When you invest, you are committing money or another resource in the expectation of some future benefit. A college education, for example, can be considered an investment because you invest your time (a resource) in hopes of earning a degree and a good job after graduating (the future benefit). In a financial sense, investing means that an individual commits money to a financial asset, or security, such as a stock or bond, in hopes of receiving even more money later. The potential of receiving more money later is the reason why people invest in the first place.
How Do Investments Earn Money?
Most investments earn an investor money through appreciation, interest payments or dividends. Appreciation means that the value of an asset has increased. If you purchased a collectible item for $100 and five years later it was worth $500, then the collectible appreciated in value. Securities can do the same -- a stock issued by a company can increase in value over a number of years.
You’ve likely paid interest payments on a loan you’ve taken out, whether that was a student loan or mortgage. These interest payments you paid the lender were how the lender earned money on that loan (or investment). One type of security that issues interest payments to its investors is a bond. When you buy a bond, you are lending money to the government or a corporation, who promises to pay you back and make interest payments on the amount you lent.
Dividends are also issued as a payment to investors, but they are made by companies whose stock or equity that you own. Public companies issue stock to raise money for business activities, letting investors purchase these stocks. If you own a stock in a company, that company may also issue dividend payments to you as a way to share its profits with its investors. This is on top of any appreciation in the value of the stock.
Risks with Investing
Even though investing can earn money for you, it is not without risks. The biggest risk with investing is that you may lose the money you invested. Unlike savings or checking accounts, whose value is guaranteed by the Federal Deposit Insurance Corporation (FDIC), investments have no such guarantee.
Certain investments are less risky than others, but all investments carry some amount of risk. The amount of risk also affects the rate of return of an investment, meaning for someone to take on a lot of risk, there must also be the possibility of great reward. Think about it: you wouldn’t take a big risk without the possibility a big payoff. Conversely, investments with less risk typically have lower returns.
One way that investors reduce their overall risk is by investing in a variety of different securities, such as stocks and bonds, or even in different types of the same security, such as government bonds and corporate bonds. This is known as diversification, and it’s an important concept for any investor to understand.
Another big risk in investing is your own emotions. Many investments are volatile in the short term, meaning that their value may fluctuate a lot over one to five years. During economic recessions, the value of many investments may fall dramatically. As an investor, it is difficult to watch your investments lose money. This can lead to investing decisions based on fear or panic, such as selling stocks when the prices fall too low for your comfort.
When you invest, you should be holding most of your investments for ten, twenty or more years. It’s over these longer time periods that the value of investments has historically increased. The Standard and Poor’s 500 (S&P 500), a stock market index, averaged a 7% inflation-adjusted return from 1950 to 2009. Keep this in mind when you make investing decisions. You’ll perform better as an investor if your investing decisions are based on logic and reason rather than emotions.
You may have heard investing compared to gambling, and if you invest in a lackadaisical way, it may be the same. However, smart investors will approach investing strategically to choose investments that have a good expectation of return. Gambling, on the other hand, is usually based purely on chance.
Why Does Investing Matter?
When you think about investing in terms of compounding and time, it’s easy to understand why people would risk their money for a potential return. You may remember learning about compound interest in math class, but the principle is simple: the returns that you earn on money can be compounded, and then they start to earn returns too. When you give your money plenty of time to compound, the growth can become exponential.
In the chart above, we looked at two people who invested $10,000 with no additional investments and earned a 10% return every year. This means that after one year they would have $11,000 ($10,000 x 10% = $1,000 and $1,000 + $10,000 = $11,000). The only difference is that Person 1 began investing at age 20 and Person 2 began at age 30. By age 65, Person 1 has more than double what Person 2 has thanks to 10 extra years. While 10% returns every year is not realistic, investments have historically grown in value over time. The sooner you start saving and investing, the better -- and if you haven’t started yet, you should consider starting now.
How to Start Investing
The advent of online investing has made it easy to start investing. Many online brokerages don’t require a minimum amount to start, so you could start with as little as $50. Some types of brokers, like full-service brokers and robo-advisors, will even select your investments for a truly hands-off approach. Be aware that all brokers charge a variety of fees for using their services; you should understand them before signing up.
You also need to understand what type of account you will open, how much you have to invest and what you will invest in. Most new investors would be wise to invest in low-cost index mutual funds and ETFs rather than picking specific stocks or bonds. This is because funds allow you to hold a piece of tens or hundreds of different securities and many are well diversified and affordable. With whatever strategy you choose, make sure you do your research and understand all of the risks involved.