How Does Investing Work?

Investing means putting your money into assets with the goal of earning a profit over time. In other words, you’re making your money work for you, aiming for higher growth than a standard savings account could provide. Investing always involves taking on some risk in exchange for the potential of greater rewards. 

What Counts As Investing?

Investing is the act of buying assets you believe will increase in value or generate income in the future. There are many forms of investing. You might, for instance, purchase financial products like stocks or bonds, or even tangible assets like real estate. 

Profit from investing can come in a couple of forms. Your asset’s price can go up, so you can sell it for more than you paid. Or you can earn money from the asset while you own it. For example, a stock might pay you dividends, or a property can provide rental income. 

Investing is different from saving. Savings usually stay in cash or bank accounts and are typically easy to access. Money in a savings account grows slowly and often fails to keep up with inflation, meaning your saved money might lose purchasing power over time.

On the other hand, many investments have the potential to outpace inflation, preserving or increasing your money’s purchasing power. But first, your investment must be successful, which isn’t guaranteed. After all, your investment might lose money. Always consider this trade-off: you accept some risk and uncertainty in exchange for the opportunity to grow your wealth faster than you likely could by saving alone.

Why Do People Invest?

Investing is a key strategy for achieving long-term financial goals. Some common goals that drive people to invest include saving for retirement, buying a home, funding a child’s education, starting a business, or even leaving a financial legacy. 

For big goals like these, simply saving cash might not be enough due to inflation and the large sums needed. By investing wisely over years or decades, people give their money a chance to grow significantly. 

Another reason people invest is the power of compound growth. Compounding means that the returns you earn on your investments start generating their own returns if you reinvest them. Over time, this snowball effect can accelerate the growth of your money. 

For example, if you invest $100 and earn a 5% return ($5), reinvesting that $5 means next year’s 5% gain is on $105, not just $100 – resulting in $5.25, and so on. This phenomenon of earning returns on top of returns is what makes investing so powerful over long periods. The longer you keep your money invested, the more compounding can boost your overall returns. 

Common Types of Investments

What can you invest in? Here’s an overview of the major types of investments and how they work:

• Stocks (Equities): When you buy stocks, you’re buying a small ownership stake in a company. Stocks are a popular investment because they offer high growth potential. If the company does well, its share price can rise, and you can sell at a profit. Stocks may also pay dividends, which provide income while you hold them.
  
• Bonds (Fixed Income): Bonds are loans you give to governments or corporations. When you buy a bond, you’re lending your money to the issuer for a set period. In return, the issuer pays you regular interest. When the bond matures, you get your original principal back. Interest rates impact bond prices. When interest rates rise, existing bond prices typically fall because newer bonds offer better returns. Conversely, when rates drop, existing bonds become more valuable.
  
• Mutual Funds and ETFs: These investment funds enable you to hold a basket of many stocks or bonds (or other assets) at once. When you buy a mutual fund or an exchange-traded fund (ETF), you’re pooling your money with other investors to own a diversified portfolio managed according to the fund’s goal. This helps reduce risk because even if one investment in the fund performs poorly, it’s balanced by others that may do well.
• Real Estate: Investing in real estate involves buying property or investing in real estate funds. The idea is that property values increase over time, providing capital gains if you sell. In the meantime, you can earn rental income if you lease the property. Some invest directly by buying rental properties, while others invest through Real Estate Investment Trusts (REITs) or real estate crowdfunding platforms.
  
• Commodities: Commodities are physical goods such as gold, silver, oil, natural gas, or agricultural products like wheat and corn that are traded on exchanges. Commodities can be invested in directly (by buying physical gold, for instance) or more commonly through commodity ETFs, futures contracts, or commodity-focused mutual funds.
  
• Alternative Assets: This ranges from niche investments like art and sports memorabilia to cryptocurrencies like Bitcoin and Ethereum.

Risk vs. Reward in Investing

Generally, investments that offer higher potential returns also come with higher risk. If you want the possibility of higher returns, you have to be willing to tolerate more ups and downs in the value of your investments. At the same time, safe investments tend to have lower returns.

Understanding your own comfort with risk is a key part of making investing work for you. This is often called your risk tolerance — how much volatility in your portfolio can you stomach without losing sleep or making rash decisions? 

Another way to manage risk is to consider your investment time horizon, which is how long until you need the money. If you have a long time horizon, you might feel more comfortable taking on riskier investments because you have time to ride out downturns.

Knowing your risk tolerance and time horizon is a critical first step towards developing an investment strategy aligned with your needs. An accredited and trustworthy financial advisor can help you identify your needs and develop your strategy.   

With a solid foundation in these investing basics, you’ll be well on your way to making informed decisions and joining the millions of people who use investing as a tool to achieve their financial goals.