Investing

What is investing?

Most Americans have some sense of what investing is, but in an overview of the topic it can be helpful to start with a definition. The Merriam-Webster dictionary defines investing like this: “Investing involves committing money in order to earn a financial return.” This essentially means that you invest money to make money and achieve your financial goals.

It’s important to make a distinction between investing and saving or trading. Saving money can be a valuable part of budgeting and spending, but it is not investing because it does not earn any sort of financial return over time. Investing is riskier than saving, because every investment comes with a possibility – however small – that it could lose you money over time. There is no such thing as absolutely risk-free investing. 

Investing is so much more than what traders on Wall Street do. It’s something that every American can do, and for the vast majority of us, it’s an important part of securing a stable and satisfying financial future. 

To illustrate just how powerful of a tool investing can be for building wealth and achieving more financial stability, let’s say you have $20,000 that you can dedicate to your financial future 30 years from now. If you stuff that $20,000 in your mattress and save it, in 30 years you will still have…$20,000 (and it will be worth much less in three decades than it’s worth now due to inflation). If you put it all in a standard savings account with a bank, you could get up to 2 percent interest. After 30 years that interest would turn your $20,000 into $36,337, a sizable increase, but still not especially helpful if inflation erodes your money’s value at about the same rate. 

However, if you invest that $20,000 and earn a 5.48 percent annual return (a reasonable expectation from a mix of stocks and bonds), then in 30 years your money will have multiplied nearly five times over to $99,113!

Given more time and with the right investments, your money can achieve even greater returns. Someone who invested $10,000 in the S&P 500 index 50 years ago, for instance, would have nearly $1.2 million today!

This is why many people decide to invest their money.

Types of investments

There are many different kinds of assets one can own when investing, but for our purposes here we’ll focus on five outlined by The Balance: common stocks, bonds, mutual funds, real estate, and structures and other entities.

The general consensus among financial experts is that, historically, buying stocks is the best way to build wealth. A stock is a share of ownership in a particular corporation. To own a share of Microsoft, for instance, is to own a tiny piece of that company. The value of that share, therefore, rises and falls with the fortune of the company – and also with the state of the economy more broadly. 

Some stocks pay dividends, which is a regular return of the company’s profits. Others allow investors to realize capital gains if the shares grow in value beyond what they paid for them. 

Stocks are a great option for investors looking for higher returns, but they require a higher risk tolerance and the investor’s confidence that companies will be successful. 

Bonds are debt securities from a company or institution. Often this is the U.S. Treasury or municipal government, but it can also be a corporation or other type of debt. When someone buys a bond, they are basically lending money to the institution or company that issued it. Until the bond is paid back at a predetermined maturation date, the borrower will pay interest on a regular basis. 

For investors with a lower risk tolerance, bonds are a good investment option as they tend not to fluctuate nearly as much as stocks and offer consistent, predictable payments.

Mutual funds are one of the most popular ways to invest in stocks and bonds. These funds are pooled money investments that have a certain focus aimed at achieving someone’s investment goals. Through different combinations of stocks and bonds, for instance, investors can change their investments from high-risk and high-return assets when they are young, and gradually shift to a lower risk portfolio as they near retirement. 

This is an appealing option for beginner investors or those who want a diverse portfolio without spending as much time managing their investments. Their popularity is evident in the fact that people are more likely to own shares of companies through mutual funds like their 401(k) or Roth IRA than they are to own individual investments.

The biggest downside to mutual funds is that they charge fees, which takes a chunk out of any investment gains. Additionally, in some cases they can increase your tax bill at the end of the year even if you didn’t sell any shares.

When it comes to investing in real estate, the most obvious and popular examples are buying a home for oneself or buying properties to rent out. In some regions and during certain periods of time these investments can increase in value quite drastically, but they are subject to risk just like anything else. 

Rather than buying individual properties, individuals can also purchase securities like a real estate investment trust (REIT). These are set up similar to a mutual fund: a professional manager of the trust handles each of the assets in the trust’s portfolio. The difference is that all of the assets are strictly real estate. 

Investing in real estate is ideal for those who want more tangible, concrete assets than stocks or bonds. However it takes experience to make profitable choices as to which pieces of real estate to invest in. Without knowledge of the asset, location, and regulations, real estate investors can be in for a world of financial headache and loss. 

Lastly, individuals can invest in structures and other entities. Rather than investing in stocks or bonds, many Americans may choose to invest in a family business like a restaurant or retail shop, a trusted friend’s startup company, or countless other options. More experienced investors may turn to hedge funds, private equity funds, or deal in futures or options contracts. 

Is investing right for you?

There are several important factors to consider before you begin investing. 

First, do you have a lot of credit card debt? If so, then it’s better to do everything you can to get that debt paid off before you start investing. Credit card companies charge high annual percentage rates (APR), often as high as 14 percent or more, to service debt. You’re unlikely to find an investment that consistently outperforms that. 

Second, do you have an emergency fund? The reality is that unpredictable life events happen. Layoffs, pandemics, natural disasters, illness, and more can turn one’s life upside-down at any time. As such, the foundation of financial security and well-being rests on having an emergency fund. Most financial advisors recommend having six months to a year worth of total living expenses in cash or a savings account in case tragedy strikes. 

Once you have that emergency fund banked away and no credit card debt, here are several principles that can help guide you to successful investing, courtesy of Wealthsimple:

Avoid lifestyle creep. Most likely you will earn more money in your thirties than you did in your twenties, and more still in your forties. Lifestyle creep happens when your living standards and expectations rise with the amount of money you make, so that things that once seemed like luxuries now feel like necessities. Maybe you used to make coffee at home and only occasionally treat yourself to a six-dollar latte, but after that recent promotion you can afford a pricey latte every day. Instead of spending more on your morning java, why not invest that money in something that could multiply many times over by the time you retire? 

Even if it’s only a little at a time, start investing. Inflation will almost always outpace the interest you get from a savings account at a bank, so once you’ve saved enough for emergencies and other significant purchases like a vehicle or down payment on a home, your money will better serve you when you invest it. 

Know what you’re investing for. It’s important to have goals and plans for your investments and not just throw your money at the first flashy opportunity you see. You may want to invest in your child’s college tuition coming up in five years, or put money away in a retirement account where it can earn returns for decades. With different time horizons, these will require different investment strategies that may be more conservative or risky.

Understand the risks you are taking. Before making any major investments, you need to decide for yourself how much you can afford to lose. If money is tight and you can barely make rent, your risk tolerance is very low. If losing the money you’re looking to invest won’t affect your life in any meaningful way, you have a much higher tolerance for risk and can invest in assets that have the potential to produce very high returns. 

Diversify your investments. This is perhaps the most tried and true advice in the investing world for reducing risk and ensuring smooth, consistent returns in the long-term. Rather than going all-in on one stock that you think will perform well, consider spreading out your money in a variety of investments. That way, if the stock performs poorly, you won’t lose everything. For investors playing the long game, fluctuations in the value of their investments isn’t the biggest risk, it’s how they react to those fluctuations. It can be hard to stick to your investing plan if you start losing money, but having a diverse portfolio makes those dips less severe. Equally important, it makes it easier to manage your emotions and ride out the rises and falls that occur in any market or industry over time. 

For more advice on investing, AIF will be hosting a variety of events and resources aimed at educating everyday Americans about the power of informed, prudent investing and how it can set you up for long-term financial success and well-being.

Additionally, the U.S. Securities and Exchange Commission has information about the different kinds of investment products available, as well as guidance about whether you are on the right track in your personal saving and investing endeavors. This includes resources about how to save for retirement, switching jobs, how the markets work, and more. Many other websites and organizations offer more detailed advice about how to start investing in the stock market specifically, or about investing in other types of assets.