I’m sure that many of you have a basic understanding of what a savings account is. (Or maybe you don’t, that’s fine too). But what about your other investing choices, like stocks, mutual and index funds, bonds, and options? Many of them are not mentioned nearly as much but still, knowing about them is just as important.
If you are a kid wanting to get started with investing, it’s crucial to learn as much as you can. You may not have all the tools and resources (namely, money) to dive in fully, but it’s great to gain a good understanding now. If you want to get a jump on your investments, follow this guide for investing as a kid. You may have more opportunities than you know.
Guide
Traditional Savings Accounts
The most basic form of investing is through savings accounts. These are the generic accounts at the bank: you put your money in and it sits. But the nice thing about these accounts is there is guaranteed growth. Many bank accounts have a set interest rate and every year, your money will grow by that percentage.
For example, if you open a savings account with 5% and you put in $1000, it will grow to $1050 by the next year. And the year after that, it will grow another 5% and become $1102.50. As you can see, every year it will grow even more than the year before. That is the power of Compound Interest. If you continue to put more and more money in your account and you leave it there to grow, it can become quite a sizable sum.
Note that when you invest in the stock market, there is no guarantee that your money will go up. You can reduce the risk of losing money but it is not a given that you will grow your money. But with a savings account, the interest rate is set and your gains are confirmed. But the main reason that many people still choose to invest is because of the higher possibility for growth.
With a savings account, your interest rates can be quite low. Compared to the stock market, many people choose to take the risk and invest in a more money-making bet. Nevertheless, the choice is yours and I would definitely recommend experimenting with both.
CDs
CDs or certificates of deposits are extremely similar to savings accounts. However, there are a few key differences. With a CD, there is a set term for your account: it can be anywhere from 6 months to a few years. You may ONLY deposit your money at the start of the term and once it is in there, it is LOCKED: you cannot withdraw or deposit without penalty until the end of the term.
The reason that people choose to invest in CDs are because they offer a higher interest rate than the average savings account. And, this interest rate is locked in. So in exchange for your money being locked, your interest is higher and cannot go down. Once the term has ended, the CD has matured. At maturity, your interest ends but you can withdraw your money.
Stocks
Let’s start off with the most well-known form of investments: stocks. While it is a relatively simple concept, it can be overwhelming. Let’s break it down.
Many large corporations like Amazon, Apple, and Disney are broken down into tiny, tiny pieces. These pieces are called shares and they are worth a set amount of money. All of the shares from one corporation make up that company’s stock.
All of the shares are worth the same amount of money and that is called the stock price. So as an example, let’s say a company called Beta had 5 different shares each worth $3. The stock price would then be $3. But the stock price changes all the time. Tomorrow, Beta’s shares might be worth $5. But next week, it could fall to $2.
The way you make money through stocks, and with all other forms of investing, is by buying something at one price and selling it at a higher price. The more you sell it for, the more you profit. But it can also go the other way around: if you buy something and it drops in price, then you will lose money if you sell it.
Partial Stocks
Many big companies’ stocks can cost hundreds of dollars. But don’t let the price point stop you from trying to invest in the best. Many brokerage companies (stock-trading companies) allow you to buy partial shares of a company. This means you can buy a fraction of a stock instead of the whole thing.
Besides making it a lot cheaper to buy a stock, this also makes it easier for you to buy multiple stocks and diversify your portfolio. For example, you could buy a third of an apple share, a third of an amazon share, and a third of a Disney share, instead of only buying one full share. Diversifying your portfolio is a great way to reduce your risk of losing money: if one stock falls, you still have your other company shares to look towards.
Mutual/Index Funds
Mutual and index funds are the prime example for diversifying your portfolio (investing in different stocks). They are basically a collection of stocks which your money is spread into. So instead of choosing the stocks that you put money into, you put money into the fund. Then, the money that you put into the fund is divided up and invested into all of the stocks that are a part of the fund.
Mutual Vs Index
What’s the difference between a Mutual and an Index fund though? One of the main differences is that a mutual fund is usually actively managed while an index fund is passively managed. What this means is that an index fund takes your money, invests in a certain index of companies, and then lets it sit.
On the other hand, a mutual fund is more active with regards to your money. They analyze the markets and use their data to create predictions of what companies will perform well. Instead of letting your money sit, mutual funds use their judgements to reinvest in new opportunities. But this also comes at a cost…
The cost
For both index and mutual funds, there is an annual charge for their services. This is usually a percentage of your principal investments (the amount that you put in). By taking a cut of your principal investments instead of any money you make, they run no risk of losing money if your investments don’t pan out.
Due to mutual funds taking more of an active role, they also charge a higher fee for their services. While index funds like the S&P 500 charge very little like 0.03% annually of your principal, mutual funds usually charge around 0.5%-0.75%.
Which is Better?
You might be thinking that a mutual fund probably makes a lot more than an index fund would. However, that’s not necessarily true. Despite it being actively managed, it doesn’t mean mutual funds are dead on in their investments: nobody can predict everything right. In fact, the S&P 500 has outperformed the large majority of mutual funds.
Ultimately, it’s up to you what you think will work. But large-scale index funds like the S&P 500 and the Dow are definitely a good option and shouldn’t be discounted.
Bonds
You might’ve learned about bonds in history class as a method for countries to raise money from their citizens. But how do they work? Bonds are basically a loan that corporations and governments take out in order to fund themselves. But these loans are not to the banks: they go out to the markets.
If you buy a bond, you are basically loaning a certain amount of money (usually $1000) that will be payed back to you with interest. The amount of interest each bond pays is different and the interest rate is called the coupon rate. Each bond has a maturity date which is when the principal amount will be payed back to you.
For example, let’s say you buy a 10 year bond from the US Government for $1000. The coupon rate is 5% annually. So every year for 10 years, you will receive $50 in interest. Once 10 years have passed, the whole value of $1000 will be payed back to you. In total, you will have spent $1000 and made $1500.
Besides the standard bonds, there are many other types, including one that doesn’t pay interest but you can buy at a discount. If you’re curious about these different types or you just want to go much more in-depth into bonds, check out this article from Investopedia.
Defaulting
What happens if the government or corporation can’t pay you back? If the entity you bought the bond from does not have the means to pay you back, they can default on their loan. Defaulting would mean that you will not be payed interest nor your principal amount back.
In order to lower your risk of this happening, monitor the credit ratings of the bonds you invest in. Certain services evaluate bonds in order to see how risky they are in terms of defaulting. For entities like the US Government, their credit ratings are quite high because they will likely have the means to pay you back. But many corporations or governments are not judged nearly as high and have a higher chance for defaulting. To make up for that, they can have much higher interest rates.
Options
Now this is where it gets a little more complicated. Just remember that a lot of what an option is is actually being an option. Before we delve into it, keep in mind that there are two types of options: calls and puts. This is going to be confusing but stick with it: options are a very interesting tool to learn.
All options are a contract. There is one buyer and one seller. The buyer of this contract gets the option to (buy or sell) 100* shares of a certain stock in a certain timeframe at a certain price** (from or to) the seller. However, they do not have to go through with it if they don’t want to. On the other hand, the seller has to (buy or sell) the stocks if the buyer does choose to go through with the trade. In return, the buyer pays a premium to the seller for their services. This premium is paid regardless of if the trade occurs.
*All options use a standard trade of 100 shares
**this set price is called the “strike price”
Call Options
Call options are one of the two types of options. Do you see how I used parentheses in the past paragraph for “(buy or sell).” That is because having the option to buy or sell the stocks depends on if it’s a call or put option. With a call option, the buyer gets the right to BUY 100 shares in a certain time frame at a set price from the seller. This buyer doesn’t have to buy the stocks but until the option’s expiration date, they have the opportunity.
As mentioned before, this buyer would also have to pay a premium (the buyer always pays the premium in Put and Call). So if they do not choose to buy the stocks from the seller, they will overall lose money from having to pay the premium.
Example: John thinks Toyota’s stock price is going to go up a lot in the next month. Right now, it’s at $100 and he thinks it will go to $120. But he doesn’t want to spend a ton of money on stocks in case he’s wrong. So John decides to enter an option contract.
John is given the option to buy 100 shares of apple at a strike price of $110 until an expiration date of 1 month. However, he has to pay 20 cents per share as a premium: $20. Luckily, John was right and two weeks later, Apple’s stock has shot up to $122! He decides to go through with the option and buy the 100 shares for $110. Now he can sell them for the market price of $122.
Overall, John spent $110 on 100 shares and a premium of $20. That amounts to $11,020. However, he sold 100 shares for $122. That amounts to 12,200. In total, John made $1,180.
Put Options
Now, put options were always more confusing to me but in reality, they’re very similar to call options. Instead of getting the option to buy stocks from the seller, the buyer now gets the option to sell 100 shares of a certain stock in a certain time frame to the seller. Keep in mind that the seller is the person writing the contract: they are deciding they will buy 100 stocks from somebody if that person chooses to sell them.
Once again, the buyer of the contract will pay a premium to the seller of the contract. If the buyer does not end up selling stocks, then they will overall lose money.
Example: John is jumping back into the markets with a new option. John thinks that Amazon stocks are going to fall in price over the next month. Right now, the stock price is $100. He thinks they will fall to $80. Let’s see what he can do.
John enters an option that will allow him to sell 100 Amazon stocks for $90 with an expiration date of 1 month. His premium is once again 20 cents per share so $20. Once again, John is right on the money. In 3 weeks, Amazon’s stock has fallen to $81. Now, John decides to sell. But before he can do that, he first buys 100 shares of Amazon stock for the current price of $81. Then he goes through with the contract and sells them for $90.
Overall, John spent 100 shares for $81 and a premium of $20, costing him $8120. But he sold his 100 shares for $90, making him $9000. In total, John made $880.
Buyer VS Seller
You might have noticed that the buyer has significantly more to gain and a lot less to lose in these scenarios. For both call and put options, the most the buyer can stand to lose is the premium. However, the seller can lose much more than that depending on how high or low the stock price may go.
Sellers in a call option are usually confident that a stock will either stay the same or fall in value. Because of their belief, they write an option to sell stocks to the buyer if that person goes through with the trade. However, the most this seller can receive is the premium value. If they were right and the stock price does not go up, the buyer will obviously not buy the stocks and the seller comes away with their premium after the expiration date. However, if they are wrong and the stock climbs higher than the strike price, they can stand to lose a lot of money depending on how high the stock price climbs to.
The same goes for a put call, but in reverse. The seller is confident that a stock will stay the same or go up. As long as they are right, the trade will not go through and the seller makes money through the premium. If they are wrong and the stock goes below the strike price, they still make money through the premium, but will lose money by buying stocks at a point higher than market price.
American VS European Options
One important factor to look out for is if an option is American or European. In both types of options, the opportunity to buy or sell the stocks is lost after the expiration date. However, in American options, the buyer can go through with the transaction at any time within the set time frame. But for European options, the buyer can ONLY go through with the trade on the expiration date.
Futures
Futures are similar to options in that they are contracts with both a buyer and a seller. However, while an option gives the right for the buyer to make the trade, a future says that they HAVE to do it. Additionally, futures are often used used for commodities such as oil and metals. And there are no puts and calls with futures: just buying and selling.
If you enter a future contract, you can either agree to buy an item or sell an item at a specific point in the future. On that date, you are obligated to go through with the deal: there are no options here. The purpose of futures are to limit risk and secure a deal ahead of time based on what you think will happen with the markets.
If you’re interested in commodities, definitely explore more about these fascinating but complicated investments.
Bottom Line
One of the defining features for options is that they are sold only as groups of 100 shares. Now obviously if you are a kid, that can end up being way more money than you’re comfortable with. That’s totally fine. Hopefully, this section still explained options in a simple and clear way. If you ever want to dabble in them, it’s always great to have a rough idea of what you’re doing.
In case you’re still a bit lost, here’s a video to clear it up:
