Investing is one of the most complicated aspects of personal finance. When I first started investing, I was so confused about the logistics of the whole affair. Where do I put my money? How do I invest? What type of accounts do I need? The questions were endless and the answers weren’t simple.
Today, I’d like to try to elucidate the first step in investing: the logistics of investment accounts.
An account is like a binder
I’ve spent a lot of time trying to think of the right analogy to explain how various accounts, especially investment accounts, work. Forgive me if this seems condescending or overly simplified, but this explanation would have helped me when I started investing, so I hope it will help you too.
The best analogy I could come up with is a binder. When I was in high school, I had a separate binder for each subject I was taking. Each of the binders had folders within them for handouts, reading, notes, assignments, etc.
Investment accounts are like these binders. You have a binder for each account – one for retirement investments, one for non-retirement investments. You may even have more than one account of a certain type. For example, I happen to have two retirement accounts at different financial institutions. This is akin to having both a biology and a chemistry binder. They’re both science, but they’re still different.
Each binder has folders within
Within each of these accounts, you can have various investments. The investments are like the folders in your binder. Your investment accounts can each have several folders for each type of investment, many of which might be the same from account to account. These folders can include stocks, bonds, mutual funds, REITs, etc. For example, I own S&P 500 index funds in both a retirement account and a non-retirement account. This is the same as having notes, assignments, and reading sections in both my biology and my chemistry binders.
To make an investment, you first have to put your money into an investment account, the way you’d put a paper into the appropriate binder. Then, within that account, you can choose which investment type that money should go in. Do you want to invest in a large cap stock? An index fund? A bond? You can usually buy all of these things within a given investment account.
Investing is a two-step process
First, money must be transferred into an investment account. Then, you can invest the money within that account by purchasing a stock, bond, mutual fund, etc. It’s a two-step process. Putting money into an investment account does not mean it is invested. You have to actually buy an investment with the money in your investment account to be invested.
Does this analogy make sense? How would you explain investing to someone new to the game?