Investing 101 – What Is Investing And How It Works

If you're new to investing, it might seem intimidating at first. But it doesn't have to be. We are going to give you a primer on investing and talk about what investing is and how investing works, Investing 101 if you will.

By the end of reading this article, investing should no longer seem so mysterious, and you should be ready to start letting your money make you even more money.

Because after all, that's what investing is.

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What Is Investing?

Investing is when you buy something today, with the goal of getting paid for your purchase in the future. In other words, when you invest, you’re buying ownership of something, expecting it to gain more worth and ultimately profit from it.

“Investing is the process of laying out money now to receive more money in the future.”

– Warren Buffet

The profit is commonly known as a return on investment, and more often than not you won’t be seeing any huge ROI in the following months (sometimes even years) of your initial purchase. Successful investing is a long-term game. It takes years for your investment to grow into a return that can make you wealthy. 

That said, there’s no guarantee for any returns. So don't invest what you can’t afford to lose. If you don't have a strong financial base with an emergency fund, you'll need to start budgeting and establish that before you can start investing. Otherwise, you'll put your finances at risk, and investing won’t do you much good.

How Risky Is Investing?

You’ve heard about the 1920 stock market crash and the Great Depression when bankers were jumping out of their office windows on Wall Street.

And you witnessed the 2008 financial crisis when the subprime mortgage market collapsed, Lehman Brothers failed, and we were plunged into the worst financial crisis since the Great Depression.

Oh, and don’t forget about Bernie Madoff, the investment advisor who swindled people out of billions and left them with nothing.

But this doesn’t mean you should stay away from investing and keep your money stashed under a pillow. Actually saving is riskier than investing. How? Well, inflation chips away at your money’s buying power.

Let’s say you kept $1,000,000 in the bank. After one year, you’ll be short around $20,000 due to inflation. There’s no way to earn money by saving, but investing sure offers many opportunities to grow your wealth.

The key is to study the economic cycles, stay patient, and learn to profit off of other people's emotional investing.

The Importance Of Investing

You have 24 hours in a day and only so many that you can (or want to) devote to working for money, even if you love what you do. Because let’s be real, unless you’re a celebrity, there are only so few careers in the world that can make you rich. Or let’s say you want to retire early – where do you find the money to live comfortably for the rest of your life?

How can you make money even when you're sleeping, vacationing, socializing, or doing nothing? Well, that’s when passive income comes into play.

And what is a source of passive income? Investing – the number one tool for building money

When Should You Start Investing?

Investing should be done like voting was done during the Capone era in Chicago, early and often. Early is especially important because time is crucial to successful investing.

via Business Insider

The more time your money has to grow, the wealthier you can become, even if you don't have lots of money to invest.

When you have more time, you can compound your investments. Compound interest investing is when you reinvest the profits that your money made. Bit of a tongue twister but that's the concept.

If you invest $1 and you get a 7% return on your money, that means you turned your $1 into $1.07 after one year.

With compound interest, the next year you will have $1.07 invested instead of just $1. So now your original $1 will be making you money and the profits your dollar made ($0.07) will be making you money as well.

Now imagine that happening over and over for decades and with a lot more than just $1 invested.

If you save $5 a day, everyday, from the day you turned 20 until the day you turn 65, you would have saved just over $82,000. Not bad.

But, for the sake of this example, if instead of saving that money you invested your $5 a day into something with a 10% annual return and you reinvested all of your profits, your $82,000 savings would now be worth almost $1,500,000.

That’s why Albert Einstein called compound interest the 8th wonder of the world.

Sure, maybe you can’t guarantee a 10% return every year, but this concept is crucial to understand if you’re trying to build wealth.   

As long as you don't sell off or pull some money out of your investment, your money will keep accumulating and growing, so long as your investment stays strong.

This chart shows you how powerful time is when it comes to investing. The investor who invested the least amount of money for the most amount of time came out far, far ahead of her fellow investors.

via JP Morgan Funds

Even investing four times more money did not make up for the lost time.

The longer you wait to invest, the more money you are leaving on the table.

How Much Money Do You Need To Start Investing?

Contrary to popular belief, you don’t actually need a lot of money to start investing. In fact, you can start investing with $100 or even less. 

However, the amount of money you invest depends on your personal financial situation. 

If you’re young and don’t have many expenses, you can be more aggressive with your saving and investing. In this case, you should aim to invest a minimum of 30% of all your earnings.

On the other hand, if you’re older and have more liabilities, 15% of all your earnings is a good start. We wrote a whole article explaining how to start investing later in life, so you might want to check it out for better insights.

One trick when it comes to investing – you want that money invested before you see it. Move it to a separate account. Out of sight, out of mind. You can’t spend what’s not sitting in your checking account, right? Additionally, keep in mind is that your investments are not the same as your savings and emergency fund. 

Common Types Of Investments

Usually when we say investing we think about stock investing, however, there are other types of investments that can be just right for you. 

Stock Market Investing

The stock market is where investors come together to buy, sell, or trade their stocks, which are shares of ownership in public companies. When you invest in a company's stock, you’re not becoming a manager of the company, and you don’t have to attend company meetings. To rephrase it, you don’t have to do any work for the company or business in order to share in their profits.

On the flip side, that also means if the company drives itself into the ground, your money goes with it and there's not much you can do to stop it.

Moreover, stock market investments are not tangible. If you buy one share of the McDonald’s company, you don’t own a tangible building or asset. You own a paper share of the McDonald's company. However, your investment is liquid so if you need cash, selling your stock is easy.

There are two ways you can earn from stock investing:

• Dividends – when a company pays its investors just for investing in their stock. Think of it as a ‘thank you’ check for investing with them.
• Appreciation – the profit from selling the stocks i.e. the difference between the buying price and the selling price.

If stock investing is something you’re interested in, we advise learning the basics of stock investing before you jump into it.

Real Estate Investing

When you invest in real estate, you’re becoming the owner or partial owner of a property which unlike stocks is a tangible asset. Here, the investment is the house, building, or land that you buy. And you have complete control over it.

There are several ways to invest in real estate and profit from it.

Rental property: Essentially, you buy property, a commercial building or a housing unit, and then lease it out to people who use or live in your property in exchange for a monthly rent.

Flipping: Another way you can make money with your real estate investment is by selling your property for more than what you paid. Basically, you buy it cheap, fix or upgrade it to increase its market value, and then sell it for a larger sum. 

REITs: Real estate investment trusts are an excellent way without purchasing property for yourself. In essence, you will be a partial owner of a company that invests in real estate. The advantage here is that you avoid the complexities of becoming a landlord or hiring a property manager.

Crowdfunding: Like Acorns opened investing in the stock market to lots of people, Fundrise has done the same for real estate investing. This real estate investing platform lets you become a real estate investor for as little as $500. With crowdfunding, your money will be invested across a portfolio of real estate properties. In exchange, you will get your share of rental income, interest, and appreciation if there is any.

Commodity Investments

When you invest in a commodity, you’re investing in a tangible asset like gold or silver.

Remember the Gold Standard? In the past, this meant that if you had $100 in paper money, there was a bar of gold worth $100 at Fort Knox that backed it up. Under this plan, paper money just represented the gold that the US had in a vault. But as of 1971, that’s no longer the case. Now the government mandates the value of our money and we just trust and believe in their better judgment.

That’s what makes commodities valuable. Unlike paper money that loses value during a recession, commodities don’t. In fact, in a crisis, they often increase value. They’re a safety net for your financial plan. 

But gold isn’t the only type of commodity. You can invest in other physical assets like:

• Silver
• Livestock
• Energy
• Agriculture

Cryptocurrency Investing

Cryptocurrency is the new commodity on the block. Cryptocurrencies like Bitcoin are intended to be a global currency that is run by ordinary people without government intervention. But, because it’s not regulated by most world governments, you can’t use it like paper money.

Many businesses are beginning to accept cryptocurrency as a means of payment. Although that changes by the day and companies like Facebook, Amazon, and Tesla are getting involved, there’s no telling what lies ahead. Many will argue that investing in cryptocurrency is pure speculation.

However, we strongly believe that cryptocurrency is the future. The key is to educate yourself and learn what cryptocurrency actually is and how it works before you throw any money on it.

Why Diversify Your Investments?

Diversification is a fancy way of saying, “Don’t put all of your eggs in one basket.” When you have a diversified portfolio, you theoretically reduce your risk.

But, diversification reduces your profit potential as well.

Let’s say you had $100,000 and you invested your money evenly, $20,000 each, across 5 stocks: A, B, C, D, and E.

After one year: A went up 2%. B went up 5%. C went down 1%. D went up 4%. And E went down 7%.

That means:

• Your $20,000 investment in A went up to $20,400;
• Your $20,000 investment in B went up to $21,000;
• Your $20,000 investment in C went down to $19,800;
• Your $20,000 investment in D went up to $20,800; and
• Your $20,000 investment in E came down to $18,600

Overall, your $100,000 grew to $100,600 which is a profit. However, if you invested all of that money in either stock A, B, or D you would’ve had a better return.

As Warren Buffett says, “Diversification makes little sense if you know what you’re doing.”  So, you should understand the pros and cons of diversifying your money within one market (e.g. the stock market).

Diversifying across different markets, on the other hand, like owning real estate and investing in the stock market, will provide you with better diversification.

Investing For The Long Term

Another important thing to consider when choosing investments is your time horizon i.e. how long you plan to leave that money invested. The longer your time horizon, the riskier your investments can be. This is why younger investors are encouraged to be more heavily weighted towards stocks than bonds.

A short time horizon is five years or less. This might be money you want to save to buy a home or take a vacation. A medium time horizon is five to ten years. This could be money to buy a rental property or to send a child to college. A long time horizon is ten years or more. This is typically money you are saving for retirement.

Manage your investments accordingly. You can sell a stock pretty quickly, but selling an apartment complex can take months.

Investing 101 – Final Thoughts

Investing is one of the best ways to grow your wealth and secure your future. The longer you wait to get started, the harder it is to catch up. Investing can help give you the financial freedom we all want.

Knowing that you have a growing nest egg allows you to do things like start your own business, switch careers, go back to school, or retire early.

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