Investing: What It Means and How It Works

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Investing simply means to buy assets that have the potential for generating a return on your money. Investing is intended to generate medium- or long-term wealth through the growth of assets and compound interest.

This makes it different from savings, which is a conservative, short-term way to set aside money for more immediate goals, such as taxes, a vacation or an emergency fund.

How Do Investments Earn Money?

When an investment makes money it’s called generating returns. It does this in two broad ways: capital appreciation or income.

Capital appreciation refers to the increase in price of an asset. For example, if you buy a stock at $40 per share, and it rises to $50, you’ve generated a capital gain of $10 per share.

Income can come in the form of dividends or interest. When companies earn profits, they can distribute some of them to their stock holders in the form of dividends. Interest is paid on bonds, CDs, savings accounts and other interest-bearing investments that don’t typically offer much opportunity for capital appreciation.

Types of Investments

There are countless types of investments, but these are the most commonly bought by average investors:

Stocks

Stocks offer ownership shares in companies and allow participation in corporate growth; some may also pay a portion of the company’s cash flow in the form of a dividend.

Bonds

Bonds are loans to companies or governments that typically pay a fixed interest rate and promise the return of the principal at a set maturity date.

Real Estate

Homes, rental properties, land and REITs offer the potential for recurring income and the growth of your wealth.

Mutual Funds and ETFs

Mutual funds and ETFs pool money from investors and use the collective sum to buy investments in line with their stated objectives and risk profiles. They are often managed by professional investors, but they may also passively track major indexes like the S&P 500.

Cryptocurrency

Cryptocurrencies are digital assets that are just emerging as an asset class. They have no intrinsic value, making them highly speculative, but some have provided astounding returns to risk-tolerant investors.

Alternative Investments

This is a catch-all phrase for investments outside of traditional assets listed above, except for cryptocurrency. Commodities such as gold, silver, pork bellies or orange juice can provide a diversification element to a typical portfolio of stocks and bonds.

Collectibles are items such as coins, artwork, baseball cards or vintage cars that have value in certain communities due to their rarity and condition.

How to Make an Investment

• Decide your financial objectives and risk tolerance. What do you want to do with the money you earn from investing? Some assets are meant to be held for years, so understanding when you want to sell is important.
• Determine your risk tolerance. The higher the potential return that an investment offers, the greater the risk it carries as well. Plus, the market is constantly fluctuating. Before you invest, you’ll have to decide how much risk you feel comfortable with.
• Research the assets you’re interested in. There are so many assets to invest it, luckily you don’t have to — and shouldn’t — pick only one. Make sure you understand the terms of your assets. Some, like stock are easier to sell. Assets like bonds take years to pay out.
• Understand tax implications. If you make money on an investment you sell, you have to pay capital gains taxes.
• Find a broker. This is where you will purchase and hold your investments.

How Do Companies Use the Investments They’re Given?

Investments play an important role in how companies use and generate money to grow and expand.

For example, if a company goes public and issues shares of stock to general investors, it takes that money and uses it for general corporate purposes, which could include purchasing additional assets and equipment or contributing to research and development.

As an investor, you can participate in the growth or the income stream of other companies. Alternative investments could offer growth through other means, such as the rising demand for a commodity or collectible.

Benefits of Investing

Every person has their motivation for investing. Here are some common reasons:

Building Long-Term Wealth

The primary reason to invest is to build long-term wealth. This is particularly true for younger investors or those looking to build a nest egg for retirement. Investments offer the opportunity for capital appreciation and compound growth that can beat inflation and generate significant wealth.

Generating Passive Income

REITs and some stocks generate dividends, which is when a fund shares revenue with shareholders. This can be used as income or reinvested.

Preparing for Retirement

Once you stop working, you’ll need a source of income to fund your lifestyle. That’s why building a retirement nest egg is the primary financial goal for most investors.

Beating Inflation and Preserving Purchasing Power

Keeping your money under a mattress may prevent you from losing it in the stock market, but the value of that money will steadily erode over time, thanks to the effects of inflation.

If you stuff $500,000 in a safety deposit box and keep it for 40 years, for example, with just a 3% average inflation rate, you’ll need $1,631,018.90 to enjoy the same lifestyle. Put another way, that $500,000 will only be worth about $153,278 in today’s dollars after those 40 years. This is why growing your money over time is so important.

Real-World Examples of Investments

The S&P 500 has posted a long-term average annual return of approximately 10%. If you invested even $1,000 into that type of investment, after 40 years, you’d end up with a nest egg of about $53,699. If you added just $100 per month over those 40 years, your account would be closer to $686,000.

Returns are even more dramatic for certain high-growth stocks. Nvidia, for example, has been the best-performing stock over the past 20 years. If you had invested $1,000 into Nvidia just 20 years ago, it would now be worth $928,900.

Risks and Challenges in Investing

All investing involves taking on some level of risk. You’ll have to understand how market volatility and price fluctuations may affect your investment before you make it. Here’s what else you need to consider:

Inflation Risk

Inflation risk refers to your loss of purchasing power over time, and it primarily applies to bonds. If you buy a bond for $10,000 today and get that same $10,000 principal payment back in 10 years, it simply won’t be worth as much.

Due to inflation, that $10,000 will buy less in terms of goods and services in 10 years than it can today.

Interest-Rate Risk

Interest-rate risk refers to the drop in value that bonds sustain when market rates rise. If you buy a bond that pays you a 4% interest rate today and in six months, new bonds pay 5%, your bond will decrease in price as investors will prefer the 5% bond.

To understand interest-rate risk, remind yourself that when interest rates rise, bond prices fall, and vice versa.

Diversify Your Investments

Diversification refers to owning different types of assets that don’t move in lockstep. For example, a large-cap stock like Apple won’t trade the same way that a short-term bond or bar of gold will.

The idea is that a portion of your portfolio will always be rising while part of it is falling, smoothing out the ups and downs of your portfolio value while still generating profits over time.

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