Investing is putting your money to work in a stock, bond, or other financial instruments with the potential of making a profit. It's less intimidating than you may think, and you don't need to be a finance guru to understand and start investing. All you need is a little familiarity with some of the main concepts. Here are the basics.
A few types of investments you may be familiar with:
- Stocks. These are issued by companies and are also referred to as shares. When you buy a stock, you become a partial owner of that company. Stocks offer more growth potential than bonds, but also carry more risk. Stocks are also called equities.
- Bonds. When you buy a bond from a government entity or company, you're lending them money. And like any lender, you expect to be paid back in full, plus interest. Bonds generally have less risk than stocks, but offer lower return potential. Bonds are also called fixed income.
- Mutual funds. This is a collection of stocks or bonds that's professionally managed. Mutual funds pool your money with other investors to purchase securities. The price is based on the value of the securities held in the fund at the end of the trading day.
- Exchange-traded funds (ETFs). These are baskets of securities that trade like individual securities throughout the course of a trading day. The price fluctuates as ETFs are bought and sold, to reflect the changing prices of the underlying holdings.
How do you make money through investing?
Your investments can make money in 1 of 2 ways. The first is through payments—such as interest or dividends. The second is through investment appreciation, aka, capital gains. When your investment appreciates, it increases in value.
Give me a simple example
Let's say you purchased a single share of a company for $10 and the share price increased by 10% over the course of a year. If you sold that share at $11, you'd make $1 in profit, minus any trading costs or taxes. Any increased value of your holdings is "realized" when you sell your holdings. Until then, any appreciation is considered "unrealized" gains. If the stock also paid a $1 dividend, your total return would be $2 or 20%.
Investing is a critical piece of your financial strategy
Over time, inflation—the general increase in the cost of goods and services—eats away at your purchasing power. Think of how much your parents or grandparents paid for their first home. Compare that to the price of real estate now. The growth potential of investing seeks to help you stay ahead of inflation.
The power of compounding over time
The snowball effect of compounding can be quite powerful, since if you have gains on your initial principal, you may then start making gains on the gains, and so on. As an example, an initial principal of $100 with a 10% return per year would be worth $110 after the first year, $121 after the second year, $133.10 after the third year, $146.41 after the fourth year, and so on. This is, of course, a hypothetical situation and assumes a steady 10% return every single year, which is not a likely scenario.
The snowball effect of compounding makes early investing, particularly in a retirement account due to the tax benefits, that much more enticing since the earlier you start investing, the greater the compounding opportunity you can hope to have. Additionally, the more you contribute to your retirement plan, the better; try to contribute the maximum amount each year so your principal has the potential to generate the most return possible.
More risk means the potential for more reward, and vice versa
Risk and reward have an inverse relationship. There's no such thing as an investment with consistently high returns and no risk. Each investment type carries different risk levels. You can use the different qualities of stock and bonds to your advantage. This is where the concept of diversification comes into play.
Diversify: Don't put all your eggs in one basket
Instead of investing your money into 1 company or only 1 asset class (like stocks or bonds), diversification is spreading out risk by choosing a wider mix of investments. Think of it like a team sport where each player has different strengths and weaknesses. One bad play doesn't have to cost you the whole game, since it's the collective team effort that determines the outcome. The right mix of stocks and bonds depends on your risk tolerance.
Different timelines require a different money approach
Say you're investing for a goal that's further out in the future, like 3 or more years away. Since you have more time, you can consider introducing more equities into your portfolio. If stocks have a down year, you have more time to recoup any losses before you need the money.
I need to access my savings soon but don't want to keep it in cash
Investors have a variety of places to hold cash that they don't want to invest, including savings accounts, money market funds, certificates of deposit (CDs), and certain short-term bonds. In deciding whether and when to invest your cash, you need to consider your goals, time frame, attitude, and needs.
The bottom line
Investing can be for everyone. You don't need deep pockets or an advanced degree to become an investor. It's possible to start small. And the sooner you start, the more time your money will have to potentially grow