People invest with all sorts of goals in mind, but at the end of the day, investing is all about putting your money to work where it has the potential to grow over time.
But how, exactly, does investing work?
While this may sound like a basic question, knowing a few terms and some simple details can be helpful — especially for new investors who are just getting started.
Below, we answer this and other questions commonly asked by new investors who are just getting started so you’ll better understand how investing works and why it’s such an important part of building long-term wealth.
Why do people invest?
People tend to invest for at least one of two reasons: Because they expect that the assets they purchase will generate income or because they expect the value of the asset to increase over time, at which point they can sell it for a profit.
When it comes to specific investment goals, some of the most common goals that people invest for are:
How does investing work?
Investing is, at its simplest, the act of buying assets that you believe will eventually produce a profit.
This profit could come from price appreciation — when the price of your asset increases, and you sell it for a gain. But it could also come in the form of distributions that you receive by being an investor in certain assets — such as dividends (stocks, REITs) or interest payments (bonds, CDs). If you own physical assets like real estate or vehicles, you could also profit by earning rent payments.
Of course, no investment is guaranteed to make a profit. While certain investments are more risky or less risky, all investments carry some risk, and that includes the possibility that you can lose some or all of your money.
Selecting the right investment assets for your unique goals and investment horizon is an important part of managing this risk.
What can you invest in?
If you think of stocks when you think about investing, you’re not alone. Typically when you start out, you’ll likely be buying stocks or bonds. While you can buy individual stocks or bonds, mutual funds and exchange traded funds (ETFs) offer an easy way to diversify your holdings. Of course, you can invest only in stocks, but doing so concentrates your risk in a single asset class.
For this reason, it’s typically advised to invest in multiple asset classes (for example, stocks and bonds). This is known as diversification, and it’s a way to reduce some of the risk that is inherent in investing. Depending on the size of your investment portfolio, at some point you may want to add other asset classes such as real estate, commodities or alternative investments, but those are generally used by experienced investors with large amounts of money to invest.
What is ‘the market’?
When people talk about “the market,” most of the time what they are referring to is the stock market, but they may also be referring to other markets where assets are bought and sold. Some other more common markets include the bond market, and real estate market.
How to invest in ‘the market’
Often, the first type of investment account many people have is a retirement account offered through their employer. However, if you want to invest in the stock market outside of a work-sponsored retirement account, you will most likely need a brokerage account. This will allow you to buy and sell different types of investments from shares of individual companies. If you don’t want to build a diverse basket of stocks and bonds yourself, you could choose to purchase mutual funds or exchange-traded funds (ETFs), which are baskets of stocks and/or traded together as one. Some ETFs are designed to replicate an underlying index, like the S&P 500, Nasdaq Composite Index or Dow Jones.
Kinds of investment accounts
What kind of an investment account you choose all depends on the financial goals that you are working to achieve. That’s because different types of accounts may be better suited to helping you save and invest for certain goals; many have tax benefits that can help your money go further.
If your primary goal is building a retirement nest egg, for example, you may choose to save using certain types of retirement accounts. This includes employer-sponsored accounts like a 401(k), 403(b), 457(b), SIMPLE 401(k) or SIMPLE IRA. It also includes personal retirement accounts like an IRA, SEP IRA or Solo 401(k). Which types or are available to you will largely depend on your employment status.
If you are investing for your child’s future educational expenses, on the other hand, you may opt instead to save in a 529 plan.
For most other investment goals, a brokerage account as mentioned above will probably be a good option. While brokerage accounts may not come with any tax-advantages, they can provide more flexibility, allowing you to access the funds when you need them regardless of purpose — for example, traveling the world, starting a business, paying for a wedding or buying a house — without paying a penalty or fees.
How to get started investing
When you are ready to start investing, you’ll need to follow the basic steps below:
Decide what type of account will serve your needs
Open the account
Determine your asset allocation
Start making deposits
What kind of investment account you open, what kind of assets you invest in and how much of your budget you prioritize for investing will all depend on your personal risk tolerance, investment timeline and financial goals. Before you get started, it’s important to think carefully about each of these points so that you feel confident in your investing strategy.
If you’re unsure how to answer these questions, a financial planner can help you get started. These professionals seek to understand your risk tolerance, investment timeline and financial goals, and then use that to craft a financial plan that is best suited to your needs.
All investments carry some level of risk including the potential loss of all money invested. No investment strategy, including diversification and strategic asset allocation, can guarantee a profit or protect against loss.