As someone with little financial experience, making the leap from saving to investing can be more than a little daunting, especially when banks pay consistent interest and guarantee deposits. However, interest rates paid by banks are typically much lower than rates available to investors, and could even result in financial loss if they are less than inflation. In order to make the switch from saving to investing, it is important to understand how the market works, the types of investments available, and the best way in which to meet your goals through investing.

There are two ways in which invested money earns returns: dividend payments and capital gains. Consider the following example. Suppose your farsighted friend buys $1,000 worth of LensMakers stock, at $10 per share, under the assumption that the optical strain of computer use, coupled with an aging population, will increase demand for glasses and contact lenses in the future. Through this transaction, your friend has become a partial owner of the LensMakers Corporation. As such, he is entitled to a proportion of the profits earned by the company.

Typically, a firm reports profits quarterly and has the option of reinvesting in the company or distributing profits among shareholders. Dividend payments, as they are known, typically come in the form of cash or additional share in the firm. Thus, every time LensMakers reports a profit, your friend stands to gain financially. As the value of a company increases, so does the value of its stock. Assume your friend was correct, and the demand for glasses and contact lenses increases significantly.

The subsequent success of the LensMakers Corporation increases the desirability of its stock, thereby increasing the price of shares from $10 per share to $15 per share (see Exhibit 1). One thousand dollars now buys a smaller share in the company than it did when your friend made his initial investment. He can therefore sell his 100 shares for $1,500 and pocket the difference; a capital gain of $500.

Unfortunately, your farsighted friend was not expecting BigPharm to invent an inexpensive drug, free off any side-effects, that prevents and even reverses the loss of vision. News of this wonder-drug causes the value of LensMakers’ stock to plummet, as it is believed that glasses and contact lenses will become obsolete in a matter of years. Scrambling to find a buyer, your friend is forced to sell his shares at far below $1,000, incurring the losses of this unforeseen development.

Therefore, compared to saving, investing can offer a higher return, but at a greater risk. Fortunately for the inexperienced investor, mutual funds help mitigate the risk associated with investment. A mutual fund is a collective investment drawing from a pool of money supplied by many investors. Typically, a parent company (Fidelity, JP Morgan, etc.) will provide investors with a diverse offering of mutual funds, each with a unique investment agenda.

Because the pool of money is so large, mutual funds can reduce risk by investing in a diverse portfolio of stocks, bonds, and money markets. In this regard, your financial future is no longer inextricably tied to the fortune of a single company. Furthermore, inexperienced investors may take comfort in the fact that their money is being managed by a well-trained financial professional, who is supervised by a board of independent directors.

Of course, mutual funds are not free. Fund managers charge a management fee for their services, which is taken from the investor’s pool of money. Investors must also pay a transfer agency fee each time shares are traded, a custodian fee to the bank that holds the money, a fee to the board of directors, printing and postage expenses, and marketing expenses, to name a few.

Many of these fees can be avoided, however, by investing in an index fund. An index is a group of firms that are similar in some important way. For instance, the S&P 500 is an index containing the stocks of the 500 largest companies in the United States. The performance of an index fund, then, depends directly upon the index in which it invests. Index funds are not managed, and therefore do not charge a management fee.

Actively managed funds, on the other hand, operate on the belief that money managers can compile a portfolio that will outperform the comparable index, justifying the extra fees and expenses. Over the long run and after expenses, however, it seems that managed funds frequently under-perform comparable index funds.

My advice, as a financial beginner to a financial beginner, is to invest in an index fund for the long term. You will receive a higher return than from your bank account, sidestep the risk of choosing your own stocks, and avoid pesky management fees charged by actively managed funds.

A good way to get started is to open an account with any of a variety of low-cost providers, many of which are decreasing minimum investment requirements in an effort to acquire younger customers, and purchase an index fund containing a large portion of the US market. In the future, you might want to consider balancing your portfolio with an international index fund as well.

To enjoy the full benefits of compound interest, set aside a portion of your income and gifts from relatives for your account, and always think long term.