Understanding Investing

Investing is a strategic method of using current wealth to create future wealth. Individuals and companies invest money in projects or financial instruments that meet their requirements. In return for the use of the invested funds, the investment entity promises to repay the original money invested (the principal) plus a return on the money (interest, dividends, or a profit). The amount that is returned will depend upon the creditworthiness of the investment entity.

Money can be invested through the use of a broker who is licensed to trade in investment vehicles. It can also be invested through deals that are brokered privately. Individuals can even make investments on their own through the use of investment sites that allow them to open accounts, fund them with money, and invest the money online through the site.

Investing money is not the same as saving money. The difference is a critical one if there is limited money to set aside. It is important to understand the difference and to be familiar with the best practices as well as the importance of timing investments to the advantage of the individual before investments are made.

Background

Many people plan ahead for future expenses such as college tuition, retirement, a dream vacation, or a medical emergency. One way to fund more short-term plans is to save money by setting some aside in a money market or savings account that is insured by the Federal Deposit Insurance Corporation (FDIC). These accounts are insured up to $250,000 per depositor per insured bank, and they pay the going interest rate. The objective in saving is to preserve the principal being invested—to not lose the money put into the bank.

Another way to accumulate money for future expenses is to invest it. Investing is different from saving because with any investment, there is some element of risk concerning the rate of return. Because of this fact, it is possible to lose the money put into the investment. There is no insurance for the investment and the amount to be earned is subject to the amount of risk inherent in the investment. The greater the risk is, the more likely there will be a problem or loss; therefore, the potential return must be greater to compensate for the potential loss.

Examples of different common types of investments include bonds, stocks, exchange-traded funds, mutual funds, and real estate investment trusts. In some cases, individuals choose to invest capital in a small business or even a start-up company. To minimize the large risk in these situations, investors must thoroughly research the entrepreneurs themselves, the business model, the potential market, and the competitive landscape to predict the company’s possibility to thrive. If the company performs well, the investor can see significant returns.

Money earned through investments is subject to tax at a rate that varies with the type of investment and how long the investment is held. It is up to the individual to understand the consequences before making an investment. For that reason, many individuals consult with brokers or attorneys or educate themselves with information from reputable sites before making an investment plan.

Since saving seeks to preserve principal while investing puts principal at risk for a return that exceeds what is possible through saving, many individuals incorporate both savings and investments into their financial planning. By setting aside some money for savings and other money for investments, they are able to have a dependable source of funds for their immediate needs along with the proceeds of their investments—assuming conditions remain favorable to the investment—to meet future needs.

Overview

One of the most important things to consider when making an investment plan is not only how much can be invested but how tolerant the investor is to risk. Even if the money to be invested is considered extra money, that does not necessarily mean the investor is indifferent to the loss of that money. The extent to which it matters if the money is lost is an indicator of the investor’s tolerance for risk. There are categories of risk that are assigned to investments. Companies such as Moody’s and Standard & Poor’s rate investments and give the criteria for the rating. A first step is to seriously consider how much risk is acceptable and then gain an understanding of the rating system.

If an investor puts money into the bank for three years and does not touch the money, at the end of the three years, assuming there were no service charges on the account, all of the principal plus the interest earned is sitting in the account. Because it is a risk-free investment—it is a form of savings rather than investing—the amount of interest earned is very low.

Another investor puts money into a junk bond—the riskiest of investment vehicles. At the end of the investment period, the company that issued the bond is no longer in business and the investor not only fails to make a return on the investment, but the principal is also lost.

A third investor has money to invest and decides that some risk is worth the possibility of a greater return than a savings account, but not so much risk that all of the principal can be lost through a market downturn or failure of the company issuing the investment. This investor looks for an investment with a company with a long track record of good performance. That is an amount of risk that investor can tolerate.

Risk is not only in the failure of a company to pay dividends or interest as expected. Risk is also in the form of a stock or bond’s volatility—the swing in the price of that investment vehicle in comparison to the rest of the stock market. Even if the stock market hits a very bad day and every stock drops, not every stock drops by the same amount. Not every stock takes the same amount of time to recover. The beta of a stock will determine whether it is more or less volatile than the market. As with all indicators of risk, the more volatile the stock or other investment vehicle, the greater the promised return must be. With an investment that an individual intends to be able to sell for a profit, or if cash is needed, the performance of the stock is very important. Principal will be lost if the price of the stock at the time of sale is less than its price at the time of purchase.

One way investors can protect themselves from losses in one part of the stock market is to diversify. If investments are held in a number of sectors—in manufacturing and farming or technology and shipping, for instance—a loss that lowers the value of the stocks in one sector may result in a rise in the value of the stocks in another sector. At the very least, it may be the case that a loss in both sectors will not occur at the same time.

To diversify, an investor needs to become aware of the conditions that affect the performance in different sectors and then invest accordingly. It is also possible for an individual to invest in a fund that holds investments in a variety of sectors with the intention of having an overall average positive return. However, nothing is guaranteed with an investment. Just because something has behaved in one way in the past does not mean it will continue to behave in that way.

It is vital to keep informed about market conditions and new technologies coming into the market when choosing to invest. Investors who insisted cars would never be used as a major mode of transportation missed an important investment opportunity. On the other hand, those who hurried to invest in 8-track tapes as the next big thing have also had ample time to reconsider that decision. In general, the appropriate time to invest depends upon an individual’s financial security and the money available to invest. While many try to predict the best time to invest in stocks, the constant fluctuation of the market makes this task quite difficult.

A conservative investment strategy is to determine the risk tolerance of the investor, categorize the money available for investment or savings (setting aside money for both), and research the available options to see which best fits the investor’s needs. Monitoring the investment is also important to be sure that it is performing as anticipated and to make a change if necessary. Understanding investing, including the difference between investing and saving, the importance of knowing the investor’s risk tolerance, an appreciation of the risk levels of investments, and the benefits of a balanced investment strategy will put the investor in the best position to actively manage risk in order to potentially earn the returns desired.

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