An Introduction to Investing

The desire to increase your wealth and, consequently, your financial security, is natural. And, no, we are not talking about making billions out of your millions. We’re talking about setting your hard-earned dollar aside today so that you can have better financial prospects years down the line.

You see, many falsely believe that the world of investment is somehow reserved for well-to-dos. But everyone needs to grow and secure their wealth in the long run. Think of your retirement (be it 50 or 5 years from now), sending your kids off to college, or simply buying a house.

Return on investment works for everyone – it’s not an exclusive club. What is often the greatest hindrance to making the first step is the lack of sufficient financial literacy. However, you’d be surprised how a bit of education on personal finance and investing will increase your comfort – in the end, it’ll be another source of revenue. So, don’t sweat it: you are reading this blog, so you are off to a great start.

Investing is all about creating and sustaining a passive income stream. It’s where money works for you instead of what most of us are used to doing (i.e. work for money).

Without further ado, let’s take a look at the ins and outs of investing. This includes the types of assets you can invest in, their characteristics, and the different risk management strategies you can employ to protect your investments. Before long, you’ll be ready to take your first steps.

What is investing?

We hear a lot of buzz words in the financial news every day, but “investment” is one of those words whose meaning everyone is familiar with. In the broad sense of the word, investing is using resources (usually, but not exclusively, money) to acquire assets that would eventually yield a profit.

The element of time is what sets investing apart from other types of financial activity. Why? Because the underlying idea is that the value of your assets will grow over time or that they will generate income (e.g. interest or rent).

It’s like landscape gardening – you plant a seed that will one day grow into a tree with a big, fat trunk.

Still, as much as the concept of investing is familiar to us, it’s not spared the occasional mix-up with other finance terms. Let’s take a look at how investing is different from the rest.

Saving vs. Investing vs. Trading 

Saving and trading are examples of terms that are sometimes used interchangeably with investing, even though their meanings are quite different.

To begin with, the time scale of saving money is narrow (usually less than 5 years). What’s more, saving is mostly done by adding money to a bank account, and there is the strict purpose of setting that money aside. Some of us save our money in an emergency fund to be used on short notice (colloquially referred to as a rainy day fund).

While a savings bank account will accumulate some interest over time, this simply can’t be compared to the compound interest from investments in financial assets you hold in the long term.

Then there’s trading. Traders deal with extremely short windows, sometimes no longer than a day. They enter high-risk environments and use the constant fluctuation in market value to make small but frequent profits.

Investors enter the market (or obtain assets) too, but the time frames in their playbook span over decades. Investing requires a lot of discipline and patience because the goal of investing is to hold on to the assets for as long as possible to reap the greatest rewards.

Asset classes

Now, here’s where it gets a bit tricky. Asset classes include bonds, stocks, futures, diversification – the whole nine yards. While this is the type of lingo that drives most of us away from discussing investments, luckily, it’s not as intimidating as it might initially seem.

Historically, assets have been divided into different classes because investors have to follow specific guidelines to manage each type. The characteristics of assets can vary significantly (owning a small part of a company vs. owning someone else’s debt). Also, the set of financial regulations imposed by governments are not the same across the board. 

Let’s take a look at the different types of assets and how they differ.

Types of asset classes

In essence, you can invest in a stock, a bond, or a fund. 

Stock owners have a very small part of a given company. Investors buy stocks to profit if the company performs well. This happens when dividends (part of the profit) are shared with all co-owners. 

Another return of this type of investment is when the value of the stock increases over time. For example, the investor got 100 shares of stock at 10$ each in 1995 but today the stock is worth 14$ each. If they sell these shares today, they will have earned 400$ or (100×14 – 100×10) by simply holding the stock all this time.

A bond is a certificate of debt and it can be issued by a corporation or a government. Why would anyone buy someone else’s debt? Because the corporation or the government that sold you the bond is obligated to return the debt, with interest. So, an investor will profit by collecting the interest on the bond.

Finally, we all know what funds are – a stash of cash or its equivalent in financial instruments. Investors collect interest on the fund and their money makes more money by simply sitting there, stacked away.

These are the three most basic asset classes – stocks (or equity), bonds (of fixed income), and funds (or financial instruments).

However, other asset classes had to be introduced to account for alternative forms of wealth you can invest in. These include real estate (commercial or residential), commodities (gold, tobacco, crude oil), hedge funds, global markets, and even cryptocurrencies. We will delve deeper into these below. But before we do that, let’s look at where you fit into this story as well as the perks and risks involved in different types of investments.

You as an investor

We know what’s on your mind – when can I start investing and what’s the lowest amount of money I can invest? 

Actually, your first investment can be as low as 5$ and you can start today. However, we feel duty-bound to point out a few caveats before you invest your earnings. 

It’s very important to set investment goals right at the beginning. What do you want to achieve? Do you want to save money for retirement, or do you need some extra dough to cover future expenses? Despite what entertainment media might have you believe, the world of investment is definitely not a get-rich-quick scheme. Those investments that promise high interest often include high risks, too. Your safest bet is low-profit income over a long period of time – usually, that’s the most reliable investment option.

But even in this case, investing in one type of asset is not enough. To ensure profit, you need to diversify your portfolio.

The need for a portfolio

Do you believe you found the ideal asset that works best for you? Well, think again, because if you put all of your eggs in one basket, you might lose all of them in one sweeping move. To avoid this grim scenario, it’s recommended that you create an investment portfolio and invest in a mixture of different asset classes.

This is what analysts refer to when they speak about diversification. By spreading the risk across different assets in your portfolio, you increase the chances of actually profiting in the long run. It’s the best way to limit the likelihood of losing your initial investment.

So, stick around as we explore each individual asset class and the pros and cons of investing in each of them.

Funds: Cash as an asset

The most straightforward way to invest is to put money in a bank account. Keep in mind that we are not talking about savings accounts, because that money can be withdrawn on short notice without a penalty. 

In the context of investing, we are referring to financial instruments known as Certificates of Deposit (CDs). They are time deposit accounts that allow the bank to hold your money during an agreed-upon amount of time (usually years). Does that sound familiar? Well it should, because if you take the concept to an extreme, you get a retirement account. We will take a look at both CDs and retirement accounts. 

Certificates of deposit 

What’s in it for investors in CDs? Well, the bank will pay you interest for using your cash to service their other clients. However, you have to respect the time limit, because if you ask for the money before the agreed time has passed (before the CD matures), you automatically waive a part of your interest.

The pros and cons of certificates of deposit

Pros:

• Low risk – This cash won’t go anywhere unless the bank goes bankrupt. CDs and similar instruments are some of the safest investment options out there.
•  Guaranteed profit – Your earnings are tied to an exact figure and you will get it as long as you let the CD mature. This is not the case with other investment options like stocks, where the value fluctuates.  
• No fees – The terms for CDs are better than those for savings accounts. There are no maintenance fees associated, and even if there are some processing fees, they are low relative to those for other types of bank accounts.
• High interest – CDs usually either have high interest from the start or the interest grows over time as the instrument matures.

Cons:

• No availability – You have money, but they aren’t accessible to you. If you need them urgently, you have to give up a part of the profit, so your investment is partially unsuccessful.
• Inflation – The rate of inflation over time is a great concern for typical savings accounts and it can eat up a lot of the interest. Carefully study the terms of the CD so that inflation doesn’t affect your investment in a significant manner over the years.
• Conservative gains – Compared to stocks and bonds, CDs will deliver low earnings. They are great for growing your retirement account, but if you are into high-yield investments, look elsewhere.

Retirement accounts

While simply deciding to nurture your retirement nest egg might not seem as exciting as the other fancy and glorified investing opportunities out there, it is in fact a legitimate investment with valuable returns.

You are probably familiar with some of the options for individual retirement accounts (IRA). The main differences between rollover, Roth, or traditional IRA are related to taxation and you can study them closely to make sure they fit your retirement plans.

The pros and cons of retirement accounts

Pros: 

• Securing your retirement – We have enough worries as it is. The retirement account grows consistently until the time of distribution.
• Employer matching – You can go for a long-term investment vehicle like the 401(k), where employers match each of your invested dollars. Who would refuse contributions from a partner in their investment, while being the sole beneficiary of the accumulated fund?
• Emergency fund – You can borrow from yourself, i.e take a loan from your retirement account if you are in a financial crisis.

Cons:

• Money is tied up – If you have a 401 (k) plan, there are penalties of 10% for early withdrawal (before the age of 59½). In theory, the retirement fund is available, but most people won’t use the money until they actually retire. No one wants to lose their nest egg.
• High account fees – Retirement accounts that are liquid investment funds attract more fees for processing. 
• Limited investment options – In a retirement account, the aspect of saving money is more prominent than the investing component. You can usually invest only in basic assets. 

Bonds

Given the fact that bonds are a certificate of debt (and often issued by the government), they are one of the safest investment assets out there. The value of this debt can’t be completely lost over time and each bondholder is guaranteed to get a specific amount of money once the bond is repaid.

There are three elements to bonds that investors should keep in mind. 

• First, there is the principal, or the money lent to the bond issuer. 
• Then, there is the interest, and bondholders usually get their interest annually (or semi-annually). 
• Finally, bonds have a fixed due date for repayment, also known as a bond maturity date.

If the investor holds onto the bond right until the end, they get the full principal back, and they’ve received their return on investment in the form of annual interest before the bond matured. However, if you as an investor want to sell the bond before it matures, you lose part of the investment. Usually, this is in the form of a commission you pay to the broker that settles the transaction.

The pros and cons of bonds

Pros:

Investing in bonds is very reliable because you know most of the relevant figures right from the start. The maturity date and the returns are known, and there are no major changes you need to look out for. Also, investors are partially exempt from tax on interest from bonds. 

Cons:

No investment is totally risk-free, and bonds are no exception. If the interest rate on the bond is fixed, the investor will lose some of the returns due to inflation. 

Also, if the investor needs to pull the money on short notice, this will not only cause losses because the bond is traded before its maturity, but it can also hold up your money indefinitely. Bonds are not a liquid instrument so you might end up having an asset no one wants to buy. The market for bonds is most active when the government increases interest rates, and trading is easier in those periods.

Mutual funds

Mutual funds are another type of investment that allows investors (yes, more than one) to pool their resources together and jointly purchase assets. By joining in this shared venture, investors gain access to stocks and securities. However, the fund requires active management and incurs greater costs. Mutual funds are handled by professional portfolio managers, yet they are still accessible to an investor willing to enter with as little as 1000$. 

There are many mutual funds and the decisions on asset allocation are usually completely delegated to portfolio managers who track opportunities. Most of the activities concerning the management of such funds are done after the markets close. The transactions (buying and selling) can’t take place earlier than that because the funds are valued at the end of the trading day.

The pros and cons of mutual funds

Pros:

• Risk is managed by professionals – Rookie investors would benefit from some help in the strategizing department. Portfolio managers follow investment options and their decision-making is based on accumulated experience.
• A greater level of diversification – If the portfolio manager pools the investments in the mutual fund together, they can invest in bonds, stocks, securities, and other asset classes. This level of diversification improves the risk management profile of both individual investors and the fund as a whole.
• It’s a liquid investment – Since investors own shares in the mutual fund, they will have an easier time redeeming their shares, which is not always the case with other asset classes. Plus, they can take their returns at the current net asset value (NAV). 
• Sharing costs – As you can imagine, investing in mutual funds allows for the sharing of costs, hence the relatively low threshold for new investors.

Cons: 

• Portfolio managers cut into your returns – If you were to manage a fund on your own, this would take up a lot of your time and nerves, so funds are handed over to professionals. And obviously, if you hire a professional to take care of your fund full time, you will have to forfeit a big chunk of the expected returns as compensation for their services. 
• Costs can’t be avoided – Even if you settle the charges for fund management upfront, you still need to turn over trade commissions and other fees. 

ETFS

Exchange-traded funds (ETFs) are a step closer to stock investments because fund managers can buy or sell these funds during the trading day, not after it. They are also preferred by inexperienced investors, since ETFs offer some of the benefits that are typical for mutual funds.

The fact that an EFT investor can benefit from value fluctuations during the day (and get a good bargain on stocks) or follow market indexes like s-p-500 (Standards and Poor 500) is enough to yield more reliable profits. 

Most online brokerage platforms will offer you the option to invest in ETFs. This may be the best method to invest in EFTs if you can’t directly buy individual shares in these funds.

Stocks

We explained the streams of profit from buying stocks earlier (in case you forgot: dividends as well as selling the stocks once their value has increased), so now we’ll talk about other aspects of this investment asset and flesh it out a bit. While it may seem that the stock market (or investing in equity) is out of bounds to most of us, discarding the idea of investing in it altogether would be a mistake because that means you are missing an opportunity.

Pros and cons of buying stocks

Pros:

Don’t let the downsides of stocks as an asset discourage you from investing in them. By now, you already know that trading and investing are two different beasts, and if you stay focused on your long-term goals, stock can add value to your investment portfolio. So, here are the advantages of investing in stocks.

• Stock returns capitalize on favorable trends – Holding onto stocks is definitely better than keeping your money in a bank account. As the economy grows, you reap greater rewards compared to the constant efforts to beat inflation rates with advantageous interest rates typical for cash. 
• Stocks are accessible and easy to sell – These days, you can invest online through a brokerage firm and this makes the whole process quite convenient. At the same time, equity is a liquid instrument and if you need to pull your investment from the market (for whatever reason), you can do it on short notice. The stock exchange is very dynamic and there is always someone that is buying what you are selling. 
• Risk management strategies work on stocks, too – You can set yourself apart from day traders and start thinking and acting like an investor. You can restrain your emotions by delegating control over your investment to a professional, or by using software that follows preset parameters. Risk can be managed by employing investment strategies like diversification, for instance. We will expand on these strategies further down in the text.

Cons:

Ever since the concept of selling stocks was introduced by the Dutch East India Company back in the 1600s, a sense of uncertainty has clouded the judgment of investors. And rightfully so. 

• The risks are high with stocks – Everyone buys stocks to sell them once they go up in value. But what if they lose value over time? You’ve practically lost your investment. And if the absolute worst-case scenario comes to pass (i.e. the company declares bankruptcy), large stockholders get preferential treatment so you can’t claim any compensation even though theoretically you are entitled to it.  
• Not all dividends are the same – Some companies don’t pay dividends. This is typical for new companies that reinvest whatever profit they make into expanding operations. Study the dividend yield in detail to have a clear picture of your return on investment over time.
• Emotions run wild – The stock exchange is ruled by emotion. Daily fluctuations in value might seem attractive for a moment, especially if you are a sucker for the romanticized depictions of trading and investing we have thanks to the entertainment industry. In reality, you don’t want your investment to be at the mercy of unhinged waves of greed or fear that are a regular part of the market.
• You are up against professionals – The stakes are high and you are rubbing shoulders with professional traders and investors. Not only do they carefully follow metrics (known as technical analysis indicators), but they work full-time and employ automation software to their benefit. Also, instances of using unfair advantage have been documented in the past (malpractices like insider trading, short selling, etc.), and even public officials aren’t immune to such abuses. 

Alternative investment assets 

What we discussed thus far are the most common types of assets rookie investors put their money into. Other assets can also be used to bring returns, but keep in mind that there are usually more risks involved with these alternative options.

Real estate

Everybody knows how you can profit from owning a property – you either rent it out or sell it. Not all of us are in a good enough financial standing to invest in real estate on our own, but pulling forces together does have a lot of benefits. 

REITs, or Real Estate Investment Trusts, function very similarly to mutual funds: they allow co-owners (or shareholders) to collect returns on income-yielding properties. The primary purpose of REITs is to rent commercial real estate to the likes of malls, warehouses, and hotels, as opposed to the practice of real estate agencies that focus on selling such assets.

Costs of maintenance can really bring profit down, but if you invest through a trust, you share those costs, too. And selling shares in a real estate trust is far easier than selling an actual building, so this is a fairly liquid instrument.

Commodities futures

Those are two big words. In essence, investors buy a fixed amount of commodity at a certain price and this contract is to come to fruition at a specific date down the line (hence the futures part). The commodity can be precious metals, food (e.g. wheat), crude oil, etc. The terms of the contracts are to be respected to the letter. 

These assets are traded at the futures market, with oversight and regulation enforced by the government. It’s a highly volatile market and investors don’t earn passive income by holding these assets. They are practically a form of insurance against inflation (commodities keep their value, even if money tanks) and are good options for diversification.

The spectrum of investment opportunities out there is really wide, but assets like hedge funds are not accessible to novices, and Forex trading is not recommended because inexperienced investors can lose their money quickly.

Recap

Newcomers in the world of investing face a lot of challenges – they might not have enough capital or time on their hands and there are always risks. We know this can all seem overwhelming, but there’s also a variety of opportunities. And since we covered a lot so far, let’s do a quick recap.

“Investing” by depositing money in savings accounts is on the most passive end of the management spectrum: you just hand over the money and it sits there for years on end. Bonds call for some decision-making throughout their life cycle (buy or sell, usually during the trading periods), but nothing too taxing. 

Luckily, mutual funds and ETFs hold the middle ground in many respects when it comes to asset types, which makes them perfect for making the first steps. Stocks are for visionaries and professionals who follow and analyze a lot of data. And the alternative assets (real estate, futures, and such) carry detailed specifics, so they might not be for every investor. 

Of course, making decisions on investment requires skills, so let’s take a look at that.

Tips on getting started

Now that you know more about the different asset classes, you probably feel more or less attracted to a certain type of investment. At the very least, you have an idea about what investment options you want to explore. We encourage you to do just that, but before we let you get on with it, there are two important aspects of investment portfolio management we can’t skip out on: diversification and robo-advisors.

Diversification

No matter where you’re at in life, no one wants to be taken for a fool. And blowing away what hard work has earned you thus far on a high-risk venture is not the way forward.

As we already mentioned, creating a portfolio that consists of investments in different asset classes will help manage and mitigate the risks. There are different schools of thought on how to actually do this, though. Not only do investment strategies differ depending on your character, style, and life goals, but they’ll also change as your financial needs change throughout life.

So, you will hear about “aggressive” portfolios focused on investing in up-and-coming companies aiming for high returns. The opposite end of the spectrum are “defensive” portfolios that place money in commodities in order to cling to value that’s capable of weathering societal turmoil. And fat cats will pontificate about their approach to investing, without it having any bearing whatsoever on your personal finances.

Conservative investing philosophy dictates placing a hybrid mix of cash, bonds, and stocks in your portfolio. It’s recommended that young folks prioritize stocks, because they are yet to create their wealth, while those that are closer to retirement should prioritize bonds, to consolidate it. Going for mutual funds like ETFs that are diversified by their very nature is also a safe bet.

Underestimating investment risks will make a poor investor out of you, sometimes even in a matter of days. But blowing those same risks out of proportion will make you even poorer in the long run, because you will miss out on lucrative opportunities to grow your wealth.

Robo-advisors

“I think Donald Trump’s hair is actually another creature” – comedy legend Robin Williams told Craig Ferguson when they riffed off each other during an interview back in 2010. “Donald goes to sleep and the hair is going: Keep investing! Keep investing!”

Well, robo-advisors might not be considered a separate creature (not in your dictionary), but they can certainly take over for you while you are minding your own business. They are financial advisers programmed to offer investment advice based on algorithms. 

This is actually a very beneficial development for new investors because it eliminates human emotion from the equation. No wonder adrenaline-packed environments such as Forex trading floors also use trading robots to limit the possibility of hasty decisions made in the heat of the moment. Trading robots are programmed to enter the market when conditions are favorable and to leave the market once a certain benchmark is met.

Robo-advisors operate in pretty much the same way. Financial goals are programmed into the software and they follow these parameters in the decision-making process. Also, these Robo-advisors significantly cut investing costs (no brokers, no fees, low investment minimums) and make investing accessible through an app.

In closing

It’s a fact: our education system doesn’t provide appropriate financial education on long-term investment. While this is not your fault, you can easily cover the basics by taking small but consistent steps into the world of personal finance. If you made it all the way here, you can probably successfully pass an exam on investing in different asset classes, or at the very least a midterm.

Investments can take many forms, but they all boil down to accumulating as much wealth as possible for your future self. Finance is associated with steep learning curves, so don’t expect such a short guide to do justice to such a broad topic. In any case, this is a great start. First get the hang of your bonds, your stocks, and your funds, and then you can try out different investment strategies. It will take time to master risk management, but you actually don’t need to know much to start diversifying your investment portfolio. Plus, you can always use software to your advantage.

One thing is for sure, you can easily find a lot of online resources to learn more about investing, be that on our blog or elsewhere.

Invest wisely.

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