Investing For Dummies - Eric Tyson

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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 when you allow it to keep your money. The bank then turns around and lends your money to some other person or organization at a much higher interest rate. The rate of interest is also known as the yield. So if a bank tells you that its savings account pays 2 percent interest, the bank may also say that the account yields 2 percent. Banks usually quote interest rates or yields on an annual basis. The 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 2 percent, which compounds to an effective annual yield of 2.04 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 value after they’re issued.

A formula for calculating a company’s stock, when the stock increases (appreciates) in value, where a stock can also decline, or depreciate, in value.

      For example, if one year ago you invested $10,000 in a stock (you bought 1,000 shares at $10 per share) and the investment is now worth $11,000 (each share is worth $11), your investment’s appreciation looks like this:

An investment’s appreciation depicting that if one year ago you invested 10,000 dollars in a stock (you bought 1,000 shares at 10 dollars per share), the investment is now worth 11,000 dollars (each share is worth 11 dollars).

      Stocks can also pay dividends, which are the company’s sharing of some of its profits with you as a stockholder. Some companies, particularly those that are small or growing rapidly, choose to reinvest all their profits back into the company. (Of course, some companies don’t turn a profit, so they don’t have anything to pay out!) You need to factor any dividends into your return as well.

      Suppose that in the previous example, in addition to your stock appreciating from $10,000 to $11,000, it paid you a dividend of $100 ($1 per share). Here’s how you calculate your total return:

A formula for calculating a company’s total return, when adding dividends to the current investment value and original investment.

      You can apply this formula to the example like so:

Calculation for a stock appreciating from 10,000 dollars to 11,000 dollars, which paid a dividend of 100 dollars (1 dollar per share), giving a 11 percent return on the invested dollars.

      After-tax returns

      Although you may be happy that your stock has given you an 11 percent return on your invested dollars, remember that unless you held your investment in a tax-sheltered retirement account, you owe income 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 (for investments held more than one year) and stock dividends are lower than the tax rates on other income. In Chapter 3, 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.

      If you’ve invested in savings accounts, money market accounts, or bonds, you owe federal income taxes on the interest plus whatever state income taxes your state levies.

      If you’re in a moderate tax bracket, taxes on your investment probably run in the neighborhood of 30 percent (federal and state). So if your investment returned 6 percent before taxes, you’re left with a return of about 4.2 percent after taxes.

      Psychological returns

      Profits and tax avoidance can powerfully motivate your investment selections. However, as with other life decisions, you need to consider more than the bottom line. Some people want to have fun with their investments. Of course, they don’t want to lose money or sacrifice a lot of potential returns. Fortunately, less expensive ways to have fun do exist!

      Psychological rewards compel some investors to choose particular investment vehicles such as individual stocks, real estate, or a small business. Why? Because compared with other investments, such as managed mutual and exchange-traded funds, they see these investments as more tangible and, well, more fun.

      

Be honest with yourself about why you choose the investments that you do. Allowing your ego to get in the way can be dangerous. Do you want to invest in individual stocks because you really believe that you can do better than the best full-time professional money managers? Chances are high that you won’t. (See Chapter 6 for details.) Such questions are worth considering as you contemplate which investments you want to make.

      Savings and money market account returns

      You need to keep your extra cash that awaits investment (or an emergency) in a safe place, preferably one that doesn’t get hammered by the sea of changes in the financial markets. By default and for convenience, many people keep their extra cash in a bank savings account. Although the bank offers the U.S. government’s backing via the Federal Deposit Insurance Corporation (FDIC), it comes at a price. Most banks pay a relatively low interest rate on their savings accounts. (I discuss banking options, including the sometimes higher-yielding online banks, in Chapter 7.)

      

If you don’t need immediate access to your money, consider using Treasury bills (T-bills) or bank certificates of deposit (CDs), which are usually issued for terms such as 3, 6, or 12 months. Your money will generally earn more in one of these vehicles than in a bank savings account. (In recent years, the yields on T-bills has been so low that the best FDIC-insured bank savings accounts have higher yields.) Rates vary by institution, so it’s essential to shop around. The drawback to T-bills and bank certificates of deposit is that you generally incur a penalty (with CDs) or a transaction fee (with T-bills) if you withdraw your investment before the term expires (see Chapter 7).

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