Maybe you’re new to investing and you aren’t sure about the concept on the whole. Maybe you are wondering why people invest at all. These are good questions that I’ll try to explain.
Investing is a confusing concept to many individuals. They have heard mixed signals from the talking heads on CNBC, FOX, and countless other media sources. Big words, complex information, hot tips and insider trading are what comes to mind when picturing the idea of investing in stocks, bonds, or any other alternative.
The good news is much of what you’ve heard is wrong. The people spewing most of the investment nonsense on TV are just plain wrong, and they get paid to talk the loudest. They play on people’s emotions while taking advantage of the general ignorance that surrounds investing. If you were to track the investment recommendations produced from these broadcasts (Jim Cramer, once or twice) you would see just how abysmal they are. Funny thing is, somehow they’re still being paid to give investment advice…
The concept of investing itself is quite simple. It’s the practice of lending your money to an individual or institution. In return, you’ll hopefully end up being paid more money than you originally invested. This occurs through a variety of means which I’ll discuss in a later article.
Simply stated, people invest to make more money.
Investing to Beat Inflation
The more technical reason that most people choose to invest is inflationary pressures. Inflation is an economic concept that explains why the price of goods and services increases over time.
In this country, the Federal Reserve (Fed) tries to control and manipulate inflation. In fact, they think some inflation (2-3%) is good for the economy. Many people would disagree, especially since many wages haven’t kept up with inflation over the last 20 years, but that’s how it is.
Because the Fed manipulates the money supply and interest rates to control the inflation rate, inflation will continue to occur, and prices will continue to rise.
Pretty sucky, right? Dollars are worth less and prices keep going up! Yeah it sucks if you stick your money in a mattress or a local bank that pays you 0.5% interest.
That’s what a lot of people don’t understand. By refusing to invest in something that at least keeps pace with inflation, they are actually losing money. The purchasing power of their money is decreasing, as is their true wealth.
Investing has historically provided a way to outpace inflation and grow wealth. Although inflation has averaged close 3% per year over the last century, some investments have returned far more than that. In fact, the aggregate U.S. stock market has returned close to 10% per year, on average, over the last century.
Investing to Meet Goals
Investing allows us to set aside money for specific goals, while often providing tax benefits. A perfect example is saving for retirement through a 401k plan. If you choose to set aside money from your current paycheck to fund a 401k retirement account, the government won’t tax you on that money until many years down the road when it is withdrawn for retirement. This money is said to be tax deferred because it is not taxed in the year it is earned, providing a temporary tax break, and tax free growth until withdrawal.
There are numerous other tax benefits related to investing. Many pertain to retirement accounts, but not all. There are also lower tax rates for the earnings on certain asset classes, most commonly stocks and real estate. These are known as long term capital gains, and they provide another incentive to invest instead of consume.
By saving and investing, it is possible to earn enough passive investment income to pay for all living expenses. Some might call that milestone financial freedom. At that point, you can choose to pursue whatever career, job, or hobby you desire. How’s that for motivation?
Primary Investment Options
As stated above, stocks are a good investment and have historically provided high returns for investors. Stocks represent actual ownership of a publicly traded company, and the stock owner (investor) is entitled to a share of company profits. So by investing in stocks, you are providing the money necessary for companies grow, expand, and create profits to eventually give back to you. The stock market has risen roughly 10% per year over the last century in this country, which means there are far more profitable months than bad months.
Stocks are not without risk. The stock market has plummeted many times throughout history, and it will almost surely do it again. Protecting against unlucky market events is called “hedging” and is a common practice among investors. The most widespread way of hedging is using negatively correlated assets and options. For example, if a company’s revenue and share price are strongly dependent on foreign trade and exchange rates, one can hedge the investment in stocks of said company by trading fx options based on the currencies involved.
Bonds are much different. They represent debt. A company issues bonds to raise money as well, but the bond represents outstanding debt that must be paid. So the investor lends money and purchases a bond, and the company is in debt to the investor. The company must pay the investor back at a set date, along with periodic interest payments to reward the investor for loaning the funds and accepting risk.
Bonds are less risky than stocks and have historically provided lower returns. Older individuals tend to favor bonds more than young investors because of the decreased risk and guaranteed income provided by the interest payments made by the issuing company. However, bond prices are inversely related to changes in interest rates. When interest rates rise, bond prices fall, and vice versa.
Real estate is another viable investment option. Historically, real estate prices have risen at about the same rate as inflation. Not great you say? Well most people make their money in long term rentals or fixing and flipping. With a little knowledge and hustle, real estate can provide excellent returns while offering some additional tax benefits for investors.
Why Do People Invest?
In summary, we invest to make more money. This is important to reach financial goals, maintain purchasing power, etc.
If you are looking to begin investing and need some guidance, consider reading my reviews on companies like Betterment and Wealthfront. Both of these firm will invest in stocks, bonds, and real estate for you in exchange for a minimal fee. They recommend advanced portfolios based on sound academic research, complete with tax-loss harvesting, and a number of other great features.
If you have any questions, just let me know.