Making your money work for you is a significant step to financial independence. But what is investing, and how can you get started?
You might have heard of investing but are not sure what investing is and how it is different from similar financial topics, like saving or trading.
Investing is one of the best ways to increase your wealth over time by purchasing assets that provide a positive return. If you understand investing and can apply it correctly, it will help you improve your financial security and support your dreams financially.
In this chapter, you will learn what investing is, how it differs from similar approaches, why investing is important, and why investing works in the first place. For now, this chapter will only provide a brief look at the fundamentals of investing. We will take a closer looks at each individual section in the upcoming chapters.
As an investor, you buy assets that you expect to produce a positive return. While we will only talk about investing from a financial perspective, many investment principles can also apply to other aspects of your life. For example, spending your money or time well to improve your life can also be considered investing. However, in the financial world, investing refers to buying and selling assets, like stocks, bonds, investment funds, real estate, and more complex securities.
There are different ways how you can make money as an investor. You can either make money from paid-out income or an increase in the asset’s value. If you make money from paid-out income, your asset will pay you money for owning the asset in the form of dividends, interest, or rent.
When you save, you put away your money in a safe place. You usually save for a specific short-term goal, such as a vacation or a new phone. Your savings will 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 usually comes with little risks but also low returns.
Unlike your savings, your investments can increase or decrease in value depending on the risk of the individual investment, the price at which you bought the asset, the overall market sentiment, the current political climate, the accuracy of your own research, and many other factors. In addition, it takes longer to sell and convert your investments back to cash again. As a result, it can take much longer before you can access the value of your investment when you decide to sell it.
To summarize, saving and investing differ on a few key points:
You might have heard about some people who made a lot of money trading stocks in a short amount of time. These people are so-called traders who buy and sell assets, like stocks, for short durations to exploit price fluctuations.
While it might not be immediately obvious, there are essential differences between trading and investing:
Unlike traders, investors purchase assets with a long-term mindset. They don’t invest because they expect the price of an investment to go up or down soon. Instead, they investigate each asset they purchase beforehand and only invest if they expect the asset to produce a positive return in the long-term future.
Investors are always looking to the future, as they either expect to receive a fixed income or sell their assets at a higher price than they bought them at. Therefore, investing always carries some risks. For example, the stock of a company you purchase might decrease in value because the earnings aren’t growing as expected. Similarly, a company may outperform expectations, and the value of your stock will increase more than expected.
The risk you take depends on each investment and how well you researched it before committing your money to it. However, some types of investments generally tend to be riskier than others.
In addition, the risk you take is often directly correlated to the possible return you can make. For example, an investment with a high potential return also has a higher risk of failing to generate the expected return. As a result, low-risk investments usually offer lower returns than high-risk investments. Otherwise, no investor would be willing to invest in high-risk assets if they can make the same return with a low-risk asset.
Some people might tell you that investing is like gambling and purely based on luck. Both investing and gambling involve the risk of losing your capital with the hope of achieving a profit. However, there is a clear difference between investing and gambling.
Let's have a look at the main differences between investing and gambling:
You might wonder why you should invest in the first place? Couldn’t you just keep your money in your savings account without all the risks that come from investing?
Unfortunately, if you just keep your money in a savings account, you will most likely not be able to grow your wealth. While savings accounts provide you with a lot of safety, they also will pay low returns on your money. At the same time, your money will lose value because of the negative effects of inflation.
On the other hand, investing can provide you with much higher returns that will help you maintain or increase your money’s value. Therefore, you will be able to grow your wealth and support your current and future financial security. It will also help you to support your dreams financially, like buying your own house or retiring without the need to reduce your expenses.
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 you have 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 assets that compound grows exponentially rather than linearly. However, it can also work against you as, for example, interest on your loans also compounds.
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 time value of money, together with the concept of compounding, is probably the most important investing concept. It helps you to decide how you pick the investments that will offer you the best return.
The idea behind the time value of money is that money you can earn now has a higher value than the money you can make in the future, as you can earn compound interest on the value of your money now. If you wait for a future payment, you will miss out on the compounded interest you could receive if you invested the money right now. Therefore, delaying the time at which money is received 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.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.