We all want to live a comfortable life. While what you consider "comfortable" may differ based on your specific circumstance and your outlook on life, there's a good chance that whatever it may be has a good deal to do with wealth. I encouraged all of you to start investing early in my post Why You Should Start Saving - Yesterday!. But what is investing and how do you go about doing it? Let's address the basics.
What is Investing?
According to Dictionary.com, to Invest is to "put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value." In short, investing means using your money for things that may make you more money.
What can I invest in?
Anything! Education, house, cars, jewelry, art, pretty much anything you think that may be worth more as time goes on can be an investment. But usually when you hear the word "investment" being tossed around by CNN and Wall Street types, they are talking about financial instruments such as stocks and bonds. So let's examine investments .
Almost all investments fall into 2 categories: equity or debt.
- Equity is a shorter way of saying "ownership". Say your family runs a restaurant and you, your mother and your father each owns 1/3 of the business. At the end of the month your restaurant made $3,000 in profit, and you each take home $1,000. It's the same for stocks - the prototypical equity investment. For example, when you buy shares of Apple stock, you become a part owner of the company. Therefore, when the company makes a lot of profit, you benefit by being a owner. There are usually 2 ways this reward happens:
- The company may decide to return some of that profit to the shareholders in the form of cash, this is called a "dividend"
- When your company makes profit, other people may want to get shares of the company so they could partake in your success. Since there are a fixed number of shares of the company, when demand increases and supply stays the same - the price for that product increases. The same thing happens to the shares you own - their price goes up, or down if you happen to have invested in a poorly run company.
- Debt is just that, when you borrow money from someone, the lender expects you to pay that back in the future with interest. So when you loan money to someone else, you expect to earn a little extra when that money is repaid. The prototypical debt investment is a US Treasure Bond. When you buy a treasury bond, you are loaning your money to Uncle Sam for a promised return at some future time. At the time of this writing, the 10-year US Treasury Bond has a yield of 2.19%. Why does Uncle Sam get such a sweet deal? Well it's because Uncle Sam ALWAYS pays. In fact, the United States' constitution prohibits us from ever defaulting on our debt. So when you're a good borrower, people like to lend to you because they know they will get paid.
- All other investments - mutual funds, ETFs, currency, commodities, futures, options, etc. are all variations of either debt or equity. We will leave these alone for now.
When should I start investing?
AS EARLY AS POSSIBLE! See my post Why You Should Start Saving - Yesterday!
How do I invest?
Now that's the 6 million dollar question! Just like what you consider "comfortable" may differ based on your specific circumstance and your outlook on life, how you should invest will vary by individual as well. The key is to know thyself. If you are one to have large mood swings - you know who you are - then biotech startups may not be the best investment for you. If there is one rule to increase your chance of generating a good return on your investments - that is to have a diversified portfolio. It is the same reason your health insurance company makes a profit - by distributing the risk of rare diseases (read expensive) among the majority of healthy paying clients.
How do I guarantee a great return?
The answer is there is NO guarantee. Even great investments in the past can turn out to be big losers in the future. To invest is to accept risk, a risk free investment does not exist (although US Treasure Bonds come pretty close). If anyone guarantees you a great return, say 20% a year, they are either lying or doing something illegal. Think Bernard Madoff.