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Investment Concepts

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In order to understand how to adjust the amount of risk you take on when investing, you have to first learn the language of investing, and the fundamental concepts that underlay how investment works. Investment language and concepts are described in the next sections.

Inflation. In simple terms, the term inflation describes the general tendency of prices to increase over time. Over time it becomes more expensive to deliver goods and services, so the price of these goods and services tends to go up. The consequence of inflation is that year after year the same dollar has less and less buying power. Remember how much candy you could buy when you were 6 years old? Assuming that you are a lot older than age 6 today, it is likely that you could not buy a single piece of candy today for the same amount of money you used to spend for several pieces. This is inflation.

It is critically important that you account for inflation when planning for your retirement or any long term investment goal. It will take the average person 25 to 30 years to save and invest enough money for retirement. In that time, a dollar will buy about 1/3 as much as it did when investment was started. That means that if you are using today's dollars to calculate how much money you will need each month in retirement, you will need to triple that monthly amount to account for the effect of inflation. It takes more money to retire than you think it will! This is why it is best to start saving and investing for retirement early on in your life. A phenomena called compound interest will help you offset the effects of inflation, but only if you start investing for retirement as soon as you possibly can.

Compound Interest

Compound interest is interest on top of interest. That is, if you have a savings account, for example, the bank will use the money you have in the account for its own purposes and will pay you interest for the privilege of doing so. Compound interest occurs when the interest earned is added back to the original amount you have on deposit (as opposed to being paid directly to you in the form of cash). The bank will then use the interest money it just deposited into your account for its own purposes again, and will pay you interest on that money too. Ideally, this cycle repeats indefinitely. So, your money begins to make money for you.

Compound interest is a wonderful thing so long as it is working for you. When you owe money, however, compound interest can make it difficult to pay the debt off. When you owe money on a credit card and don't pay each month's interest off in full at the end of the month, you start to own interest on the interest you didn't pay last month! You will find compound interest being used against you in credit card accounts, overdraft lines of credit, and other such revolving accounts. So, do your best to keep compound interest working for you instead of against you by eliminating these forms of undesirable debt.

You can get compound interest working for you by investing in some sort of tax-protected retirement account. In fact, retirement accounts depend on compound interest to earn large enough sums of money to support you from retirement until your death, which generally occurs several decades after retirement. Since you will need a lot of money to support yourself in your twilight years, you will need compound interest to help you get there. Even with compound interest, most people still need 25-30 years to save and invest enough money to support themselves in retirement. It takes this long this long for effect of compound interest to work. The more time interest has to compound (grow) the more money it will yield. Similarly, the more money you have to compound the more money you will make. This is why it is important not to withdraw money from accounts where interest is compounded. It is almost always a bad idea to withdraw money from retirement accounts.