ALL YOU NEED TO KNOW ABOUT INVESTING
1. What does it mean to invest?
Investing means committing your money to a financial asset (stock, bond, mutual fund) or endeavor (business, rental property) with the anticipation that it will pay you back with a sum of money greater than what you could have earned with the next-best alternative.
For example, let’s say you saved $1,000 over the course of the year. You have the choice of
- putting it in the bank, in a savings account that earns 1% per year,
- investing in your cousin’s rental-property business in exchange for a share of the profits, or
- buying the stock of a publicly traded company on the stock market.
In each investment scenario, you expect that at the end of the year you will have more than the $1,000 you started with. (Your alternative to investing, in this case, is not doing anything with the money.) This is the starting point of every investment.
2. What’s the difference between investing and gambling?
Gambling is generally defined as an activity where the outcome is determined by chance. Now, it’s not surprising that some people compare investing to gambling, since they feel they have no control over or insight into the outcome of the investment decision. The key difference is that while investments can both rise and fall, similar to the outcome of a series of bets you might make on sports, the core of an investment is tied to an income-generating activity.
For example, owning a share of a company means you have a claim on its future cash flow. You are essentially making the decision to buy into a business that produces a good or service that other consumers are willing to pay for. When the business sells its goods or services, it makes money, which raises the value of the business, which you are now part owner of.
3. Does saving count as investing?
Saving is generally not considered to be investing since it is not earning any return above the risk-free rate.
4. Why should I be thinking about investing?
Investing is a way to grow your money over time. You’re essentially increasing your income, which has a variety of benefits inculding financial protection, saving for retirement and increased spending power.
5. Where do returns come from?
Investment returns can come in several forms, including
- interest (what banks or institutions are willing to pay you to borrow your money),
- dividends (your share of profits as a shareholder) and
- capital appreciation (any increase in the value of your investment).
Remember that the expected value of the sum of these returns is ultimately the risk premium you required to make the investment in the first place.
For example, let’s say you invested $10 in a share of stock, which then appreciated to $12. In the interim, you also received $0.50 in dividends. The total return over this time period is $2.00 + $0.50 = $2.50. To calculate the return on your investment, you would divide $2.50 by your original investment of $10, which means your return is 25%.
6. What is the link between risk and reward?
It makes sense that the riskier an investment, the greater the potential payout must be in order to convince someone to take the risk.
Imagine that the last 10 times you lent money to Flaky Frank and Steady Sam, Flaky Frank failed to return the money five times, while Steady Sam returned your money all but one time. You could then make the reasonable assumption that Flaky Frank has a 50% chance of returning your money, while Sam has a 90% chance of returning your money. And the next time they come around looking to borrow $10, you can accurately price the risk between the two borrowers.
You could say that lending money to Flaky Frank is almost twice as risky as lending to Steady Sam. This means you would demand a higher risk premium from Frank before lending him money. Thus you can see how risk and reward are intimately connected.
7. What is a risk premium?
If you were to leave your money in your bank account, the interest you’d earn would be an amount calculated using the 3-month U.S. Treasury Bill Rate, or what’s known as the "risk-free" rate —it’s the minimum amount you should expect to see your money make for you by sitting still. If someone came to you and asked to borrow money, the risk involved would be higher—a new restaurant or a hot tech company has a greater chance of failing than does the U.S. government, which backs the Treasury bills—and so you should ask for a higher rate of return. The difference between what you charge that person and what you’d earn from the risk-free rate by leaving your money alone is called the risk premium on the investment.
The risk premium you require will vary according to how much risk you’re willing to take and your assessment of the riskiness of the proposed investment. You most likely would charge a higher risk premium to Flaky Frank than you would to Steady Sam.
8. What is compounding, and why does it matter?
Compounding, in the financial sense, refers to interest or returns earned on interest from prior periods.
9. How much money should I have before I can invest?
Before investing, you should ensure that you’ve put away a small fund toward retirement and paid off any credit card debt. Once you’ve done that, it takes relatively little money to get started. Many brokerage accounts have no account minimum, meaning you just need to be able to cover the trade commission and the price of a single share. You can easily get started with as little as $100.
10. OK, I’m ready to invest. Where should I start?
When most people think of investing, they think of the stock market. What can we buy on the stock market, anyway?
• Stocks: When you purchase a share of stock, you are essentially purchasing a claim on the company’s assets and earnings. A company’s stock price goes up when the market collectively assesses that the value of the business has increased relative to earlier assessments—say, if the company is growing faster than previously anticipated, or has announced a big product that is expected to be a big hit. Some stocks may pay dividends. A dividend is a payment by a company to its shareholders. It is usually paid on a quarterly basis, out of company profits (or cash reserves). The amount is decided by the board of directors.
• Bonds: When a company or government needs to borrow a large sum of money, they may choose to issue bonds to a public market. Each bond is like a tiny loan. Investors who buy the bonds are essentially lending little chunks of money to the company or government. The borrower agrees to pay back the amount with interest, according to a specified timeline.
• Mutual Funds: A mutual fund pools money from a bunch of different investors in order to invest in a large group of assets. Some mutual funds focus on a single asset class, such as stocks or bonds, while other invest in a variety. Unlike index funds that track market indices such as the S&P 500, or exchange-traded funds that track defined bundles of stocks, mutual funds are actively traded. This means there is a money manager who makes investment decisions about how the funds should be allocated. The cost of each share is calculated as the fund''''''''s per-share net asset value, or NAV. Some mutual funds offer multiple classes of shares, each of which has different fee structures, though they all invest in the same portfolio.
• Options: In the investment world, if you own an option on a security, you have the right—but not the obligation—to buy it at a specific price, or to sell it at a specific price. The right to buy is called a "call" option. The right to sell is called a "put" option. The specified price at which you can buy or sell is called the strike price. Investors sometimes use options as a way to get exposure to a particular asset class, without having to own the assets outright.
All of the above are commonly refered to as securities. A security is a certificate that has financial value and indicates you are an owner or a creditor. It generally refers to stocks or bonds.