If you're just starting your investing journey, you probably have plenty of questions. One of the biggest is: what exactly is investing?
You may also be wondering why so many people recommend investing your money instead of leaving it in a bank account or hiding it under the mattress. If that sounds like you, read on.
In this article, we'll explain what investing is, why people do it, and how it can help you build wealth over the long term. We'll also clear up some common misconceptions that stop many people from getting started, such as the belief that you need a lot of money to invest or that investing is too complicated for beginners.
The good news is that there are many different investment options to suit a wide range of goals, risk appetites, and experience levels. With a bit of patience, discipline, and a long-term mindset, investing can be a powerful way to grow your wealth and work towards greater financial security.
Image source: Getty Images
So, what is investing?
Investing is the process of putting resources into an asset, project, or opportunity with the aim of generating a future benefit.
Those resources can take many forms, including your time, money, or effort. The return you receive will depend on what you value most.
For example, you might spend hours learning a new skill to improve your career prospects or dedicate time to exercising to improve your health and wellbeing.
In the financial world, the resource being invested is money. The goal is to grow that money over time by earning a return that helps you achieve your financial objectives, while taking a level of risk that suits your circumstances.
Financial investing
This involves using your money to acquire financial assets (like shares, bonds, and even real estate and currencies), which you hope will deliver a positive financial reward in future.
The financial reward might come from additional ongoing income, such as dividends from shares, coupons earned on bonds, or monthly rent on an investment property. It can also come from a capital gain if you can sell your asset at a higher price than you paid.
Not all types of financial assets provide the same return profiles.
For example, junior growth shares may need to generate more income as they grow to pay their shareholders a dividend. So, investors who buy these stocks expect to make a capital gain from a sharp increase in the share price instead.
On the other hand, established companies with dependable profits, such as blue-chip shares, are more likely to pay their shareholders a regular dividend. However, that dependability means their share prices typically remain stable over time. So, while these stocks might provide shareholders with good ongoing income, they're unlikely to generate much capital gain.
There are many, many, many different types of financial assets out there for you to invest in. Although this array of investment choices might initially appear daunting – never fear. We have plenty of articles here at the Fool that break them down into more digestible morsels.
Bonds, currencies (including cryptocurrencies), commodities, and real estate provide different risk and return profiles. There is even a more complex class of financial securities called derivatives, including stock options and futures, that investors can use to make bets on the future direction of asset price movements (to hedge or speculate).
Why invest?
Think of investing as putting your money to work. You have to go out and work every day, so why shouldn't your money get out there and hustle a bit too?
Rather than letting your money sit in a savings account earning next to nothing in interest, investing in income-generating assets can create significant new revenue streams. This can supplement your income and ultimately help you maintain your lifestyle in retirement.
Investing helps protect your purchasing power
Leaving your money in a bank account can also result in a loss of purchasing power over time. Here's why:
- High inflation means the cost of everyday goods and services rises quickly
- Money saved in a bank account last year won't buy as much as it used to
- In other words, the 'real' value of your savings declines over time
Investing strategically gives you a chance to earn a return that at least outpaces inflation, making it one of the best ways to grow wealth and increase purchasing power over the longer term.
The magic of compounding
Investing wisely also means you can benefit from the magic of compounding — earning interest on your interest. Here's a simple example of how it works in practice:
- You invest in a blue-chip dividend-paying stock
- When it pays a dividend, you use that money to buy more shares
- Next time a dividend is paid, you earn even more revenue because you hold more shares
- You reinvest again, growing your shareholding and dividend revenue further
- Repeat — and watch the snowball effect take hold
This exponential growth is why we at the Fool advocate a longer-term view of investing. Short-term price fluctuations are inevitable, and panic is never your friend when making sound investment decisions. Keep your eyes on the prize.
The earlier you start investing, the more time compounding has to work in your favour — and the greater the wealth you can build.
Investing versus saving
A significant difference between saving and investing is the risk you take.
| Saving | Investing | |
|---|---|---|
| Risk | Practically risk-free | Always carries some risk |
| Returns | Low interest, vulnerable to inflation and fees | Higher potential reward |
| Access | Easily accessible | May be tied up in assets |
The greater the risk you take, the higher your anticipated reward if your investment pays off. This is what we call the risk-return trade-off. The level of risk you're personally willing to take on will depend on many different things, including your age, salary, financial position, and personal circumstances. Once you weigh these up against your financial objectives, you can decide what type of investment is best for you.
For example, investors with a low-risk appetite who nonetheless want some additional income from their money could invest in government bonds. Because the government backs the bonds, it's unlikely to default on repayments, meaning these investments carry minimal risk but provide only modest returns.
At the other end of the spectrum, the short-term returns on some cryptocurrencies have been astronomical in recent years. However, many cryptos have also collapsed in value, and the industry is constantly under regulatory threat, making crypto just about as risky as it gets. These assets better suit investors with a very high risk tolerance who can afford to absorb heavy losses in exchange for a longshot chance at a potentially eye-watering payout.
When creating an investment portfolio, you can mix and match asset classes anywhere along that broad risk-return spectrum, tailoring it to suit your interests, financial knowledge, risk appetite, and personal ethics.
One final note on saving
It's vitally important to keep some cash available to cover any unexpected expenses or changes in your personal situation, like a sudden loss of income. Ideally, your emergency fund should cover three to six months' worth of living expenses, held in cash rather than riskier assets like shares, so you can access it immediately when you need it most.
You can find out more in our article on Investing vs saving.
How much money (and time) do you need?
It is now cheaper than ever to start investing, especially in the share market. Most major brokers will help you start investing with as little as $500 (plus transaction costs). More recently, a new breed of digital micro-investing platforms like Sharesies and Stake has made it possible to start trading stocks for even less by enabling users to invest in fractional shares, down to just a few dollars if you want to.
A few things to keep in mind with these platforms:
- Transaction fees can eat into your returns, so always check the fine print
- Foreign exchange fees can be particularly costly if you buy international shares
Diversification is easier than ever
Diversifying your portfolio is also much cheaper and quicker than ever before. Building a well-diversified portfolio should be a key aim for investors who want to grow their wealth predictably and sustainably over the long term. Put simply, it's about not putting all your eggs in one basket.
Exchange-traded funds (ETFs) make diversification possible in just a single trade. In an ETF, the fund manager pools cash from investors and uses it to buy a portfolio of assets according to the fund's mandate. When you buy a unit in the fund, you're essentially purchasing a fraction of that entire portfolio in one transaction, without spending hours on research or a fortune in brokerage fees.
ETFs come in many different varieties, including funds that:
- Track a well-known index like the S&P/ASX 200, investing in shares that comprise the index weighted by market capitalisation
- Focus on particular share types, such as growth, value, or high-dividend shares
- Invest only in companies with a positive social or environmental impact, like green energy companies
- Replicate the price performance of other assets like bonds, gold, or oil
You can also combine different ETFs within one portfolio to suit your goals. For example:
- A mainly defensive portfolio focused on income might combine a gold ETF, a bond ETF, and a high-dividend ETF
- A more bullish outlook on the share market might call for adding a growth-focused small-cap ETF, which tends to be more cyclical
The choice is entirely up to you. And if you're ever unsure, it's always a good idea to consult a financial advisor.
For more, check out our article on how much money you need to start investing.
Foolish takeaway
Think of financial investing as just putting your money to work. By investing (wisely) in financial assets, you can open up whole new avenues of income.
And, through the magic of compounding, investing makes it possible for you to grow your wealth much faster than if you left your money to wallow in a savings account.
Investing does mean taking on more risk – it's just the nature of the game. This means you should carefully consider your risk appetite and financial objectives before you start investing. These should take into account your stage in life, salary, financial position, and other personal circumstances.
However, once you've worked all that out, investing itself is cheaper and easier than ever – and you don't need a degree in finance to get started.
Those who want to build a real 'set and forget' investment portfolio can buy units in ETFs – diversified portfolios of assets that can provide investors with risk and return profiles that align with their objectives.
Hopefully, this article helps you take the first step on your investing journey. And remember, we have many other informative articles here at the Fool that can help you build your knowledge and become a financially successful investor. Good luck!
Want to learn more about investing?
You've come to the right place!
This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.
Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.
Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.
- Check out our next article in this section on why invest?
Frequently Asked Questions
-
Investing is the process of using your money or resources to buy assets, like stocks, bonds, real estate, or gold, in the expectation that these assets will increase in value over time. In simple terms, it's like planting a seed (your money) in a fertile field (the market or a specific asset) and hoping it grows into a large tree (increased value) that you can benefit from later. This can also apply to non-financial investments, like education, where you devote time and money in the hope of obtaining future benefits, such as a better career.
-
Investors look for investments that have the potential to increase in value (a capital gain) and/or provide investment income. Investors make capital gains when they sell assets for more than they paid for them. For example, they might buy shares at a low price and sell them when their value increases. Investment income accrues to the holder of assets, like dividends from shares, interest payments from bonds, or rent from real estate properties.
In a nutshell, investment income typically comes in the form of regular, periodic payments while an asset is held, and capital gains are realised upon the sale of an asset.
-
The amount of money investors make varies widely and depends on factors like the types of assets they invest in, the amount of money they invest, their investment strategy, and market conditions. While some investors do make significant profits, especially those who invest wisely in high-growth areas or get in early on trends, it's important to remember that investing also comes with risks.
High rewards often come with high risks, and not all investments pan out profitably. For most people, investing is a long-term strategy aimed at steady growth rather than quick, substantial gains.
