What is Investing?
By: Gary Palar and Eric Capruciu
What is Investing?
Maybe you have heard of the term investing before. What does it mean? It’s like saving, right? Sort of. It’s an extension of saving. The difference is, you’re not simply holding onto money – you’re making more money, with money. Confusing? I’ll explain.
Investing is making your money work for you.
By putting it to good use today, through investments, you can help it grow into much more in the future. Before we continue, let’s get this out of the way first:
“The best time to plant a tree was 20 years ago. The second-best time is now.”
– a well-known Chinese proverb
Basically, it is never too late to start investing. But to add to that, let’s go a step further.
On compound interest: “he who understands it, earns it; he who doesn’t, pays it.”
– Albert Einstein
It is never too late to start investing.
But because of compound interest, the earlier you start, the better.
“Oh cool, so I can start investing right now?” Yep.
“But what’s compound interest?” Good question. Let’s use an example to show you what compound interest is. Think about it this way: if you took one cent and were able to double it every day, after 14 days you would have $164. But after 28 days, you would have $2,684,354! The idea is that you make more with what you have by using what you’ve earned, again.
Mind. Blown. Read that again. Using it again makes more. More interest. Compounding.
Imagine what you could achieve if you improve yourself by 1% every day? Or, if instead of buying a bubble tea every day, you put the money you would have spent to work for you? Making investments is a way for people to use the money they have now, to increase or preserve their wealth for the future.
More on investing: Types of investments
In general, the most common ways to invest can be compiled into four broad categories. You may have heard of some of these terms already.
When you invest in them, they become known as investments.
- Equity (also referred to as stocks)
- Bonds (a type of debt)
Risk and Return: Part of an investor’s toolkit
The return on an investment can be put as the amount of money you have gained or lost on the original amount you invested.
Different investments have different returns over a long period of time.
This is because they each have different risks. The idea of risk is important to explain these returns. But, more importantly, it can explain how we can use risk to our advantage, as investors. In general, stocks and property have the highest historical returns. But these are also the riskiest. Risk, in this context, is the chance that an investment’s actual return is different from its expected return.
It’s easier to explain what they are from an example.
So, say you “held” stocks, and I told you they had an expected return of 10% per year over many years. If you had $10,000 at the start of the year, you could expect to have $11,000 by the end. At the end of the year, say the return of stocks was -15%. Your $10,000 turned to $8,500. What?! What happened?! This result was due to risk.
“Stocks are risky! I knew it!”
Right, stocks are risky.
But I told you these stocks return 10% over the long term. The reason they didn’t just then was because of the risk you took. That is the risk that your return would be different from 10%.
And there’s more… Higher risk in the short term is the trade-off for higher returns in the long term.
The importance of the long term
That’s what investing should be. The idea of investing should be to use the money we have now to generate returns in and for the future. For most of us reading this, the future is the long term.
Take note. We should look at the bigger picture of investing, being for the long-term. Sometimes though, it’s easier said than done. So, let’s use another example.
Risk and return; a closer look
I’ll use this to make sure we’re clear with what risk and return is, and how it’s useful for us in the long term. I used stocks first, so let’s continue that:
First, think about the returns of stocks in any year as a “random return generator”. Realistically, the return of stocks is almost no different to this.
And, let’s say you know the average of these random returns over a very long period in the past is 10%. Nobody knows what return you’ll get in any year from now. But, if you keep pressing this random return generator, chances are, you’ll be averaging 10% over many years (again, in the long term). So, let’s invest $10,000 and assume 10% expected returns. Let’s also use this generator, perhaps for a period of 10 years. We have our returns each year on the second row. These fluctuate wildly.
At the end of the first year, we ended with $8,440. At the end of the tenth year, we get $20,337. In the first year, we made a single-year return of -15.6%. Over 10 years, the average return was 8.5%. Much closer to the 10% expected return.
Now, add some zeros to that $10,000, and look what that would have become in the same time period. What do we get? $100,000 would have been $203,370. $1,000,000 becomes $2,033,700. That is a lot.
I’m not convinced. Why don’t I just use my savings account?
Alright, I’ll pose this to you – it’s a reasonable situation we might find ourselves in.
You have $10,000, and you don’t need it right now. You’re thinking of investing it. You could put it in a high-interest savings account, or invest in the stocks in our previous example. Again, you don’t need the money now – or any time soon.
You know savings accounts have practically no risk. Sounds good in the long-term, right? Wrong.
Say we put $10,000 into “competitive” high-interest savings accounts. For one account, we either leave it and don’t make further deposits and for the other, we make the minimum deposit to receive “bonus” interest. Then we leave it for 10 years. Let’s compare it to our returns for stocks.
At the end of 10 years, which of our investments had a higher return? The riskier one. Our stocks made more than twice as much as the high-interest savings account even though it had bonus interest. What was the penalty for not taking on any risk in a savings account? Lower returns. And over many years, what you miss out on could be substantial.
So, over the long term: higher risk, higher returns.
That’s the idea of risk and return in investments. “Risk” is not necessarily bad, and it depends in the context. How long are you investing for? We’ll go further in-depth into the different types of investments later in this series. But, for the first part of our tour, here are the main things you should take with you through your own investing journey:
- You are never too late to start investing.
- Compounding over many years is the most powerful tool in investing.
- Higher risk, higher returns.
- Returns are more predictable in the long term.
There is an infinite number of things you can do with a $100 note. Of all the possibilities, some are better than others.
Spending it on several bubble teas can quench your immediate sugar craving. Or, you could put that same money to work for you in an investment to compound. Then maybe, you can use it to own your own bubble tea store in the future. No matter if you’re planning to buy your 10th house in the Hamptons, or saving for retirement:
Investing is relevant to how all of us can achieve our financial goals.
So, what can you do now to learn more about investing?
Starting this semester, UNIT will publish an article for beginners interested in investing every fortnight.
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Other Related UNIT Articles:
Take a look at other articles in our series:
- ‘Introduction to Stocks’
- ‘Introduction to Bonds’
- ‘Introduction to Property’
- ‘How to Invest’
- ‘Introduction to Portfolio Allocation’
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.