Types of Interest Rates & Investments

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  • 0:01 Who Invests?
  • 1:42 Types of Investments
  • 6:04 Interest Rates
  • 7:08 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Ever wonder how to make any sense out of all those investment options you constantly hear about? This lesson helps provide some understanding, as well as introduces the concept of the real interest rate.

Who Invests?

One of the most important uses of money is as a guarantee against the future. After all, chances are that you don't waste all your money on payday with no mind for how you're going to afford food until your next paycheck. However, putting money in a coffee jar or under the mattress is not the best way to hedge for the future. For one thing, what if the house burns down? Even if such tragedy doesn't strike, money is best put to work for an individual. When an individual puts money to work in hopes of making more money in the future, this is called an investment.

Before we go any further, please understand that the word investment has two different meanings for economists. For a macroeconomist who studies the whole economy, an Investment, with an upper-case 'I,' is something made in order to make a firm more competitive. In this mindset, putting money away for the future, something individuals do, is not an Investment. Instead, it is classified as a form of savings. This is because Investments are those expenses that make something more competitive. Your education is an investment since it allows you to make more money in the future. Buying stocks and bonds, on the other hand, has nothing to do with your future competitiveness. Instead, you are hoping that those stocks and bonds make money in the future. Therefore, they are savings in the eyes of macroeconomists. Needless to say, this is a bit confusing. However, for this lesson, we are only going to focus on investments as a form of savings for consumers.

Types of Investments

Let's say that you were an investor interested in adding to your portfolio. You could just leave all your money as cash, but that has one big disadvantage. You don't get to take advantage of any growth opportunities. As a result, inflation slowly eats away at your money. To put this in perspective, the median home price in 1995 was around $150,000. By 2010, it was $300,000, and that's after a major fall in housing costs in 2007! Had you been saving for a house, simply putting money under a mattress would have resulted in you missing out. This erosion of the value of money is called inflation. Luckily, there are a number of investments that allow individuals to beat inflation and even make more money.

Open up any financial newspaper or magazine, and you are immediately hit with a wide variety of investment options. However, at their core, these boil down to two main classes: stocks and bonds. Stocks offer a share of the ownership of a company, whereas bonds are a way of loaning a company money in exchange for interest. Of the two, stocks have considerably more earnings potential, but bonds have much less risk. Throughout economics, and finance especially, you'll notice that the higher the earnings potential, the higher the risk.

Stocks make up the vast majority of investments, so let's say that you were interested in purchasing stock. In the past, you could choose between thousands of companies. Now, you can choose to own stock only in those companies or you can choose to buy funds that buy some, many or all of the stocks on the market. These range from mutual funds, which buy a preset ratio of pre-chosen stocks, or an exchange-traded fund, that is a basket of funds that can be traded like a stock. You can even buy an index fund that owns bits of every company that is traded on a given exchange.

That's a lot to try to understand, so let's look at it from the perspective of food. If you were preparing to set your menu for an automated food delivery service, putting all your money in a given stock would be akin to only ordering pizza every day. Some days, the pizza will be great. Other days, the pizza will be cold. A mutual fund would be agreeing to a set slate of meals, but you don't know what day that they will arrive. It could be that you get a delivery of sushi on a day when you are really hungry or get a pizza on a day when you are sick. An exchange-traded fund would allow you to remain on the mutual fund meal plan, but you are paying someone to predict when a delivery of tuna casserole is coming, so you could sell it in time to avoid the upset stomach. Finally, an index fund is like getting a sampler platter every day. Sure, you miss out if there is steak one day since you only get a little piece, but you also aren't stuck eating a whole plate of tuna surprise.

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