Exploring the basics of investing, why investing works and how you can use investing to your advantage.
You are investing when you purchase assets in order to achieve a positive return. There is a wide variety of different investment types, such as stocks, bonds, or exchange-traded funds to choose from. Investing works because of the power of compounding which increases the value of your investments exponentially. To benefit from compounding you, however, need to follow a long-term investing strategy.
15 percent of US stock market investors started investing in 2020 according to a study from Charles Schwab.
You might also have considered starting investing recently but feel lost or overwhelmed by the amount of available information about the topic. We wrote this guide to help beginner investors, like you, understand the basics of investing.
This guide does not cover investments into specific asset types, like stocks or exchange-traded funds. Instead, we will focus on the basics of investing and answer what investing is, why you should invest, how you can make money with it, why it works, what investments you can choose from, and what rules you should follow.
When someone invests they buy assets that they expect to produce a positive return. The return of an investment can either come from paid-out income or an increase in the value of the asset.
While investments can earn you a positive return they may also result in a loss. The size of the loss depends on the characteristics of the investments.
Some types of investments generally tend to be riskier than others. The risk of the investment is often directly correlated to the possible return.
You will achieve a lower return with a low-risk investment than with a high—risk investment. Cash in a savings account, for example, is less risky than an investment in stocks.
Saving and investing differ on a few key points:
When you save you put away your money into a safe place. You usually save for a specific short-term goal, such as a vacation or a new phone. As a result, your savings will typically also be highly liquid as you will keep them in a place which can be easily and quickly accessed, like a savings account. Saving itself is not subject to big risks. However, you also cannot expect any bigger return from your savings.
Unlike your savings, your investments can increase or decrease in value depending on the risk of the individual investment. Investors invest their money with a long-term time horizon. Therefore many investments have to be first converted back into cash when selling them. As a result, it can take much longer before you can access the value of your investment.
People often confuse the difference between trading and investing. However, there are some key differences:
Traders attempt to exploit short-term price fluctuations of securities, like stocks. As a result, they are speculating in which direction the price will go. They tend to perform multiple trades within a single day and only hold the securities for as little time as needed. Due to the speculative nature of trading, there is generally high risk of losing money. However, the increased risk leads to a high reward.
Investors, on the other hand, purchase securities with a long-term mindset. They pick their investments based on the characteristics of the investment rather than based on speculation. While investing can still be risky it is considered to be less risky than trading.
When you start to invest you can choose between an active and passive investing approach.
Active investors put a lot of effort into identifying individual investing opportunities. They attempt to buy those at a low price and later sell them once the price increases. Investors following an active investing approach usually implement distinct investing strategies, such as value investing or growth investing.
Passive investors on the other hand don’t attempt to buy investments low and sell them high. Instead, they average their purchasing costs through regular purchases. This strategy is called dollar-cost averaging. When you follow a passive investing strategy you usually don’t pick individual investments. Instead, you would invest in securities that track a specific market index, market sector, or geographical region.
As a young person, you may not yet have many financial options. However, there are many reasons why you should begin investing while you’re young:
There are two possible ways how you can earn money from your investments:
Your investment might increase (appreciate) in price due to many different factors. For stocks, these might be the release of a new product, a change in the management, or better-than-expected earnings results.
Another way to earn money from investments is to receive income from them. Some stocks regularly pay a dividend. There are also preferred stock which entitles the shareholder to receive dividends. On the other hand bonds and other fixed-income securities pay out income in the form of interest payments.
Investing is the best way to grow your wealth in the long term. It works because over the long run the power of compounding works in your favor.
Albert Einstein once said that compound interest appears like magic to those who don’t understand it. But once you understand it, it will be the most powerful tool at your disposal to build wealth and achieve your investing goals.
Compounding happens when you earn a return on both the original value of the investment and the already accumulated return. This means that investments that compound grows exponentially rather than linearly.
The concept of compounding applies to both investments or interest rates on loans and deposits.
Imagine you make a €100 investment at a 10% annual growth rate. After the first year, your investment would have a value of €110. This includes your initial €100 investment plus €10 interest on your initial investment. In the second year, the value of your investment would rise to €121 as you would receive €11 interest on the previous value of €110. After 25 years your €100 investment would have accumulated to a whopping €1,083.
The rule of 72 is a simple mathematical calculation that can help you to quickly figure out when your investment will double in value. You can calculate the time to double your investment by dividing 72 by the expected annual growth rate.
While the rule is not always 100% accurate, it provides a quick and rough estimation of the potential return.
You want to figure out how long it will take for your investment to double. The annual growth rate of the investment is 10%. You divide 72 by the growth rate of 10%. The result is that the investment will double in value after 7.2 years.
The time value of money is another important investment concept.
The idea behind it is that money you can earn now has a higher value than the money you can earn in the future. This is because you can earn compound interest on the value of your money now but will miss out on the compounded interest on the money you receive in the future.
In addition, the value of your money erodes due to inflation. It causes prices to rise over time which decreases the value of your money. The only way for you to avoid inflation is by keeping your money invested at a higher rate than inflation.
Delaying the time at which money is received therefore is a missed opportunity to grow the money and protect it from eroding value.
You’re being offered to either receive €100 now or €110 in two years. Given a current risk-free interest rate of 8%, the €100 you could receive now would accumulate roughly €28 in interest after two years resulting in a total value of €128. At the same time, the €110 you could receive in two years cannot accumulate interest yet. Therefore it would be better to receive €100 now rather than choosing the supposedly better deal of receiving €110 in two years.
When you invest, you will always have to take risks to make a profit. Risky investments usually offer higher returns than low-risk investments. This relationship between risk and reward is a key reason why investing works. No investor would invest their money if taking higher risks wouldn’t equal higher potential returns.
Due to the nature of risk and reward, you will be able to make money from your investments if you are willing to take higher risks. However, you will also have a higher chance of achieving a loss. Losing your money is arguably the most significant risk in investing.
Generally, the sooner you can start to invest, the better. Investing as early as possible has multiple advantages:
However, you should first get your finances in order before you start investing. You should ensure that all high-interest debt has been paid off. In addition, your basic expenses should be covered.
In general, you should invest as much as you can comfortably afford. This should be at least 20% of your monthly salary. But the more you can invest, the better. It will allow you to reach your financial goals quicker and build up your wealth.
Before you start investing, you should check the following things:
Most people think of stocks when they hear about investing. Yet, there are many different types of investments to choose from.
These investments can be both physical or virtual assets that can be owned and traded. They are generally divided into traditional investments and alternative investments.
Many of the asset types share similar characteristics with other types of investments. As a result, these similar types of investments are commonly grouped together into broad categories. These categories are commonly referred to as asset classes.
To be a successful investor you should understand the pros and cons of all different asset classes. Ideally, you combine multiple assets classes into one single portfolio to balance out the different risk, reward, and tax characteristics. You should also consider how the different asset classes relate to each other.
The most common asset classes are:
Traditional investments consist of cash, stocks, bonds, and real estate. They tend to be easily accessible to individual investors and have been regulated heavily by the authorities.
The following investments are considered to be traditional investments:
In addition, there are a wide variety of so-called alternative investments to choose from. Most of them are only accessible to institutional or accredited, high net-worth investors. Unlike traditional investments, most alternative investments aren’t well-regulated.
Some people might tell you that investing is like gambling and that it’s purely based on luck. Both investing and gambling involve the risk of losing your capital with the hope to achieve a profit. However, there is a clear difference between investing and gambling.
These are the main differences between investing and gambling:
Investing can be risky but doesn’t need to be.
The goal of investing is to manage the risks to achieve a good return. Risk in investing can come from various sources:
Every investor will have to figure out their investing strategy. However, there are 16 few helpful rules which can help you to become a successful investor:
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.