🏛 Basics Of Investing

Introduction

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The Basics Of Investing: Everything You Should Know

Exploring the basics of investing, why investing works and how you can use investing to your advantage.

🧭 Key Takeaways

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.

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What Is Investing?

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 vs. Investing

Saving and investing differ on a few key points:

  • The level of risk and losing your money.
  • The possible return on your savings or investment.
  • The liquidity of your assets.
  • The time horizon of your objectives.

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.

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Trading vs. Investing

People often confuse the difference between trading and investing. However, there are some key differences:

  • How investments are being selected for buying or selling.
  • The time horizon of investments.
  • The level of risk.

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.

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Active vs. Passive Investing

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.

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Why Should I Invest?

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:

  1. You can achieve your financial goals.
  2. You can reach financial indepence.
  3. You still have a lot of time to become successful at investing.
  4. You have lots of time to fix your investing mistakes.
  5. It has never been easier to start investing.
  6. You can outpace inflation and retain the value of your money.
  7. You can support causes that are important to you.

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How Do Investors Earn Money?

There are two possible ways how you can earn money from your investments:

  • The value of your investment increases and you sell it at a higher price.
  • Your investment pays out income in the form of dividends or interest.

Price Appreciation

Chart showing the effects of share price appreciation on a stock investment.
Investors make money from the difference between the buy and sell price of their investment.

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.

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Why Does Investing Work?

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.

The Power Of Compounding

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.

Chart showing the difference between linear growth and compounded growth.
Unlike linear growth, compounded growth is exponential.

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.

💡 Example

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.

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The Rule Of 72

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.

Time To Double Investment = 72 / Annual Growth Rate

While the rule is not always 100% accurate, it provides a quick and rough estimation of the potential return.

💡 Example

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

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.

💡 Example

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.

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Risk vs. Reward

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.

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When Should I Start Investing?

Generally, the sooner you can start to invest, the better. Investing as early as possible has multiple advantages:

  • Mistakes matter less when you start investing early as the invested capital is small. In addition, the remaining time to make up for losses is long.
  • In the long run, short-term fluctuations and market crashes have little to no impact on your investments.
  • The power of compounding works better the longer you invest.

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.

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How Much Should I Invest?

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:

  1. Do you have enough income to fund your daily living expenses? If not, you should look into increasing your income first.
  2. Do you have any debt with high-interest expenses? If so, you should pay these off before starting to invest.
  3. Do you have an emergency fund? If not, start with building up an emergency fund of the size of 3 to 6 months of income.

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What Types Of Investments Exist?

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.

List of different traditional and alternative investments.
You can choose between traditional and alternative investments.

Asset Classes

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:

  • Cash and Cash Equivalents
  • Equity
  • Fixed Income Securities
  • Real Estate
  • Commodities
  • Derivatives
  • Currencies
List of different available asset classes for investors.
You can choose your investments from a variety of different asset classes.

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Traditional Investments

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:

  • Cash: Cash is the most common investment due to its universal availability. Investors can earn interest for depositing their cash in a savings account. While cash is generally less risky, the possible returns are also lower than with other investments.
  • Stocks: Stocks represent a single unit of ownership in a company. They can be traded on a stock exchange. Owners of stocks can either profit from an increase in the stock price or dividends paid by the company.
  • Bonds: Bonds are debt obligations that are usually issued by governments or companies. They can be bought and sold by investors and payout quarterly fixed interest payments. Bondholders will also receive the principal back once the bond expires.
  • Real Estate: The real estate market is considered to be the largest asset class in existence. Owners of real estate can profit either from rent payments or by using their own rental property and thereby reducing their cost.

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Alternative 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.

  • Exchange-traded Funds (ETFs): An exchange-traded fund is an investment fund that tracks a market index and is traded on a market exchange. This means that the ETF is trying to mirror the performance of certain parts of the market. It only holds assets like stocks, bonds, or commodities that relate to this market segment.
  • Index Funds: Index funds work similar to ETFs. Both mirror a subset of the market and only include assets related to this subset. However, the main difference is that you cannot buy or sell index funds on a market exchange like you can with ETFs. Instead, you have to buy index funds directly from the fund managers.
  • Mutual Funds: Mutual funds are actively managed investment funds. They pool money from all investors and then invest it into a diversified portfolio. These investments are picked by one or more investment advisors who purchase investments for the owners of the fund.
  • Hedge Funds: Hedge funds, like mutual funds, are actively managed investment funds that invest money for their investors. Their goal is to achieve high returns with a variety of diversified investments. Hedge funds, unlike ETFs, index funds, and mutual funds, are exclusively open to institutional investors and high-net-worth individuals.
  • Private Equity: Equity is the value of ownership in a company. When investors buy stocks, they purchase equity in publicly traded companies. Similarly, investors can buy equity in private companies which are not yet traded in the stock market.
  • Private Debt: Private debt is investments that are not financed by banks but rather by private persons. Investors can make money from those investments through the repayment of the debt as well as through accumulated interest. The investment is secured through a collateral asset.
  • Distressed Debt: When companies are in financial troubles and threatened by bankruptcy, their debt often becomes distressed. It is at risk of default which might leave the debt owner with a total loss of their investment. Some investors deliberately purchase this distressed debt as they expect the company to recover and the debt to be sold below value.
  • Commodities: Commodities are real assets, mostly natural resources, such as oil, gas, timber, gold, silver, and other precious metals. They are the basic building blocks for producing other industrial products.
  • Derivatives: Derivatives are contracts that derive their value based on an underlying asset. Common types of derivatives are options, futures contracts, and swaps. These contracts define specific dates, the value, and the underlying asset of the derivative which will result in payment between the two parties.
  • Collectibles: Collectibles are rare items that have a limited supply. This limited supply causes their prices to increase over time as the supply shrinks. Common examples of collectibles are oldtimer cars, antiques, art, rare wines and whiskey, trading cards, and non-fungible tokens (NFTs).
  • Cryptocurrencies: Cryptocurrencies are digital tokens that are stored and traded on the blockchain. The blockchain is a distributed digital ledger that records all transactions and proves their correctness. Due to its distributed nature, it cannot be manipulated.
  • Intellectual Property: Intellectual property describes ownership rights to intangible assets which are the result of creative processes. Examples include patents for inventions or literary and artistic works such as music, books, and art. The ownership rights give the owner the ability to monetize their intellectual property.

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Is Investing Gambling?

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 requires a lot of research to find the investments with the highest return and least risk. Gamblers on the other hand rely on luck and emotions. They only bet on the outcome of an event.
  • When you invest you gain ownership of an asset with a real value. Gamblers on the other hand only own something if they win.
  • Investors invest to achieve long-term growth of their wealth. Gambling on the other hand does not require a long-term strategy.
  • When you gamble you can either win or lose everything. However, there is no way to regain your losses unless you introduce more money and continue gambling. When you invest you can always use funds from selling your assets to regain your losses with better investments.
  • Investing is a well-accepted financial practice to grow your wealth. Contrary severe gambling is widely considered to be an addiction.

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Is Investing Risky?

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:

  • The balance between risk and return. Generally, a higher return is often associated with a higher risk.
  • The level of diversification of your investment portfolio. You shouldn’t just bet everything on the same investment. Instead, make sure to own different investments of different asset classes which aren’t directly correlated.
  • Risks specific to your investment. For example, being invested in a company that is subject to changing regulations or with an outdated business model.
  • The impact of inflation. Higher inflation means that your money loses value quicker.
  • The impact of interest rate changes. Higher interest rates often result in lower interest rates on fixed-income securities like bonds.

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What Rules Should I Follow To Be A Successful Investor?

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:

  1. Start as early as possible
  2. Invest with a long term mindset
  3. Invest regularly
  4. Know what you invested in
  5. Keep your emotions in check
  6. Don't blindly follow the media
  7. Know your risk tolerance
  8. Consider risk and reward
  9. Diversify your investments
  10. Consider the liquidity of your investments
  11. Don't attempt to time the market
  12. Do not invest based on past performance
  13. Never borrow to invest
  14. Be a contrarian investor
  15. Monitor your investments
  16. Consider the impact of taxes and fees

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