Oct 6, 2022
What Is an Investment?
An investment is an item, or asset, acquired with the goal of generating future wealth. Unlike things people buy in order to use or consume immediately, investment assets are intended to be held so the value of it can grow or generate income over time. There are a wide variety of options for investing in assets that have the potential to increase in value over time, thereby generating a profit for investors.
In this article, we’ll cover:
How do investments work?
When you invest, you’re putting your money to work for results in the long term. The basic idea is that you purchase assets like stocks, bonds, mutual funds, real estate, and other things of value, then later sell them at a higher price than you initially paid. When you sell your asset for a profit, the return is called a capital gain. Earning this type of return is one way investing can make money for you. Additionally, some assets can generate profit while you hold them. For example, if you purchase and hold onto stocks that pay out dividends, you earn that money without selling the stocks.
Generally speaking, investors open an investment account with a brokerage and select assets they’d like to invest in. You put money into your account, and the brokerage buys and sells stocks, bonds, mutual funds, and other securities on your behalf. A brokerage may also offer services like financial planning and advice to help you make investing decisions that align with your specific goals.
Say you decide to invest $2,000 in stocks. You open an investment account and purchase 100 shares of a company for $20 each. While you hold these shares, their value changes over time-based on market forces; ideally, they become more valuable. In this hypothetical scenario, imagine that the company’s stock increases in value and the share price rises to $30 after 10 years. Now the 100 shares of stock you bought for $2,000 are worth a total of $3,000. If you sell them, you’ll earn a return of $1,000.
Why you should invest
Investing can play an important role in achieving your long-term financial goals. If you’re able to put aside a portion of your income after taking care of your living expenses, that money is available for future needs like buying a house or retirement. There are many ways you can stash the money you save, from tucking it under your mattress to opening a savings account at a bank to building an investment portfolio.
The advantage of investing is that you have the potential to earn money on your money. Take the example above: if you’d have put that hypothetical $2,000 in a drawer, you’d have $2,000 a decade later. By investing it, you’d have an extra $1,000 without lifting a finger. And if you re-invest any income you earn, you can take advantage of the power of compounding, which can magnify your returns over time.
Investing vs. saving
Putting money into a savings account is one way to save up for the future. Some savings accounts offer interest that allows your money to grow over time. That said, a savings account and an investment account serve different purposes. Because the interest rates offered by savings accounts are often relatively low, and can be changed by the bank at any time, your money’s growth may not keep pace with inflation. That’s why people often use a savings account for short-term goals, like a vacation or new car, or to put aside money in an emergency fund.
An investment account, on the other hand, is usually more suited to achieving long-term financial growth that could provide income during retirement or provide money for your children’s future. There are many different types of investment accounts, from brokerage accounts that allow you to invest in a variety of securities to accounts specifically designed for retirement, education, transferring generational wealth, and more. Keep in mind that all investing involves risk, including the risk that you could lose money if your assets decrease in value.
|Savings account||Investment account|
|Growth opportunities||Interest earned on your money||Capital gains when assets increase in value; income from stock dividends|
|Risks||Low interest rates that may not keep pace with inflation||Potential to lose money if assets decrease in value|
|Best used for||Short-term goals, like vacations, and emergency funds||Long-term goals like retirement and transferring generational wealth|
Different investment types to choose from
Investments come in all shapes and sizes. As you’re planning your financial future, experts recommend building a diversified portfolio that draws from several types of investment options, also known as asset classes. When you first get started as an investor, you might choose more traditional investments like stocks, bonds, mutual funds, and exchange traded funds (ETFs). Some people also decide to venture into real estate, cryptocurrency, or other types of investments. Some asset classes are considered riskier than others, so it’s also worthwhile to understand your tolerance for risk before you decide how to invest.
When you purchase stock, you’re buying a small piece of ownership, or a share, in a company. Stocks are bought and sold on stock exchanges and, generally speaking, their prices rise and fall based on supply and investor demand. Other factors can influence a stock’s price, such as the company’s financial performance or conditions affecting the company’s market sector. Stock prices can be volatile, so they’re considered somewhat more risky investments compared to bonds and funds. That said, every stock has a different level of risk; for example, owning shares of a well-established company with a history of steady share prices may be less risky than buying stock in a start-up whose share prices are fluctuating wildly.
Bonds are interest-bearing securities issued by governments or companies that investors can purchase for a set amount of time, known as the bond term. When you purchase a bond, you’re essentially loaning the issuer money. In exchange for the loan, the issuer must promise to repay the original amount of the loan when the term is up and pay you interest regularly in the form of a coupon. The bond’s price will generally fluctuate based on interest rates in the overall economy, but your interest rate payout will stay the same throughout the bond term. Bonds are a type of fixed income investment, meaning that they pay you a set amount of interest or dividends until the term is up. That’s why bonds are seen as a less risky investment than stocks, though stocks often yield a higher return over the long term.
Mutual funds and ETFs
Mutual funds and ETFs both consist of a basket of investments chosen by fund managers. When buying a share in a fund, you’re buying a share of its overall portfolio of investments. That means you’ll own a fraction of a share of each of the stocks and/or bonds the fund holds. Mutual funds and ETFs function in similar ways, with one primary distinction being when share prices are determined and trades are executed While mutual fund prices are determined and any trades are executed at the end of the trading day, ETF prices can fluctuate throughout the day. ETFs are traded on exchanges all day long, just like individual stocks. One appeal of mutual funds and ETFs for investors is that they hold many different securities, giving them a degree of built-in diversification to mitigate risk. Ideally, if one security in the fund loses value, it’s offset by other securities that hold steady or gain value. Many investors see funds as a less risky option than just buying stocks.
An index fund is a specific type of mutual fund or ETF in which the portfolio is constructed to match the performance of a financial market index, such as the S&P 500. The market index may represent the stock market as a whole or a specific portion of it. While the performance of the U.S. stock market continually fluctuates, overall it’s seen an average annual return of just over 10% per year. That makes index funds a less risky bet in the eyes of many investors. Because they aim to match an index’s performance, index funds follow a passive investment strategy that requires less active management and trading of securities, which can reduce fees and make investing simpler. Index funds are frequently used as core portfolio holdings for retirement accounts.
Other investment options
While stocks, bonds, mutual funds, and ETFs are the four types of investments many people associate with investing, there are many other options, some of which don’t even involve an investment account. These are often considered higher-risk investments, meaning there is a larger chance of loss or underperformance.
Purchasing real estate as an investment can result in profits over time if the property you own increases in value. That said, real estate investing can be risky due to several factors: property values are dependent on many factors that can be unpredictable, owning physical property often requires spending money on maintenance, and you generally need to put in a large sum of money upfront. Another drawback of investing in real estate is that transactions can take months to complete, meaning your property cannot easily or immediately be sold or exchanged for cash without a substantial loss in value.
Some people who have the means and risk tolerance find real estate investing appealing because they have the potential to earn passive income through renting the property as well as owning an asset that could increase in value. There are three types of real estate you could invest in:
- Residential: Purchasing rental properties and becoming a landlord to earn passive income
- Commercial: Investing in an income-generating property like office buildings or retail space
- Industrial: Investing in large spaces designed for manufacturing, warehousing, and distribution
Cryptocurrencies are relatively new, fully digital, decentralized currencies that use blockchain technology to create coins and conduct and verify transactions. These peer-to-peer systems don’t rely on a centralized bank, so the level of security and oversight can vary significantly. Starting with Bitcoin in 2009, the crypto market has quickly grown to more than 18,000 types of cryptocurrency. Crypto can be a risky investment due to volatile pricing, lack of regulation, and the possibility of fraud or hacking.
Collectibles, commodities, and other alternative investments
The idea of investing can be applied to any purchase of an asset that someone expects to increase in value over time. Investors might buy art, antiques, toys, and all manner of other physical objects they believe they can sell later at a higher price. There are specific markets devoted to buying and selling things like precious metals and commodities like oil or wheat. These types of investments can require a high degree of research and effort, and the risk can often be quite high due to a wide variety of variables.
Diversify your portfolio from the start
With the answer to “What is an investment?” nailed down, your next question may be “How do I get started?” It can be as simple as opening an investment account and selecting some assets to buy. But as you prepare to start investing, consider the importance of diversification when you build your portfolio. No matter which types of investments you choose, there’s a good chance that their value will fluctuate over time. Diversifying your investments among multiple asset classes, regions, and industries can help mitigate risk because losses in one area may be balanced by gains in another.
Diversification can also help you maximize your returns over time by capturing the best performance across all the assets you own. It can be tempting to put all your eggs in one basket when you see a particular company or sector producing very high returns, but diversification is what helps you plan for building wealth over the long haul. Assess your risk tolerance, lay out your long-term financial goals, and start your journey toward investment success.