Investing 101: What is investing?
invest
transitive verb
1: to commit (money) in order to earn a financial return
2: to make use of for future benefits or advantages
- Merriam Webster
I received some feedback that many of my blog articles presume some degree of existing investing knowledge and are not friendly to beginners. So I decided to start Investing 101, a short series of articles designed to introduce investing to complete beginners. To view the entire series, click here or use the navigation menu at the top of the site. This is the first article of Investing 101.
In the financial world, investing simply means using money, or capital, to make more money. In other words, if you have money, you can make your money work for you, instead of the other way around. Using money to make money is as ancient as society itself and is the fundamental goal of every investor. And the more money you have, the more money you can make. You have probably heard the expression that the rich get richer. This is absolutely true: even in the absence of any social or political factors, basic mathematics makes it so.
Investing is the best way to build wealth
While it would be a gross oversimplification to pretend that all people can be neatly divided into any two groups (for example, introverts versus extroverts), I do believe that people have fundamental differences when it comes to the use of money. Almost everybody wants more money, but they want it for different reasons. Some people, by habit or by necessity, are consumers. Consumers view money as something to be spent, and consumers want more money so they can have more money to spend. Other people are investors. Investors view money as something to create wealth with. Investors want more money so they can have more money to invest. In reality, the distinction between consumers and investors is rather blurry, and the groups are not mutually exclusive. Also, I would be remiss if I didn’t point out that while your actions can dictate whether you are a consumer or an investor, not everyone has this luxury. The investor must be fortunate enough to have excess money to invest with in the first place, and fair and free markets to invest in without fear of their assets being stolen or confiscated. This generally means, for example, having a job and living in a stable, developed country with reasonably fair laws and regulations.
I suspect that you already know whether you’re a consumer or an investor. Imagine you suddenly found a $5 bill. What is your first instinct? Buy a snack, or buy a fraction of a share of your favorite index fund? In many ways, consuming is easier than investing. And the benefits of consuming are immediately obvious and instantly gratifying. The benefits of investing are much less obvious.
Over time, however, investors tend to accumulate wealth and consumers tend to stagnate. It is no secret that the majority of wealthy people in this country built their wealth by either investing or entrepreneurship (which is really just a different form of investing - in their own businesses), whereas people who suddenly come into money, such as through a windfall or lottery, often squander their wealth by spending it. Of course, we all must consume to some degree. But anyone with basic common sense can tell you that spending money makes you poorer, not richer. The irony is that if you love consumption (as I do, despite calling myself frugal), you should invest instead, because investors also get to consume more in the long run.
So how does money make more money?
It’s actually very simple. There are hundreds, if not thousands, of financial and investment products out there, but at the end of the day, there are only two main ways for your money to make more money:
You can lend money and become a lender/creditor.
You can purchase assets and become an owner of the asset.
To become a lender, you lend your money to a borrower, and charge interest on the loan. Over the lifetime of the loan, you will receive back your original principal plus interest. Most people are familiar with this concept, at least from personal experience on the other side of the equation as the borrower. Anytime you need money and get a loan, you will always pay back more than you originally borrowed. One of the privileges of having wealth is the ability to lend, and one of the plights of being poor is the need to borrow. Again, math would dictate that in this scenario, the rich become richer and the poor stay poor. But lending is not merely restricted to banks, institutions, and governments. If you have capital to spare, you can become a lender too. In fact, there are loans known as bonds which anybody can purchase, and when you “purchase” a bond, you are actually loaning money to the entity that issued the bond.
To become an owner, you simply use your money to purchase ownership of an asset. Unfortunately, most things that you can purchase are not suitable for investment, because they depreciate in value. Your car, for example, is an asset, but it is probably worth less now compared to when it was new. Look around you at your material possessions. Your shoes, furniture, computers, phones, and clothes all lose value over time. However, there are some assets out there which don’t lose value but instead grow and generate profits. So when it comes to investing in assets, the trick is to buy these appreciating or income-generating assets instead. Where can we find these magical assets? As it turns out, businesses are the most common example of appreciating or income-generating assets. So if you have money, you can either start a business yourself, fund someone else’s business idea, or purchase an ownership stake in an existing business. As the business grows and makes profits, you get a return on your investment through your ownership stake. And if the business does exceptionally well, you can get some truly exceptional returns.
Businesses are not the only type of asset that people invest in. Real estate, for example, is another type of asset, which has the ability to appreciate in value as well as generate income (rent). Commodities, such as gold, are yet another type of asset. Gold has the ability to appreciate in value, but gold does not generate income. It just sits there, inert. Anyway, because these assets are fundamentally different, they belong in different asset classes. A large part of the complexity of investing comes from deciding what asset classes, and in what proportions, to buy and own.
No method of investing is without risk. As a lender, there is the possibility that your borrower defaults on the loan and never pays you back. And as an asset owner, there is the possibility that the asset you purchased fails to grow in value or generate income. For example, if you invest in a business, the business might lose money instead and fail eventually when they run out of money. Your ownership stake in a failed business becomes worthless.
If investing is risky, why do people invest?
The short answer is because you can’t afford not to invest. Over the course of a typical career (30 to 40 years), the opportunity cost of not investing is staggering. This comes in two forms: missing out on decades of compound growth, and losing value on your existing money through inflation. The importance of investing is so great that the next article (Part 2: Why invest?) is devoted entirely to answering this question, for those that are skeptical. In the end, for investors, the benefits of investing far outweigh the risks, and there are ways to invest intelligently and reduce risk (although not to eliminate it entirely).
Risk management
Because investing involves risk, properly managing risk is extremely important. You always want to do your due diligence before investing, and you never want to put all your eggs in one basket. For example, as a lender, it would make sense to run background checks, credit scores, and income verification on any borrower before you lend them your money. And you never want to lend all of your money away to a single person, no matter how trustworthy they seem to be. If they default anyway, you lose everything. If, however, you gave smaller loans to multiple people, it is much less likely for all of your borrowers to default, and the impact of any single default is reduced.
The same is true for asset ownership. For example, before you invest in a business, you should thoroughly research the business and only invest if you believe it will be successful. Even so, if you use all your money to invest in a single business, you can lose everything if the business fails. But if you purchased ownership stake in multiple businesses, it is much less likely for all of your businesses to fail, and the impact of any single failure is reduced.
This concept is also known as diversification. But diversification involves more than just dividing your capital and making multiple investments. Proper diversification means investing in multiple asset classes, across multiple industries, and even across multiple markets and countries. Diversification will also be addressed in more detail in a subsequent article in this series.
But I don’t have enough money to be a lender or business owner!
A common misconception is that you need massive amounts of money to lend money or buy a business. Surely, if you only had a hundred bucks, no legitimate borrower or business would have any interest in working with you. How much money, or capital, do you imagine that you would need in order to do either? A hundred thousand dollars? A million dollars?
The truth is, however, that you absolutely can start investing with $100. The beauty of our free market economy is that everyone gets to participate. The only difference is the scale of participation. If a millionaire can make 10% returns per year from his money in the stock market, then so can you. He can turn $1 million into $1.1 million and you can turn $100 into $110. Everyone has to start somewhere. The basic principles of being a lender or a business owner still apply, no matter how much or how little money you have.
This might be hard to believe at first, but it is exactly what happens when you buy bonds and stocks. When you buy a bond, you are actually lending money to someone, and you will get interest on your money in return. And when you buy a share of a stock, you are actually purchasing a tiny fraction of ownership, or equity stake, in a business, and you will get a tiny fraction of that business’s profits or growth. You can do both without very much starting capital at all. The rest is just scale.
Of course, financial markets and financial products can get quite complex. But never lose sight of the basic principles. All of investing comes down to either lending money or buying asset ownership. In the rest of the Investing 101 series, I’ll peel back the layers and reveal just how easy it is.
In the next article of this series, Part 2: Why Invest?, I will show you just how important investing is and why doing nothing with your money is the worst decision you could ever make. Happy investing!
