Contents
Investments Explained
An investment is something of value purchased to make more money. While the term "investment" is often applied to stocks, bonds, and other financial instruments, investments also commonly include real estate, artwork, collectibles, and even wine. There are often risks involved with investing, but those risks regularly pay off for countless investors worldwide.
While you are likely to lose your money at a casino, a well-planned investment strategy can help you reach important long-term goals like adequate retirement savings, homeownership, or sending your kids to college debt-free. Keep reading to learn what investments are, how investments work, and how you can start investing today with less than $10.
What Is an Investment?
According to the Consumer Financial Protection Bureau (CFPB), an investment is “something you spend money on that you expect will earn a financial return.”
While we will focus on financial market investments like stocks, bonds, and investment funds, you could buy many more types of investments with the expectation of making money.
Note
In the simplest terms, you can think of an investment as something you buy that you believe will make you more money than it cost.
How Do Investments Work?
Investments are an important part of the economy and an important part of personal finance. For individual investors, investments can allow you to grow your wealth over different periods.
One of the most important parts of investments is compounding. Compounding is a term for how your investments increase in value over time.
To get a better understanding, here’s an example: Let’s say you have $1,000 and invest it in a stock market index fund that earns 10% over the first two years. While quick math might say you would earn $100 per year, you would actually earn more with compounding.
After the first year, your $1,000 investment would be worth $1,100. But after another year growing at 10%, your original $1,000 grows by 10%, and the $100 you earned last year grows at 10%. By the end of the second year, your $1,100 investment would grow to $1,210. The extra $10 you earned is from the compound growth of your investment. If you leave that investment alone and it continues to grow at the same 10% rate, you would have $17,449 after 30 years.
Of course, you can’t plan on earning 10% every year forever. There are some good years and some bad years. You may come out, in the end, making 5% or 50%, or more or less, depending on the investments you choose and the timing of your purchase and sale. Some investments may even lose money, which is why it’s important to understand what you’re investing in and why.
To protect investors from predatory investment companies acting in bad faith, the Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and other agencies enforce important laws, regulations, and industry standards related to publicly available investments.
When you decide to invest, it’s important to only work with reputable investment companies that follow investment regulations and work to protect your best interests.
Types of Investments
While nearly anything of value can be an investment, these are some of the most common financial market investments that all investors in the U.S. should know about.
Stocks
When many people hear the word “investment,” the first thing that comes to mind is the stock market. A share of stock represents a small share of ownership in a company. If the company is successful, its share price will likely increase. Some companies also make cash payments to shareholders, called dividends.
Bonds
Bonds are a type of debt issued by governments and businesses. Bonds typically offer an interest payment called a "coupon," in addition to paying back the principal. Because bonds are often issued in large denominations, individuals and families often buy bonds through investment funds.
Mutual Funds
A mutual fund is a type of investment through which you can buy a portion of a pool that owns many stocks, bonds, or other investments. For example, if you buy shares of an S&P 500 index mutual fund, your investment dollars are combined with the money of other investors to buy a portfolio of stocks that mirrors the S&P 500 index. Mutual funds typically charge fees but give you investment exposure to an index or a professionally managed portfolio.
ETFs
ETF is short for “exchange-traded fund.” An ETF is similar to a mutual fund, but you can buy and sell them nearly instantly, just like a stock. ETFs also come with lower fees on average than mutual fund investments, making them a better choice for many investors.
Do I Need Investments?
Most people don’t need investments to survive on a day-to-day basis. However, investments are often needed to reach long-term financial goals such as retiring securely. To understand why let’s look at another example.
Let’s say you want to live on $40,000 per year in retirement. In a regular bank account that pays 0.05% interest, you would need $80 million. But if you can count on earning 5% per year with investments, you would need just $800,000.
It’s easier to save up $800,000 for retirement than $80 million, but that’s still a huge feat. If you were to save $1,000 per month with a current bank-rate interest return, it would take over 66 years to save up that much. Thanks to the power of compound investing, however, at a rate of, say hypothetically, 7% per year, it would take about 26 years to reach $800,000.
Compound investment growth is a powerful tool, which makes investments a need for many households looking to reach any large financial goal.
Alternatives to Common Investments
Options
Options are a riskier type of alternative investment that is not always appropriate for everyone. Originally created to hedge existing market risks in the underlying instruments that they are based on, options can also be used to speculate or take directional positions.
Options essentially give you a contract that allows you to purchase (or sell) a specific investment at a specific price on a specific date in the future. Options prices can be highly volatile, so they are best reserved for experienced investors who understand the mechanics of options contracts.
Futures
Futures are similar to options in that they are focused on a specific asset price on a specific future date. But unlike options, futures contracts require the owner to exercise, meaning buy or sell, based on the agreement. This makes them even riskier than options and appropriate only for experienced traders.
Commodities
Commodities are an asset you can own, like a stock. However, instead of representing a share of ownership in a business, they represent a physical commodity, like corn, gold, oil, cattle, or coffee. Many investors trade commodities through options and futures, as explained above. These assets are often highly volatile and bring a risk that’s not appropriate for most individual investors.
Foreign Exchange (Forex)
Foreign exchange, or forex, is an investment in another country’s currency. For example, you could trade in U.S. dollars for euros, Japanese yen, British pounds, or other major world currencies. Forex is considered a volatile and risky marketplace for typical investors.
Cryptocurrencies
Bitcoin, Ethereum, and Litecoin are examples of cryptocurrencies. These are digital currencies not backed by any government or business. They only derive value from the community that operates them. Cryptocurrencies are only loosely regulated, if at all, and are very high-risk.
Other Investment Alternatives
While cryptocurrencies, commodities, and forex don’t belong in the typical long-term investor portfolio, there are some investment alternatives that may make sense, depending on your goals. Those may include real estate, peer-to-peer lending, fine art, and other assets outside of major investment markets.
Investments vs. Savings
Investing and saving both involve putting away money for the future, but they are different things. Investments usually have a higher level of risk and a higher expected return than savings. Savings are funds put aside, often held in a bank account, for some future purpose.
| Investments | Savings | |
|---|---|---|
| High growth potential | Yes | No |
| Can lose value | Yes | No |
| Remains in cash | No | Yes |
| Type of account needed | Investment brokerage account | Bank or credit union savings account |
When you save, your dollars are not used to buy something else to generate income or value. In the U.S., most savings accounts pay a modest interest rate and come with government-backed insurance. That means, unlike an investment, your savings can’t lose value if held with a bank, up to insured limits.
Are Investments Worth It?
For most people, investments are completely worth it. While there are risks involved with investing, a balanced portfolio that’s built in line with your investment goals should work out well for your needs in the long term.
Looking at the example above comparing investing to saving for retirement, it’s easy to see how some financial goals may be impossible without investments.
Note
Trying out paper trading or a similar type of practice account allows you to buy and sell virtual investments with no risk. For example, you may set up an account with a virtual $100,000 to test your own trading strategy by monitoring your trades over time as if you had invested real money in them. If you played the stock market game in school, think of paper trading as the grown-up version.
How To Start Investing
Getting started as a new investor is easier than ever. You can open an investment account quickly on the web or using an investment app on your smartphone. Some investment accounts are available with no minimum balance, so you can test out an account before you fund it. If you choose an account with no trading commissions that support fractional-share investments, you can likely get started with less than $10.
Follow these steps to start investing:
- Choose an investment account: Start by researching the best online brokerage or investment app for your investing or trading goals.
- Complete the account application: Opening an account typically requires personal information such as your name, contact information, Social Security number, and investment experience.
- Fund your account: After your account is approved, the quickest way to fund an account may be to connect to your bank account and transfer funds electronically.
- Choose your first investment: Don’t just buy a stock because you’ve heard of the company issuing it. Research the investment to understand what you’re buying, the potential investment return, the risks, and whether it fits with your portfolio goals.
- Enter a trade: Now you have a funded account and know what you want to buy. Enter the ticker symbol, quantity, and order type into your investment account website or app to buy your first investment.
Key Takeaways
- Investments are something you buy to make money. Unlike cash savings, investments are assets you buy or sell intending to make more money than you spent on them initially.
- Investments may be risky. Few investments are risk-free. Investments can lose value.
- Investing is best for long-term goals. Savvy investors often follow long-term investment strategies to reach their financial goals. Shorter-term trading carries a higher level of risk than long-term investing.
- Investing requires an investment account. To get started with stock, ETF, or other investments, you will need a brokerage account or an account with the investment company or app provider that handles your investments for you.
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