How Do Investors Make Money From Investing?
Investing is a great way to make money and reach your financial goals. But how do investors make money from investing?
In this chapter, weâll take a look at:
Investing is one of the best ways to build wealth. However, you may wonder how you can make money from investing. When you invest you can either make money through fixed income that is being paid out to you, or through the price increases of your assets. To invest successfully, you should understand the difference between both ways of making money with investing.
đ§ Key Takeaways
- Investors can make money from their investments if the asset increases in value or pays out income in the form of interest, dividends, or rent.
- Fixed-income investments can help you to build a reliable passive income source.
- An increase in the value of your assets is not guaranteed, and you might not be able to make a positive return.
- Both approaches to making money from your investments are not mutually exclusive.
How Do You Make Money From Investing?
Investing is an effective way to create passive income streams by utilizing your money to work for you. However, there are different ways to earn money from your investments.
As an investor, you can make money from investing in two different ways:
- The asset pays you money for owning it.
- The asset increases in value and can be sold at a profit.
Both ways of making money from your investment are not necessarily exclusive to each other. For example, your asset can both pay out fixed income to you and increase or decrease in value at the same time. Many investors also mix income-producing and value-appreciating assets in their portfolios to reduce their overall investment risk. The combined return from your capital gains and all paid-out income you received is called the total return of your investment.
đĄ Example
If you have bought a stock that pays out a dividend, you will receive both fixed income from the dividend and can benefit from a value increase of the stock.
On the other hand, if you invest in a certificate of deposit or a savings account, you may receive regular income from interest payments. But the value of your deposited money will not change apart from the impact of inflation.
How Does Fixed-Income Investing Work?
Fixed-income investments are assets that pay out income to you for owning the asset. They are often useful if you plan to preserve your wealth and protect it from inflation. In addition, fixed-income securities are also helpful if you need to receive regular income without wanting to work, for example, during your retirement.
The most common types of fixed-income investments are:
- Bonds that pay out interest to the debt issuers.
- Stocks that pay out dividends to their shareholders.
- Real estate can be rented out to receive regular income.
Many fixed-income securities tend to be more stable than assets that are purely bought for capital appreciation. However, the stability and consistency of paid-out income are not guaranteed and depend on each investment you make.
When you receive paid-out income from your assets, you will typically use it in one of these ways:
- You can reinvest the paid-out income to buy new shares or bonds. As a result, your future payouts will increase further.
- You can use the paid-out income to pay for your own personal expenses. In this case, your investment income works similarly to the salary you would receive in a regular job.
Bonds
Bonds are debts that governments and companies are issuing. Governments issue bonds to raise new capital and finance day-to-day operations. On the other hand, companies issue bonds to raise new capital to grow their business without the need to dilute existing shareholders.
When you purchase a bond, you lend money to the government or company that issued the bond. In return, they will pay you interest for lending them the money. They are also obligated to pay back your initial investment, called the principal, once the bond matures.
Bonds can provide you with a regular and stable fixed income and typically pay interest each quarter. However, there is always a risk that the government or company defaults on the bond and wonât be able to pay you interest or pay back the principal. The likelihood of a default primarily depends on the creditworthiness of the bond and its duration.
For example, most governments are unlikely to default on a bond as they control their monetary policy. This is why government bonds are relatively safe and only have to pay low interest for borrowing money.
On the other hand, the quality of a corporate bond depends on the companyâs quality. For example, a company with high debt and an uncertain future has a higher risk and needs to pay higher interest to compensate. In comparison, a stable company has a lower risk and pays a lower interest.
Stocks
Many stocks will pay out part of their profits to their shareholders. These payments are called dividends and are usually paid either quarterly or annually. Sometimes a company may also decide to pay out an extraordinary dividend.
However, while all bonds must pay interest to the bondholders, companies donât have a legal obligation to pay dividends. Instead, they may stop paying dividends or change the amount based on their current financial situations. Unlike bonds, this also means that dividends can rise when a company is doing well. On the flip side, you should only invest in companies with a stable track record if you aim for a reliable dividend income.
One exception are preferred stocks that pay out a fixed and regular dividend to the shareholders. While the company doesnât have a legal obligation to pay you preferred dividends, it would risk access to future funding by not paying it. Therefore the companyâs board will generally keep paying you preferred dividends even if the company is in bad condition.
Real Estate
Real estate is one of the most commonly held assets. But the reasons for buying real estate differ. Many people purchase real estate property to have a home for themselves. However, investors purchase real estate for different reasons.
First, they expect the value of the property to increase. One way to increase the propertyâs price is to buy real estate in locations that are expected to see a spike in demand in the near future. Another way to increase the value is to improve the property through major renovations or remodeling.
Second, investors are making money from renting out the property. As a result, they will receive regular rent payments in return for providing the apartment to a tenant who rents the apartment.
Unlike bonds or stocks, which mainly provide passive income to investors, real estate requires more active work to increase the value or receive fixed income through rent payments. To increase the propertyâs value, there are often initial investments needed to improve the property, and it is uncertain if these initial investments will pay off in the end. Similarly, renting out the apartment requires someone to manage the property and deal with issues, such as repairs or non-paying tenants, that may come up.
How Does Capital Appreciation Work?
The second way to make money from your investments is through an increase in value. This value increase is commonly referred to as capital appreciation. It results from a positive difference between your investmentâs buy and sell price.
Historically, stocks and real estate are the only asset classes that have outpaced inflation. As a result, they are the best assets to invest in if you want to grow or retain your wealth in the long term.
Capital appreciation works for many different reasons:
- The longer you hold the asset, the more the value will increase due to the power of compounding.
- The value of an asset will increase (or decrease) if its underlying fundamentals change. For example, the stock of a company with growing profits will grow in value. Similarly, the value of real estate in a trendy location will increase.
However, unlike fixed-income investments, assets that appreciate in price do not make a profit until you sell the assets at a higher price than you bought them. There is no guarantee that you will manage to sell the asset at the right time or that it will appreciate at all. Therefore, it is not guaranteed to make a profit when focusing on capital appreciation of assets.
If you think the value increase is temporary, you should follow a buy-low-and-sell-high strategy. When following this strategy, you will purchase the asset at a low price and sell it once you think you have achieved the best possible return. But on the other hand, if you believe the asset will grow steadily in value, you can stay invested and follow a buy-and-hold strategy.
Next Chapter
Continue with the next lesson of our beginner-friendly guide âBasics Of Investingâ.