Investing is the process of buying assets that increase in value over time and provide returns in the form of income payments or capital gains. In a larger sense, investing can also be about spending time or money to improve your own life or the lives of others. But in the world of finance, investing is the purchase of securities, real estate and other items of value in the pursuit of capital gains or income.
How Does Investing Work?
In the most straightforward sense, investing works when you buy an asset at a low price and sell it at a higher price. This kind of return on your investment called a capital gain. Earning returns by selling assets for a profit—or realizing your capital gains—is one way to make money investing.
When an investment gains in value between when you buy it and you sell it, it’s also known as appreciation.
- A share of stock can appreciate when a company creates a hot new product that boosts sales, increases the company’s revenues and raises the stock’s value on the market.
- A corporate bond could appreciate when it pays 5% annual interest and the same company issues new bonds that only offer 4% interest, making yours more desirable.
- A commodity like gold might appreciate because the U.S. Dollar loses value, driving up demand for gold.
- A home or condo might appreciate in value because you renovated the property, or because the neighborhood became more desirable for young families with kids.
In addition to profits from capital gains and appreciation, investing works when you buy and hold assets that generate income. Instead of realizing capital gains by selling an asset, the goal of income investing is to buy assets that generate cash flow over time and hold on to them without selling.
Many stocks pay dividends, for example. Instead of buying and selling stocks, dividend investors hold stocks and profit from the dividend income.
What Are the Basic Types of Investments?
There are four main asset classes that people can invest in with the hopes of enjoying appreciation: stocks, bonds, commodities and real estate. In addition to these basic securities, there are funds like mutual funds and exchange traded funds (ETFs) that buy different combinations of these assets. When you but these funds, you’re investing hundreds or thousands of individual assets.
Companies sell stock to raise money to fund their business operations. Buying shares of stock gives you partial ownership of a company and lets you participate in its gains (and the losses). Some stocks also pay dividends, which are small regular payments of companies’ profits.
Because there are no guaranteed returns and individual companies may go out of business, stocks come with greater risk than some other investments.
Bonds allow investors to “become the bank.” When companies and countries need to raise capital, they borrow money from investors by issuing debt, called bonds.
When you invest in bonds, you’re loaning money to the issuer for a fixed period of time. In return for your loan, the issuer will pay you a fixed rate of return as well as the money you initially loaned them.
Because of their guaranteed, fixed rates of return, bonds are also known as fixed income investments and are generally less risky than stocks. Not all bonds are “safe” investments, though. Some bonds are issued by companies with poor credit ratings, meaning they may be more likely to default on their repayment.
Commodities are agricultural products, energy products and metals, including precious metals. These assets are generally the raw materials used by industry, and their prices depend on market demand. For example, if a flood impacts the supply of wheat, the price of wheat might increase due to scarcity.
Buying “physical” commodities means holding quantities of oil, wheat and gold. As you might imagine, this is not how most people invest in commodities. Instead, investors buy commodities using futures and options contracts. You can also invest in commodities via other securities, like ETFs or buying the shares of companies that produce commodities.
Commodities can be relatively high-risk investments. Futures and options investing frequently involves trading with money you borrow, amplifying your potential for losses. That’s why buying commodities is typically for more experienced investors.
You can invest in real estate by buying a home, building or a piece of land. Real estate investments vary in risk level and are subject to a wide variety of factors, such as economic cycles, crime rates, public school ratings and local government stability.
People looking to invest in real estate without having to own or manage real estate directly might consider buying shares of a real estate investment trust (REIT). REITs are companies that use real estate to generate income for shareholders. Traditionally, they pay higher dividends than many other assets, like stocks.
Mutual Funds and ETFs
Mutual funds and ETFs invest in stocks, bonds and commodities, following a particular strategy. Funds like ETFs and mutual funds let you invest in hundreds or thousands of assets at once when you purchase their shares. This easy diversification makes mutual funds and ETFs generally less risky than individual investments.
While both mutual funds and ETFs are types of funds, they operate a little differently. Mutual funds buy and sell a wide range of assets and are frequently actively managed, meaning an investment professional chooses what they invest in. Mutual funds often are trying to perform better than a benchmark index. This active, hands-on management means mutual funds generally are more expensive to invest in than ETFs.
ETFs also contain hundreds or thousands of individual securities. Rather than trying to beat a particular index, however, ETFs generally try to copy the performance of a particular benchmark index. This passive approach to investing means your investment returns will probably never exceed average benchmark performance.
Because they aren’t actively managed, ETFs usually cost less to invest in than mutual funds. And historically, very few actively managed mutual funds have outperformed their benchmark indexes and passive funds long term.
How To Think About Risk and Investing
Different investments come with different levels of risk. Taking on more risk means your investment returns may grow faster—but it also means you face a greater chance of losing money. Conversely, less risk means you may earn profits more slowly, but your investment is safer.
Deciding how much risk to take on when investing is called gauging your risk tolerance. If you’re comfortable with more short-term ups and downs in your investment value for the chance of greater long-term returns, you probably have higher risk tolerance. On the other hand, you might feel better with a slower, more moderate rate of return, with fewer ups and downs. In that case, you may have a lower risk tolerance.
In general, financial advisors recommend you take on more risk when you’re investing for a far-off goal, like when young people invest for retirement. When you have years and decades before you need your money, you’re generally in a better position to recover from dips in your investment value.
For example, while the S&P 500 has seen a range of short-term lows, including recessions and depressions, it’s still provided average annual returns of about 10% over the past 100 years. But if you had needed your money during one of those dips, you might have seen losses. That’s why it’s important to consider your timeline and overall financial situation when investing.
Risk and Diversification
Whatever your risk tolerance, one of the best ways to manage risk is to own a variety of different investments. You’ve probably heard the saying “don’t put all your eggs in one basket.” In the world of investing, this concept is called diversification, and the right level of diversification makes for a successful, well-rounded investment portfolio.
Here’s how it plays out: If stock markets are doing well and gaining steadily, for example, it’s possible that parts of the bond market might be slipping lower. If your investments were concentrated in bonds, you might be losing money—but if you were properly diversified across bond and stock investments, you could limit your losses.
By owning a range of investments, in different companies and different asset classes, you can buffer the losses in one area with the gains in another. This keeps your portfolio steadily and safely growing over time.
How Can I Start Investing?
Getting started with investing is relatively simple, and you don’t need to have a ton of cash either. Here’s how to figure out which kind of beginner investment account is right for you:
- If you have a little bit of money to start an account but don’t want the burden of picking and choosing investments, you might start investing with a robo-advisor. These are automated investing platforms that help you invest your money in pre-made, diversified portfolios, customized for your risk tolerance and financial goals.
- If you’d prefer hands-on research and choosing your individual investments, you might prefer to open an online brokerage account and hand-pick your own investments. If you’re a beginner, remember the easy diversification that mutual funds and ETFs offer.
- If you’d prefer a hands-off approach to investing, with extra help from a professional, talk to a financial advisor that works with new investors. With a financial advisor, you can build a relationship with a trusted professional who understands your goals and can help you both choose and manage your investments over time.
Regardless of how you choose to start investing, keep in mind that investing is a long-term endeavor and that you’ll reap the greatest benefits by consistently investing over time. That means sticking with an investment strategy whether markets are up or down.
Start Investing Early, Keep Investing Regularly
“Successful investors typically build wealth systematically through regular investments, such as payroll deductions at work or automatic deductions from a checking or savings account,” says Jess Emery, a spokesperson for Vanguard Funds.
Regularly investing helps you take advantage of natural market fluctuations. When you invest a consistent amount over time, you buy fewer shares when prices are high and more shares when prices are low. Over time, this may help you pay less on average per share, a principle known as dollar-cost averaging. And “[dollar-cost averaging is] unlikely to work if you are unwilling to continue investing during a downturn in the markets,” says Emery.
You also should remember that no investment is guaranteed, but calculated risks can pay off.
“Over the last 30 years, an investment in the S&P 500 would have achieved a 10% annualized return,” says Sandi Bragar, managing director at wealth management firm Aspiriant. “Missing the 25 best single days during that period would have resulted in only a 5% annualized return.” That a reminder not to sell your investments in a panic when the market goes down. It’s incredibly hard to predict when stock values will increase again, and some of the biggest days of stock market gains have followed days of large losses.
Good investing begins by investing in yourself. Learn about the types of retirement accounts. Get your emergency savings squared away. Create a strategy for paying down your student loan debt. And with those key financial tools in action, you can start investing with confidence—putting the money you have today to work securing your future.