Investing 101 – The Basics of Investing
Investing refers to committing your funds in the expectation of earning an income or profit in the future. If you are giving your money to a company, government, or any other entity hoping to get more money in the future, you are investing. The objective is to put your money to effective work in one or more investment categories, allowing it to grow over time. This means you set aside some funds from your everyday earnings to reap future rewards. Investing is a means for future financial security, enabling you to achieve your life goals, such as saving for your children’s education, creating a retirement corpus, buying a home, etc.
Investing is not like saving or trading. Investing involves putting your money away for a long period rather than regularly trading in stocks. Alternatively, investing is different from savings because of its risk parameter. Savings are your in-hand funds or money in your bank account – generally guaranteed with low risk. However, investments carry relatively more risk, allowing your funds to achieve their growth potential. For instance, if someone invested $10,000 50 years ago in the S&P 500 index, their investment would be worth nearly $1.2 million today. If you only save and do not invest, you might not have more money than what you put away. Therefore, investing is critical for the long-term growth of your funds. There is never a right time to invest. The sooner you begin, the faster you can achieve your financial dreams.
However, the investment landscape is dynamic and ever-evolving. Especially for beginners, investing is like learning a new language. Hence, it is easier to feel overwhelmed with the wide world of investing. However, if you take time to understand the essentials of investments, basic principles, and the different types of investments (such as stocks, bonds, mutual funds, alternative assets, certificates of deposits, etc.), you can benefit massively over the long haul. Each investment category has a specific risk bar, return standard, investment horizon, and more. As an investor, it is important for you to comprehensively understand these options and select investment categories that best align with your age, income, and return and risk expectations. To better understand the basics of investing, different asset classes wherein you can invest, different kinds of investment strategies, and more, consult with a professional financial advisor who can guide you on the same.
Here are a quick investing 101 guide to help you make wise and informed decisions:
Why does investing matter?
Before you begin investing, understand why you should invest. Here are some reasons that justify the need for investing:
1. It helps build wealth
If you have short-term goals (ones in the next five years or so) or want to build an emergency corpus for financial security and liquidity, you can consider saving your money and not investing. Saving accounts offer lower rates of return than investment products. However, if you have long-term goals, such as saving for retirement, funding a child’s education, etc., investing is a beneficial choice as investment products are structured for a long period and allow you to earn a high rate of return. In the long run, even the slightest difference in your rate of return can have an exponential result on your wealth accumulation and your financial goals.
2. It offers the benefit of the power of compounding
The power of compounding refers to the phenomenon of reinvesting your investment earnings to get additional growth over time. Compounding makes a significant difference in your investment growth. The earlier you begin investing, the more you gain from the power of compounding. The most effective way to invest is to start early and automate your investments. Consider setting up a pre-authorized payment plan that allows you to regularly contribute towards your chosen investment categories, such as mutual funds, weekly, monthly, quarterly, semi-annually, or annually.
3. It can help offset the impact of steeply rising inflation
Inflation refers to the rise in the price of goods and services, causing a massive and increasing drop in the purchasing power of money over a period. A high inflation rate implies the prices of goods and services are rapidly increasing, and your money might not be sufficient to buy as many goods and services in the future as it does today. Inflation consumes the purchasing power of cash over time. Hence, to ensure your money grows in the long run, you will ideally require a return higher than the inflation rate. By investing your money in the right investment categories, you might be able to outpace inflation. Depending on the different types of investments, specific investment categories might have a higher risk than putting your money in a savings bank. But such assets also have the potential to generate high returns, enabling you to offset the impact of inflation eventually.
What factors to consider before investing?
Once you understand the benefits of investing, the next step is to make informed investments. Aim to understand your financial situation to build a successful investment strategy. For this purpose, here are some factors you can consider before investing your hard-earned money:
1. Having a budget in place
Creating a budget can help you understand your earnings, spending, and savings. This will, in turn, enable you to determine how much funds you have available to invest. Building a budget will allow you to identify your overspending areas and reduce your spending to invest more.
2. Determining your financial goals
The next step is to know your financial goals and how much money you need to achieve those goals. For instance, understanding how much you need for retirement is the first step towards building a retirement corpus.
3. Purpose for investment
Determine your investment objective. Whether you are looking to grow your funds, generate a fixed income for retirement, or preserve capital while earning minimal interest, etc., you can select an investment vehicle that helps you meet your investment objective.
4. Ascertaining your investment horizon
Your time horizon has a direct influence on your investment choices. If you want to invest money for the short term, you would likely benefit by choosing investment categories such as certificates of deposits, etc., that ensure liquidity and carry low-risk. You could be negatively impacted if you invest in investment categories like stocks, bonds, mutual funds, etc., that are generally suitable for the long-term. This is because the market is volatile and subject to various cyclic fluctuations. During a market downturn, when your market-linked investments, such as stocks plummet, you might have the urge to sell them at a loss. However, if you invest in stocks for the long-term, you can weather market downturns effectively and balance loss with recovery profits in the long haul.
5. Risk tolerance
Your risk appetite is the degree of variability in returns that you can withstand or absorb. Typically, this means your risk tolerance is equivalent to your ability to bear a financial loss in investing. If you have a low-risk tolerance, consider investing in investment categories like bonds, fixed income securities, etc. Alternatively, if you have a high-risk appetite, you can opt for stocks, equity mutual funds, etc. You can also create a balanced portfolio combining different types of investments – stocks, bonds, alternative assets, mutual funds, etc. The idea is to create a portfolio that you feel comfortable holding, even during market fluctuations. Your age also impacts your risk tolerance. For instance, during younger years, your risk appetite is generally higher. However, if you are closer to your retirement, your risk tolerance can drop, and you may aim for capital preservation rather than capital growth.
These factors change over time. So, you can review these parameters at least annually or as and when your life stage changes to ensure you hold investments that are in sync with your financial goals, investment objectives, time horizon, and risk tolerance. You can also consider engaging with a professional financial advisor to conduct a goal-based review and determine which investments are best suitable for you.
What are the different types of investments?
Here are some of the top investment categories, in ascending order of risk:
1. Cash and cash-equivalents
A bank deposit is the simplest, safest, and easiest investment category for investors. You know the precise interest you will earn and are assured of your capital. There is no risk of loss. However, the interest from bank accounts is significantly low and insufficient to beat inflation. Alternatively, investing in cash equivalent instruments, such as Certificates of Deposit (CDs), can be a better alternative than a savings account. CDs have a lock-in period (ranging from months to years). They are liquid assets but provide a higher rate of return than a savings account.
A bond is a fixed-income instrument representing a loan made by a lender to a borrower. Bonds serve as a promise by the borrower to pay the lender the investment principal and interest on a loan. Bonds can be issued by a company or an institution, such as the government, municipalities, states, or sovereign governments, to fund their projects and operations. Bonds typically have a maturity date when the loan principal is due to be paid to the lender and include the interest rate and payment terms, such as variable or fixed interest payments. Bonds, especially government and municipal bonds, assure security at reasonable risk compared to equities. It is advisable to invest in bonds irrespective of risk tolerance or life stage. However, financial experts may caution against investing too heavily in bonds. You can create the right mix of bonds with other money market instruments to earn better returns. A portfolio with 100% bonds can be hard on your financial goals since it offers only moderate returns that are insufficient to cover inflation. However, bonds are a good investment if your investment objective is to create a fixed income during retirement.
3. Exchange-traded stocks (ETFs)
ETFs carry moderate risk and generate attractive returns by allowing you to invest in a mixture of securities traded on a stock exchange. Generally, ETFs include stocks, bonds, commodities, currencies, or a combination of them all. When you buy an ETF, you buy a basket of securities without investing in any security individually. Investing in ETFs allows you to create a diversified portfolio at a low cost. This is a suitable investment option if you have ten years or more until retirement.
4. Mutual funds and index funds
Another investment category you can consider is mutual funds. Mutual funds pool cash from different investors and allocate it into bonds, stocks, and other assets, per the investment strategy. Mutual funds generate returns based on the underlying security composition, such as equity mutual funds, bond mutual funds, balanced funds, etc. This investment category is suitable for hedging against market volatility and diversifying your portfolio while simultaneously generating attractive returns. On the other hand, index funds are different from mutual funds and track a specific market index, such as the S&P 500 and Dow Jones Industrial Average. These funds aim to generate returns equal to the market index and are perfect for young and mid-age investors.
One of the most popular and high-risk investment categories is stocks. A stock represents your ownership of a company. Stocks potentially offer the highest returns on your money while exposing you to a high degree of risk. However, if you adequately invest in stocks and create a diversified portfolio of different types of investments, you can accumulate significant wealth over time. Stocks are subject to high market volatility. Hence, you can invest in stocks if you have high-risk tolerance or you are young and can absorb market shocks over time. That said, financial experts recommend investing a specific portion of your money in stocks to generate returns that can offset inflation in the long run. But your stock allocation ideally should alter with age. Age-based equity allocation allows you to balance the risk and reward with each life stage. The best way to determine the equity allocation is to subtract your age by 100. For example, if you are 60 years old, you could allocate 40% in equity and the remainder in other stable investment categories.
6. Alternative assets
Other than the different types of investments mentioned above, there is a universe of alternative investments that do not fit into the conventional equity, bonds, and cash category. Alternative assets substantially carry high risk but can potentially generate exponential rewards. Some of the most popular types of alternative assets include real estate, Real Estate Investment Trusts (REITs), hedge funds, commodities, private equity funds, currencies, etc. Each alternative asset works differently and has an inherent risk degree. Investing in alternative assets might seem daunting to new investors. Therefore, it is advisable to consult a professional financial advisor to understand the different types of alternative assets, their risks, and rewards, and accordingly, make an informed investment choice.
Few investing tips for beginners
The world of investing is complicated and involves different types of investments and opportunities. Here are a few quick investing tips for beginners:
- Understand the investment terminologies, risk, return, liquidity, diversification, and more.
- Start investing early in life. Even investing a small amount every month can make a huge difference in the long term.
- Find the right asset mix for you depending on your age, time frame, risk appetite, and financial goals.
- Create a diversified portfolio. Monitor, manage and restructure your investments over time to align them with changing risk tolerance, life stage, and financial goals.
- Avoid emotional bias in investing and make sound investment decisions. Aim for the long-term and do not panic during volatile market situations.
- Consider hiring a professional investment advisor to create a goal-based, optimally diversified, risk-aligned, favorable investment portfolio.
These are some of the most useful investing 101 for beginners. Understanding the investing basics is vital for making rational financial decisions that support the long-term accumulation of wealth and financial security. Irrespective, whether you are a seasoned investor or a beginner, seeking help from a professional financial advisor with the right investment expertise and experience can also be beneficial for your investment portfolio.
If you are looking for guidance on how to begin your investment journey, which assets to invest in, and wish to create an investment portfolio that meets your financial needs and goals, use WiserAdvisor’s free advisor match service to find highly qualified and vetted fiduciary advisors who can do the same for you. Answer a few questions about yourself and get matched with 1-3 fiduciary advisors that are suited to meet your financial requirements.