If you're just starting out on your investing journey, you probably have plenty of questions – not least of which will be: Just what is investing, anyway?
And why does everyone keep telling me to do that with my money instead of stashing it in a bank or burying it in my backyard? Put down the shovel and lend us a few minutes if you're in that position.
In this article, we'll explain precisely what investing is, why people do it, and how it can help you grow your wealth.
Along the way, we'll dispel some pesky misunderstandings that can put people off investing before they even start – such as you need a bucketload of money to begin with or that the world of investing is just too complicated for beginner investors.
There are many different investments to suit various styles and types of investors – not to mention their experience levels!
We'll even show you how, with a bit of patience, dedication and discipline, anyone (including you!) can start using investing to achieve long-term financial wealth and security.
So, what is investing?
Investing refers to allocating resources toward a project or endeavour that will (hopefully) generate a positive reward in future.
You can invest any resources – such as your time, money or physical labour – to gain the personal reward you value.
For example, you might invest hours of time creating a painting simply for the satisfaction of completing it and improving your painting skills. Or invest hours of labour at the gym to improve your fitness and physical health.
In the world of finance investment, the resource you're allocating is cash. The positive reward you're seeking is more of it – ideally, as much money as possible after considering your personal risk appetite and financial 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 laze around in a savings account, earning a pittance in interest, you can create significant new revenue streams by investing it in income-generating assets. This practice can supplement your income and ultimately help you maintain your lifestyle in retirement.
Not only that but leaving your money in a bank account (or buried in your backyard) can result in a loss of purchasing power in inflationary times.
High inflation means the cost of everyday goods and services is rising quickly, which means the money you saved in your bank account last year won't buy as much stuff as it used to. In other words, the 'real' value of your savings has declined.
But, if you invested that money strategically instead, you could have earned a return that at least outpaced inflation. This makes investing a great way to grow wealth and increase purchasing power, particularly over the longer term.
One final point on investing, which will be familiar to regular readers of the Fool: Investing your money wisely also means you can benefit from the magic of compounding.
We have great articles explaining the wealth-creating wonder that is compounding, but it essentially means that you earn interest on your interest.
For example, let's say you invest in a blue-chip dividend-paying stock, and each time it pays a dividend, you use that money to buy even more of that company's stock. The next time the company pays a dividend (assuming its dividend is relatively stable over time), you will earn even more revenue (because you'll have more shares).
Again, you might use the money earned to buy more stock, thereby increasing your shareholding and your dividend revenue in the next period, and so on.
Compound interest creates a snowball effect, enabling you to grow wealth exponentially over time. Time is crucial here – we at the Fool advocate a longer-term view of investing. You don't want to get too caught up in short-term price fluctuations, as financial markets can be volatile, and panic is not your friend when making sound investment choices.
Keeping your eyes on the prize – focussing on the long-term returns you can generate from gradually building your investment portfolio by compounding your returns – is the most surefire way to grow your wealth.
This also means that the earlier you start on your investment journey, the greater the benefits you can gain through compounding.
So, start investing today! To learn more, check out our article dedicated to the question: Why invest?
Investing versus saving
A significant difference between saving and investing is the risk you take.
Placing your money in a savings account is practically risk-free – in Australia, at least. Your hard-earned cash is unlikely to be lost or stolen, and it's easily accessible whenever needed.
However, you're not likely to earn much interest (if any!), and your balance could even decline in value over time if it gets eaten away by account fees or inflation.
In contrast, when you invest your money in a financial asset, you always take on extra risk. But you are taking on that higher risk to earn a higher reward.
The greater the risk you take, the higher your anticipated reward (if your investment pays off). We in the finance biz refer to this as the risk-return trade-off.
The level of risk you are 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. This means these investments carry minimal risk but provide only modest returns to investors.
At the complete 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 threat, meaning cryptos are just about as risky as they get.
These assets better suit investors with 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. That's one of the great things about constructing your investment portfolio – you can tailor it to suit your interests, financial knowledge, risk appetite, and personal ethics.
One final note on saving, though. It is vitally important to keep some cash available to cover any unexpected expenses or changes in your personal situation (like a sudden loss of income from job loss or injury).
Ideally, this stash of cash, or emergency fund, should cover about three to six months' worth of your current living expenses. Hold onto this money as cash and not riskier assets like shares so that you can access it immediately in case of – you guessed it! – an emergency.
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). However, 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 than that.
These trading platforms enable users to invest in fractional shares – smaller pieces of a single stock. This makes it possible to invest almost any amount you choose – down to just a few dollars if you want to!
Be wary of high transaction fees on these platforms, though, especially foreign exchange fees if you buy international shares.
Diversifying your portfolio is also much cheaper (and quicker!) than ever before. Diversification is important because it helps to lower your portfolio's volatility (in other words, its risk level).
I'm sure you've heard it all before, but building a well-diversified portfolio should be a key aim of investors who want to grow their wealth predictably and sustainably over the long term. It's just like not putting all your eggs in one basket.
Exchange-traded funds (ETFs) make diversification possible in just a single trade. ETFs trade on the stock market much like regular shares but operate more like pooled investment vehicles.
In an ETF (or other managed fund), the fund manager takes the cash they've raised from their investors and uses it to buy a portfolio of assets, according to the fund's mandate.
ETFs have all sorts of different fund mandates. Some might track the performance of a well-known index, like the S&P/ASX 200 Index (ASX: XJO) or the S&P/ASX Healthcare Index. In this case, the fund will simply invest its cash in the shares that comprise its benchmark index, weighted according to their market capitalisations. This should ensure the fund's returns closely match its chosen index.
It means that if you buy a unit in the fund, you are essentially purchasing a fraction of that entire portfolio – or you can even think of it as buying the index's performance itself (less the fund's management fees). This is why we say that investing in ETFs provides diversification in just one single transaction. And the best part is that it doesn't require you to spend hours on research or a fortune in brokerage fees.
Also, index funds adjust their holdings regularly to ensure they still closely approximate their benchmark index – which means fewer hours you have to spend diligently keeping up to date with all the myriad market movements.
But there are more ETFs to choose from than just typical index funds. Other funds might be mandated to only invest in particular types of shares, like growth or value shares, or those that only pay high dividends.
And others might only invest in shares that are considered to have some sort of positive social or environmental impact, like green energy companies. These can be helpful for investors who want to tap into broader market themes rather than just industry sectors or indices.
Some ETFs try to replicate the price performance of other financial assets like bonds and some commodities (for example, gold or oil). Investing in these funds gives your portfolio exposure to even more diversified returns.
You can also combine different ETFs within one portfolio. For example, you may want a mainly defensive portfolio that provides some income, in which case you could combine units in a gold ETF, a bond ETF, and a high-dividend ETF. Or, if you're getting bullish on the stock market more generally, you might throw in some units in a growth-focused small-cap ETF (as these tend to be more cyclical).
The choice is entirely up to you! And if you're ever unsure or need further help, it's always a great idea to consult a financial professional, like a financial advisor.
Our article on how much money has the answers, too.
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!
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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?
