world through buying an existing business or investing in someone else’s budding enterprise. See Chapter 14 for more details.

Keeping Money in Lending Investments

In the first section of this chapter, “Growing Your Money in Ownership Investments,” I outline how you can make your dough grow much faster than the cost of living by using stocks, real estate, and small business. However, you may want or need to play it safer when investing money for shorter-term purposes, so you should then consider lending investments. Many people use such investments through local banks, such as in a checking account, savings account, or certificate of deposit. In all these cases with a bank, you’re lending your money to the bank.

Another lending investment is bonds. When you purchase a bond that has been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest. A corporate bond may pay you 4 percent interest annually over the next three years, for example.

An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to a company through one of its bonds that matures in, say, five years, and the firm doubles its revenue and profits over that period, you won’t share in its growth. The company’s stockholders are likely to reap the rewards of the company’s success, but as a bondholder, you don’t. You simply get interest and the face value of the bond back at maturity.

Similar to bank savings accounts, money market mutual funds are another type of lending investment. Money market mutual funds generally invest in ultra-safe things such as short-term bank certificates of deposit, U.S. government–issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.

warning Many people keep too much of their money in lending investments, thus allowing others to enjoy the rewards of economic growth. Although lending investments appear safer because you know in advance what return you’ll receive, they aren’t that safe. The long-term risk of these seemingly safe money investments is that your money will grow too slowly (perhaps not even keeping you ahead of or even with the rate of inflation) to enable you to accomplish your personal financial goals. In the worst cases, the company or other institution to which you’re lending money can go under and fail to repay your loan.

Understanding Risks and Returns

Who among us wants to lose money? Of course you don’t! You put your money into an investment in the hope and expectation that you will get back more in total than you put in. And you’d rather your chosen investments not fluctuate too widely in value. When it comes to investing, no concepts are more important to grasp than risk and return, which I explain in this section.

Understanding risks

The investments that you expect to produce higher returns fluctuate more in value, particularly in the short term. However, if you attempt to avoid all the risks involved in investing, you probably won’t succeed, and you likely won’t be happy with your investment results and lifestyle. In the investment world, some people don’t go near stocks or real estate that they perceive to be volatile, for example. As a result, such investors often end up with lousy long-term returns and expose themselves to some high risks that they overlooked, such as the risk of inflation and taxes eroding the purchasing power of their money.

You can’t live without taking risks. Risk-free activities or ways of living don’t exist. You can sensibly minimize risks, but you can never eliminate them. Some methods of risk reduction aren’t palatable because they reduce your quality of life.

Risks are also composed of several factors. Following are the major types of investment risks and a few of the methods you can use to reduce these risks while not missing out on the upside that investments offer:

  • Market-value risk: Although stocks can help you build wealth, they can also drop 20 percent or more in a relatively short period of time. Although real estate, like stocks, has been a rewarding long-term investment, various real estate markets get clobbered from time to time.
  • Individual-investment risk: A down market can put an entire investment market on a roller-coaster ride, but healthy markets also have their share of individual losers. Just as individual stock prices can plummet, so can individual real estate property prices.

    warning With lending investments, you have a claim on a specific amount of a currency. Occasionally, currencies falter. Most folks ignore this low frequency but very high impact risk when thinking about lending investments.

  • Purchasing-power risk: Inflation — which is an increase in the cost of living — can erode the value of your money and its purchasing power (what you can buy with that money). I often see skittish investors keep their money in bonds and money market accounts, thinking that they’re playing it safe. The risk in this strategy is that your money won’t grow enough over the years for you to accomplish your financial goals. In other words, the lower the return you earn, the more you need to save to reach a financial goal. As a younger investor with so many years and decades of investing in your future, you need to pay the most attention to the risk of generating low returns.
  • Liquidity risk: Some investments are more liquid (how quickly an investment can be converted to cash) than others and more readily sold at fair market value on short notice. Bank savings accounts have no real liquidity risk. A real estate investment, by contrast, takes time and money to sell, and if you must sell most real estate quickly, you’ll likely get a fair amount less than its current full market value.
  • Career risk: In your 20s and 30s, your ability to earn money is probably your biggest asset. Education is a lifelong process. If you don’t continually invest in your education, you risk losing your competitive edge. Your skills and perspectives can become dated and obsolete. Although that doesn’t mean you should work 80 hours a week and never do anything fun, it does mean that part of your “work” time should involve upgrading your skills.

Managing risks

Throughout this book as I discuss various investments, I explain how to get the most out of each one. Because I’ve introduced the important issue of risk in this chapter, I would be remiss if I also didn’t give you some early ideas about how to minimize those risks. Here are some simple steps you can take to lower the risk of investments that can upset the achievement of your goals:

  • Do your homework. When you purchase real estate, a whole host of inspections can save you from buying a money pit. With stocks, you can examine some measures of value and the company’s financial condition and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems.
  • Diversify. Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely related industries. To reduce this risk, purchase stocks in a variety of industries and companies within each industry. Even better is buying diversified mutual funds and exchange-traded funds. Diversifying your investments can involve more than just your stock portfolio. You can also hold some real estate investments to diversify your investment portfolio.

    tip If you worry about the health of the U.S. economy, the government, and the dollar, you can reduce your investment risk by investing overseas. Most large U.S. companies do business overseas, so when you invest in larger U.S. company stocks, you get some international investment exposure. You can also invest in international company stocks, ideally through funds.

  • Minimize holdings in costly markets. Although I don’t believe that most investors can time the markets — buy low, sell high — spotting a greatly overpriced market isn’t too difficult. You should avoid overpriced investments because when they fall, they usually fall farther and faster than more fairly priced investments. Also, you should be able to find other investments that offer higher potential returns. Throughout this book, I explain some simple yet powerful methods you can use to measure whether a particular investment market is of fair value, of good value, or overpriced.
  • View market declines in a different light. Instead of seeing declines and market corrections as horrible things, view them as potential opportunities or “sales.” If you pass up the stock and real estate markets simply because of the potential market-value risk, you miss out on a historic, time-tested method of building substantial wealth. Try not to give in to the human emotions that often scare people away from buying something that others seem to be shunning.

Making sense of returns

Each investment has its own mix of associated risks that you take when you part with your investment dollar and, likewise, offers a different potential rate of return. When you make investments, you have the potential to make money in a variety of ways.

To determine how much money you’ve made or lost on your investment, you calculate the total return. To come up with this figure, you determine how much money you originally invested and then factor in the other components, such as interest, dividends, and appreciation or depreciation.

If you’ve ever had money in a bank account that pays interest, you know that the bank pays you a small amount of interest in exchange for your allowing the bank to keep your money. The bank then turns around and lends your money to some other person or organization at a much higher rate of interest. The rate of interest is also known as the yield. So if a bank tells you that its savings account pays 1.5 percent interest, the bank may also say that the account yields 1.5 percent. Banks usually quote interest rates or yields on an annual basis. Interest that you receive is one component of the return you receive on your investment.

If a bank pays monthly interest, the bank also likely quotes a compounded effective annual yield. After the first month’s interest is credited to your account, that interest starts earning interest as well. So the bank may say that the account pays 1.5 percent, which compounds to an effective annual yield of 1.53 percent.

When you lend your money directly to a company — which is what you do when you invest in a bond that a corporation issues — you also receive interest. Bonds, as well as stocks (which are shares of ownership in a company), fluctuate in market value after they’re issued.

When you invest in a company’s stock, you hope that the stock increases (appreciates) in value. Of course, a stock can also decline, or depreciate, in value. This change in market value is part of your return from a stock or bond investment.

Stocks can also pay dividends, which are the company’s way of sharing some of its profits with you as a stockholder and thus are part of your return. Some companies, particularly those that are small or growing rapidly, choose to reinvest all their profits back into the company.

remember Unless you held your investments in a tax-sheltered retirement account, you owe taxes on your return. Specifically, the dividends and investment appreciation that you realize upon selling are taxed, although often at relatively low rates. The tax rates on so-called long-term capital gains and stock dividends are currently and historically lower than the tax rates on other income. I discuss the different tax rates that affect your investments and explain how to make tax-wise investment decisions that fit with your overall personal financial situation and goals in Chapter 4.