There are many different avenues one can take when learning how to invest or where to start when putting money aside. Here are some tips for getting started in investing:
- Do your own research. A common phrase used in the investing industry, it is important for investors to understand the vehicles they are putting their money into. Whether it is a single share of a well-established company or a risky alternative investment endeavor, investors should do their homework in advance as opposed to relying on third-party (and often biased) advice.
- Establish a personal spending plan. Before investing, individuals should consider their ability to put money away. This includes ensuring they have enough capital to pay monthly expenses and have already built up an emergency fund. As enticing as investing can be, individuals should be mindful to meet their daily life obligations first.
- Understand liquidity restrictions. Some investors may be less liquid than others, meaning it may be more difficult to sell. In some cases, an investment may be locked for a certain period and cannot be liquidated. Though not necessary fine print, it’s important to understand whether certain investments can be bought or sold at any time.
- Research tax implications. On a similar note, though an investment can be bought or sold at any time, it may be tax-adverse to do so. With unfavorable short-term capital gains tax rates, investors should be mindful of strategies that extend beyond what product they hold but what tax vehicle they put that investment in.
- Gauge your risk preference. As mentioned earlier, investing incurs risk. This means you may end up with less money than what you started with. Investors uncomfortable with this idea can (1) reduce the amount they invest to only what they are comfortable losing or (2) explore ways to mitigate risk.
- Consult an adviser. Many financial professionals would be happy to provide their guidance, let you know what they think about markets, and give you access to online platforms where you can invest money.
Return on Investment
The primary way to gauge the success of an investment is to calculate the return on investment (ROI). ROI is measured as:
ROI = (Current Value of Investment – Original Value of Investment) / Original Value of Investment
ROI allows different investments across different industries to be appropriately compared. For example, consider two investments: a $1,000 investment in stock that increased to $1,100 over the past year, or a $150,000 investment in real estate that is now worth $160,000.
Stock ROI = ($1,100 – $1,000) / $1,000 = $100 / $1,000 = 10%
Real Estate ROI = ($160,000 – $150,000) / $150,000 = $10,000 / $150,000 = 6.67%
Though the real estate investment has increased in value $10,000, many would claim that the stock investment has outperformed the real estate investment. This is because every dollar invested in the stock gained more money than every dollar invested in real estate.
ROI isn’t everything; consider an investment that earns a stead 10% ROI each year compared to a second investment that has an equal chance of earning 25% or losing 25%. For some, stable earnings outpace higher earning investment potential.
Investments and Risk
In its simplest form, investment return and risk should have a positive correlation. If an investment carries high risk, it should be accompanied by higher returns. If an investment is safer, it will often have lower returns.
When making investment decisions, investors must gauge their risk appetite. Every investor will be different, as some may be willing to risk the loss of principle in exchange for the chance at greater profits. Alternatively, extremely risk-averse investors seek only the safest vehicles where their investment will only consistently (but slowly) grow.
Investments and risk are often strongly related to prevailing conditions in the investor’s life. As an investor approaches retirement, they will no longer have stable, ongoing income. For this reason, people usually choose safer investments towards the end of their working career. On the other hand, a young professional can often bear the burden of losing money as they have their entire career to make that capital back. For this reason, younger investors are often more likely to invest in riskier investments.
Investments and Diversification
One way investors can reduce portfolio risk is to have a broad range of what they are invested in. By holding different products or securities, an investor may not lose as much money as they are not fully exposed in any one way.
The concept of diversification was born from modern portfolio theory, the idea that holding both equities and bonds will positively impact the risk-adjusted rate of return in a portfolio. The argument is holding strictly equities may maximize returns but also maximizes volatility. Pairing it with a more stable investment with lower returns will decrease the risk an investor incurs.
Investing vs. Speculation
Speculation is a distinct activity from investing. Investing involves the purchase of assets with the intent of holding them for the long term, while speculation involves attempting to capitalize on market inefficiencies for short-term profit. Ownership is generally not a goal of speculators, while investors often look to build the number of assets in their portfolios over time.
Although speculators are often making informed decisions, speculation cannot usually be categorized as traditional investing. Speculation is generally considered a higher risk activity than traditional investing (although this can vary depending on the type of investment involved). Some experts compare speculation to gambling, but the veracity of this analogy may be a matter of personal opinion.
Investing vs. Saving
Saving is accumulating money for future use and entails no risk, whereas investment is the act of leveraging money for a potential future gain and it entails some risk. Though both have the intention of having more capital available in the future, each go about growing in a very different way.
One aspect this is most transparent is the process of saving for a down payment on a home. Many advisors will suggest parking cash in a safer investment vehicle when saving for an important major purchase. Because investing incurs a higher degree of risk, an individual must compare what implications of loss of principle would be to their future plans.
Saving and investing are often intertwined because each may have a stated yield or rate of return. Another primary difference is the federal insurance coverage on certain accounts. The FDIC offers insurance coverage for bank accounts balances up to $250,000; this type of financial guarantee is often not present in investing.
How Is an Investment Different From a Bet or Gamble?
In an investment, you are providing some individual or entity with funds to be put to work growing a business, starting new projects, or maintaining day-to-day revenue generation. Investments, while they can be risky, have a positive expected return. Gambles, on the other hand, are based on chance and not putting money to work. Gambles are highly risky and also have a negative expected return in most cases (e.g., at a casino).
Is Investment the Same As Speculation?
Not really. An investment is typically a long-term commitment, where the payoff from putting that money to work can take several years. Investments are typically made only after due diligence and proper analysis have been undertaken to understand the risks and benefits that could unfold. Speculation, on the other hand, is a pure directional bet on the price of something, and often for the short-term.
What Are Some Types of Investments I Can Make?
Most ordinary individuals can easily make investments in stocks, bonds, and CDs. With stocks, you are investing in the equity of a company, which means you invest in some residual claim to a company’s future profit flows and often gain voting rights (based on the number of shares owned) to give your voice to the direction of the company. Bonds and CDs are debt investments, where the borrower puts that money to use in a pursuit that is expected to bring in cash flows greater than the interest owed to the investors.
Why Invest When You Can Save Money With Zero Risk?
As mentioned, investing is putting money to work in order to grow it. When you invest in stocks or bonds, you are putting that capital to work under the supervision of a firm and its management team. Although there is some risk, that risk is rewarded with a positive expected return in the form of capital gains and/or dividend & interest flows. Cash, on the other hand, will not grow, and may very well lose buying power over time due to inflation. Put simply, without investment, companies would not be able to raise the capital needed to grow the economy.
The Bottom Line
An investment is a plan to put money to work today in hopes of obtaining a greater amount of money in the future. Though that plan may not always work out and investments can lose money, it is also the primary way people save for major purchases or retirement. Ranging from stocks, bonds, real estate, commodities, and modern alternative investments, the digital age has brought about easy, transparent, and fast methods of investing money.