NEW YORK (TheStreet) -- Unless you're living in a cave, you've probably heard about crowdfunding, but you may be wondering how it compares to traditional investing and whether it can fit into your investment plans.
What's exciting is that crowdfunding now gives you more choices than just purchasing stocks and bonds through brokerages that may charge high fees.
Equity crowdfunding gives investors an opportunity to profit while helping small, exciting companies grow. Venture capital may soon also open up to the small investor, and technology makes all this possible quickly.
Before we discuss these options, let's review why you should be investing to begin with and refresh your knowledge of more traditional investments.
The Basics of Growing Money
There's a problem facing people aged 18 to 29. Polls show they're putting their money into safe but low-yielding savings accounts and CDs. Of course, everybody should have cash for emergencies, but beyond that, holding cash is a losing proposition because inflation will eat away the purchasing value of that cash. The U.S. inflation rate has ranged between 1.5% and 3.2% during the last five years. With the best savings account paying only 1% interest these days, that inflation is eroding the value of your cash over time.
Investors have traditionally purchased securities to grow their money, and the standard securities are stocks, bonds and real estate. In the finance world, stocks are known to yield good returns. Prices fluctuate, and stocks can lose value through economic cycles, but on average, the S&P 500 has yielded 10% annually, which amounts to about 7% when adjusted for inflation.
Money grows through the magic of compound interest. If you start with an investment of $1,000 and earn 5% interest per year, you'll add $50 to your principal in the first year, bringing your total investment to $1,050. The next year, you'll earn 5% on $1,050. In 10 years you'll have $1,628.89 even if you don't add another dime to your investment.
When you invest in stocks, the value of the security you hold will fluctuate with the market but should generally grow, and many stocks pay dividends, which investors can reinvest so that their principal compounds over time. Reinvesting dividends, with that average 7% growth rate in stock value mentioned above, can yield substantial returns over time.
The Layperson's Guide to Stock
Stock is a portion of ownership in a company. A company can be public, in which case its stock is traded on a major stock market, or private, where its shares are closely held and not listed on a stock exchange.
Buying stock in a large public company is generally a medium-risk investment, a decent way to get your money working for you, especially if you have time on your side.
Older investors want to take fewer risks with their money and have less time to see their investments grow. Older investors may be attracted to debt instruments such as bonds, which pay out interest regularly and have a set maturity date. But for people with more time, there are options that can yield higher rewards, with a certain amount of risk.
Private vs. Public
Early-stage investing means buying a stake in company before it goes public. It's risky, but it can be one of the most rewarding ways to invest. Most people salivate over the possibility of buying stock in the next early-stage Apple (AAPL - Get Report) or Google (GOOG - Get Report) .
New laws have changed the securities landscape. Until recently, private companies weren't allowed to publicly solicit investors when they wanted to sell equity, or a piece of company ownership. With the 2012 Jumpstart Our Business Startups (JOBS) Act, private companies can now tell the world that they're looking for investors.
FlashFunders is a place where investors have access to the open start-up marketplace, and early-stage private companies can pitch to investors around the world.
Start-up investing helps companies grow. A start-up with a great idea or product needs some capital to move forward, either for marketing, development or expansion. Rather than approach a bank for a loan, it will issue shares for a portion of the company at a set valuation, or what company officials think the company is worth. If the company does well, the value of those shares will increase.
Not all companies do well, of course, and most start-ups fail. The Securities and Exchange Commission recognized the risks associated with start-up investing and instituted rules restricting access to people making more than $200,000 a year ($300,000 if married) or having a net worth of more than $1 million. Such individuals are known as accredited investors.
The 2012 JOBS Act allows any investor access to start-ups, and the law will take effect once the SEC has established its rules -- although it's unclear when exactly that will happen. When it does, small investors will have access to crowdfunded equity investing, opening them up to big risks but possibly greater rewards.
There are other ways businesses and investors benefit from the intersection of tech and finance. Crowdfunding is among the most recent phenomena and a growing force in finance.
Crowdfunding Investment Options
The Internet made the sharing economy possible, and the financial crisis made it a necessity. A number of crowdfunding options suit any investor's risk tolerance.
The spectrum starts with donation-based crowdfunding. You simply give money to a cause on sites such as GoFundMe. A step beyond that, Kickstarter and Indiegogo give people the chance to fund a project for a return on their investment -- a product or prototype -- once the project's funding goal is reached.
Then there are crowdlending sites, such as Prosper and Lending Club, where investors loan money and receive regular interest payments. Similar to bonds, with an average $12,000 principal injection, the interest rates depend on the risk rating of the borrower. Depending on the rating, crowdlending can be a fairly low-risk way to harvest a return on capital.
The next step, or leap, is online equity funding at sites such as FlashFunders, CircleUp, SeedInvest, and AngelList, which allow investors to purchase shares directly from start-up companies. On FlashFunders, investors can browse the "pitch decks" of numerous startups and execute every aspect of their investment online. Right now, online equity funding is only available to accredited investors.
Online equity investing offers some of the greatest rewards for investors. There's transparency, because you can view a large number of companies from different places and in different industries. Investors can find teams they believe in and choose companies that are in verticals they're familiar with. Platforms such as FlashFunders have low minimum investments and allow investors to spread their risks across diverse portfolios. Investors can track funding progress online and have instant access to a team.
Most importantly, they can invest early in a company that may become a "unicorn." These investors need to have patience because start-ups need time to grow and these investments are illiquid and can't be turned to cash easily. They're for investors who can tolerate risk and have long investment horizons, and who not only have money to invest but also the time to conduct due diligence.
The Future of Crowdfunding
Once the SEC puts rules in place for Title III of the JOBS Act, online equity crowdfunding may become a reality, where small investors can purchase shares in early-stage, private companies. Most commentators expect the SEC to regulate this space stringently, since it's so risky.
As long as small investors can stomach the risk, access to start-up investments will give them a leg up in return potential, and it will give early-stage companies even more leverage to grow.
With so many options for investors to make money and hedge inflation, it only makes sense to keep cash in a savings account for emergency funds and to give you a stockpile for making investements.
Financial technology has opened a new era of investment choices for people who aren't professional investors but who want to see their money grow over time.