Investments can be a powerful tool to build your wealth over time. But as you start investing, it’s perfectly normal to feel out of your comfort zone. After all, you’ll be learning about investing concepts, strategies and even vocabulary that you might never have been exposed to in the past.
That’s okay; even the most successful investors were beginners at one point in their lives. All it takes to get started is a willingness to learn.
Below, we review some basic investing concepts that will help as you begin your investing journey.
What is investing?
Investing is simply the act of buying an asset (like a stock or bond) with the expectation that the asset will either appreciate in value or otherwise generate income and profit. More broadly, it’s the act of putting your money to work in the market, where it can grow over time.
Keep in mind, while the goal of investing may be to generate a profit, there are no guarantees. All investments carry some level of risk, including the risk that you may lose some or all of your principal (the amount that you invest). However, a solid investment strategy, which we discuss in greater detail below, helps you manage risk and is designed to reduce the likelihood that you will lose money.
Types of investments
There are many different types of investment assets that you can add to your portfolio. The most commonly held include:
Stocks: When you invest in stocks, you are purchasing a small share of a company, like Ford or Microsoft. Investing in stocks typically involves more risk than other types of assets, and prices can move up and down (sometimes by a large amount) in the short term. However, stocks also tend to offer greater potential for profit compared to bonds and cash equivalents.
Bonds: When you invest in bonds, you are essentially lending money to a government or business. In exchange, you’ll receive interest payments according to the terms of the bond; when the bond matures, the business or government is expected to pay your principal back to you. Bonds tend to be significantly less risky than stocks but also offer lower potential for profit.
Cash equivalents: Cash equivalents are short-term investments, like certificates of deposit (CDs), that earn interest. They’re insured by the FDIC, making them very safe investments, but they typically do not return large profits over time.
Other types of investments include real estate, commodities and more complex investments that may be more suitable once you have a little more seasoning as an investor.
Where can you invest money?
There are a number of different types of accounts that allow you to invest your money. Here are some of the most common:
Offered through your work, 401(k)s are where many people start to invest. These accounts offer special tax advantages to help you save for retirement.
Individual Retirement Account (IRA)
Individual retirement accounts, which are commonly referred to as IRAs, offer tax advantages to help you save for retirement. While 401(k)s are offered through work, anyone with earned income can open an IRA.
These accounts, opened with an investment firm, do not qualify for special tax treatment.
How do investors make money?
Investors typically make money from their investments in two main ways.
The first is by receiving income from their investments. This can be in the form of interest payments (known as coupons) from bonds, certificates of deposit and other fixed-income assets. It can also be in the form of dividends paid by some stocks (and all real estate investment trusts, or REITs).
The other option is to sell an asset that has increased in value. In this case, your profit will equal your sale price minus the original price that you paid for the asset, any dividends that may have added to the cost basis while you held it as well as any capital gains taxes that may be due. The opposite can also be true (a key investing risk) — it’s possible that an investment can decrease in value. If you sell it at a loss, you will have lost money. However, in many cases, you can simply wait for the investment to increase in value again.
Building a diversified portfolio
One of the most effective ways of managing investment risk is by diversifying your portfolio — ensuring that you are not too heavily invested in a single asset, asset class or sector of the economy.
Mutual funds, exchange-traded funds (ETFs) and index funds can be excellent investments for beginners. Because these funds are themselves invested in dozens to hundreds of different assets, investing in them provides an instant form of diversification.
Investing vs. trading vs. saving
While the terms investing, trading and saving are sometimes used interchangeably, they are very different activities done for very different reasons. These differences can best be understood by looking at the level of risk associated with each activity.
Investing is risky because many investments can gain and even lose value on a day-to-day (even minute-to-minute) basis. This means that it is very possible to lose money that you invest. Even the most conservative investments carry some level of risk. In exchange for that risk, you gain access to a much higher potential for growth over time, which is what makes investing such a powerful tool for building wealth.
Buying investments typically involves a trade (you trade your money for the stock or fund you’re buying). But when people talk about “trading,” they’re usually referring to someone who is frequently moving in and out of investment positions (buying and selling investments) in order to take advantage of short-term movements in asset prices. Positions can be held for as long as a couple of days or weeks or as short as minutes or even seconds.
As such, trading carries the greatest amount of risk when compared to both saving and long-term investing, and it typically isn’t recommended for most people.
Saving is the least risky of the three. It involves putting money aside for use in the future, typically in an FDIC-insured savings account or certificate of deposit (CD). Because the money you contribute to these accounts is FDIC insured (up to $250,000), there’s virtually zero risk that you will lose your money.
But that safety comes with a trade-off in the form of lower growth over time. While you don’t have to worry about losing money, you do have to contend with the risk that inflation may outpace whatever interest rate you earn on your savings, which can eat into your purchasing power over time. This makes savings better suited for short-term needs.
Money you set aside for emergencies or for specific goals would be good examples of savings.
Of course, many different factors should be considered in determining what percentage of your portfolio you allocate to different asset classes like stocks, bonds, real estate, etc. Your risk tolerance, investment timeline and financial goals are among the most important of these considerations. In addition, investing is just one part of a larger financial plan, which will look at your entire financial picture and how all the pieces fit together. A financial advisor can help you build the investment portfolio and financial plan that are right for you.
No investment strategy can guarantee a profit or protect against loss.
Quiz: How Much Do You Know About Investing and Your Finances?
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