What is Investing?
Investing is the act of allocating money into various projects or assets with the expectation of generating positive returns over time. This process involves putting your capital to work, potentially leading to income, profit, or asset appreciation.
One can invest directly, such as starting a business, or indirectly by purchasing assets like real estate with the hope of generating rental income or reselling at a higher price.
The primary difference between investing and saving is the potential for risk. In investing, capital is exposed to the possibility of loss due to project failures. Meanwhile, investing varies from speculation, where capital tries to benefit from short-term price fluctuations without being employed in productive ventures.
Key Takeaways
- Investing involves committing capital to projects or activities expected to yield returns over time.
- Returns depend on the type of asset: real estate may provide rental income and capital gains, while stocks might offer dividends and price appreciation.
- Risk and return are intertwined; higher returns generally come with higher risks.
- Investors can either use a do-it-yourself approach or seek professional money management services.
- Whether an activity constitutes investing or speculation depends on risk level, holding period, and sources of returns.
Understanding Investing
Investing aims to grow your money by expecting returns from income or price appreciation. The variety of assets you can invest in spans a broad spectrum.
Risk and return go hand-in-hand: lower risks mean lower expected returns and vice versa. For example, Certificates of Deposit (CDs) are low-risk investments, bonds are medium-risk, and stocks are considered higher risk. Commodities and derivatives often carry the highest risk.
Even within the same asset class, risk and return expectations can differ widely.
The total return from an investment includes both income (like dividends or interest) and capital appreciation. For instance, Standard & Poor’s estimates that since 1926, dividends have contributed nearly a third of the total return for the S&P 500.
Investing and saving go hand in hand; savings in banks can be directed by the bank into loans, indirectly converting your savings into investment for someone else.
Types of Investments
Here are some of the most common types of investments:
Stocks
Owning a company’s stock makes you a fractional owner, entitled to participate in its growth through stock price appreciation and dividends.
Bonds
Bonds are debt obligations, allowing you to earn periodic interest and recover the bond’s face value at maturity.
Funds
Mutual funds and ETFs pool investments in various assets and are managed by professionals. ETFs trade like stocks, providing instant liquidity, whereas mutual funds trade at end-of-day prices.
Investment Trusts
Real Estate Investment Trusts (REITs) invest in properties and pay rent-based distributions to investors, combining the advantages of real estate with the liquidity of stock exchanges.
Alternative Investments
Hedge funds and private equity funds are typical alternative investments. These are usually for accredited investors but have recently become accessible to retail investors.
Options and Other Derivatives
Derivatives derive their value from other assets and usually involve leverage, making them high-risk, high-reward investments.
Commodities
Commodities like metals, oil, and grain can be traded through futures or ETFs for hedging or speculative purposes.
Comparing Investing Styles
- Active vs. Passive Investing: Active investing aims to outperform the index through strategic trading; passive investing sticks with market indices, generally with lower costs.
- Growth vs. Value Investing: Growth investors look for high-growth opportunities, while value investors seek undervalued companies for long-term gains.
How to Invest
Do-It-Yourself Investing
DIY investing involves managing your own portfolio, often through online brokers with low commissions. This approach requires financial knowledge, time, and control over one’s emotions.
Professionally-Managed Investing
Professional managers handle investments for a fee, offering convenience despite the higher costs. Investors should verify the credentials of their investment professionals.
Roboadvisor Investing
Robo-advisors use algorithms to personalize investment portfolios at low costs. These can manage everything from investment selections to retirement planning, providing a cost-effective alternative to human advisors.
A Brief History of Investing
Industrial Revolution Investing
The Industrial Revolutions increased prosperity and instigated advances in banking, enabling significant investments.
20th Century Investing
New concepts in asset pricing and portfolio theory emerged, along with new investment vehicles like hedge funds and ETFs. Online trading brought investment opportunities to the general public.
21st Century Investing
The dot-com bubble, Enron collapse, and the Great Recession shaped the start of this century. New investment platforms and apps popularized market participation among broader demographics.
Investing vs. Speculation
Whether an action is investing or speculation depends on risk, holding period, and return sources. Lower-risk, dividend-paying blue chips represent investing, while high-risk, short-term trades like cryptocurrency flipping signify speculation.
Example of Return From Investing
Consider buying 100 shares of XYZ stock at $310 and selling a year later at $460.20. Your capital gain would be (($460.20 - $310)/$310) x 100% = 48.5%. If XYZ issued dividends totaling $500 over this period, your total return would be approximately 50.11%.
How Can I Start Investing?
Choose whether to go DIY or seek professional help. Determine preferences and risk tolerance, develop a strategy, and conduct thorough research. You don’t need much to start; even small amounts can grow your wealth over time.
What Are Some Types of Investments?
Common investment options include stocks, bonds, real estate, ETFs/mutual funds, CDs, annuities, cryptocurrencies, commodities, collectibles, and precious metals.
How Can Investing Grow My Money?
Investing isn’t exclusive to the wealthy. Options like low-priced stocks, savings accounts, and retirement plans enable you to start small. Consistent investing can yield substantial returns in the future.
Investing vs. Gambling
Investing strategically allocates resources to projects with positive expected returns. Gambling relies on chance, often resulting in a negative expected return. The underlying difference is that investments can fail due to project performance, while gambling outcomes are chance-based.
The Bottom Line
Investing prudently balances risk and return, spanning various methods and asset classes such as stocks, bonds, real estate, and more. Both independent and professional pathways are viable, with technological advancements like robo-advisors aiding the process. Research, education, and understanding fundamental investing principles are crucial for success.
Related Terms: Saving, Speculation, Capital Gains, Dividends, Return on Investment.
References
- S&P Dow Jones Indices. “S&P 500 Dividend Aristocrats: The Importance of Stable Dividend Income”.
- U.S. Securities and Exchange Commission. “Tips for World Investor Week 2020: Investor Bulletin”.
- Simply Safe Dividends. “Top 10 Pieces of Investment Advice from Warren Buffet”.
