What Is Investing?
Investing, broadly, is putting money to work for a period of time in some sort of project or undertaking in order to generate positive returns (i.e., profits that exceed the amount of the initial investment). It is the act of allocating resources, usually capital (i.e., money), with the expectation of generating an income, profit, or gains.
One can invest in many types of endeavors (either directly or indirectly) such as using money to start a business, or in assets such as purchasing real estate in hopes of generating rental income and/or reselling it later at a higher price.
Investing differs from saving in that the money used is put to work, meaning that there is some implicit risk that the related project(s) may fail, resulting in a loss of money. Investing also differs from speculation in that with the latter, the money is not put to work per-se, but is betting on the short-term price fluctuations.
KEY TAKEAWAYS
Investing involves deploying capital (money) toward projects or activities that are expected to generate a positive return over time.
The type of returns generated depends on the type of project or asset; real estate can produce both rents and capital gains; many stocks pay quarterly dividends; bonds tend to pay regular interest.
In investing, risk and return are two sides of the same coin; low risk generally means low expected returns, while higher returns are usually accompanied by higher risk.
Investors can take the do-it-yourself approach or employ the services of a professional money manager.
Whether buying a security qualifies as investing or speculation depends on three factors—the amount of risk taken, the holding period, and the source of returns.
Understanding Investing
Investing is to grow one's money over time. The expectation of a positive return in the form of income or price appreciation with statistical significance is the core premise of investing. The spectrum of assets in which one can invest and earn a return is a very wide one.
Risk and return go hand-in-hand in investing; low risk generally means low expected returns, while higher returns are usually accompanied by higher risk. At the low-risk end of the spectrum are basic investments such as Certificates of Deposit (CDs); bonds or fixed-income instruments are higher up on the risk scale, while stocks or equities are regarded as riskier. Commodities and derivatives are generally considered to be among the riskiest investments. One can also invest in something practical, such as land or real estate, or delicate items, such as fine art and antiques.
Types of Investments
Today, investment is mostly associated with financial instruments that allow individuals or businesses to raise and deploy capital to firms. These firms then rake that capital and use it for growth or profit-generating activities.
While the universe of investments is a vast one, here are the most common types of investments:
Stocks
A buyer of a company's stock becomes a fractional owner of that company. Owners of a company's stock are known as its shareholders and can participate in its growth and success through appreciation in the stock price and regular dividends paid out of the company's profits.
Bonds
Bonds are debt obligations of entities, such as governments, municipalities, and corporations. Buying a bond implies that you hold a share of an entity's debt and are entitled to receive periodic interest payments and the return of the bond's face value when it matures.
Funds
Funds are pooled instruments managed by investment managers that enable investors to invest in stocks, bonds, preferred shares, commodities, etc. Two of the most common types of funds are mutual funds and exchange-traded funds or ETFs. Mutual funds do not trade on an exchange and are valued at the end of the trading day; ETFs trade on stock exchanges and, like stocks, are valued constantly throughout the trading day. Mutual funds and ETFs can either passively track indices, such as the S&P 500 or the Dow Jones Industrial Average, or can be actively managed by fund managers.
Investment Trusts
Trusts are another type of pooled investment. Real Estate Investment Trusts (REITs) are one of the most popular in this category. REITs invest in commercial or residential properties and pay regular distributions to their investors from the rental income received from these properties. REITs trade on stock exchanges and thus offer their investors the advantage of instant liquidity.
Alternative Investments
Alternative investments is a catch-all category that includes hedge funds and private equity. Hedge funds are so-called because they can hedge their investment bets by going long and short on stocks and other investments. Private equity enables companies to raise capital without going public. Hedge funds and private equity were typically only available to affluent investors deemed "accredited investors" who met certain income and net worth requirements. However, in recent years, alternative investments have been introduced in fund formats that are accessible to retail investors.
Options and Other Derivatives
Derivatives are financial instruments that derive their value from another instrument, such as a stock or index. Options contracts are a popular derivative that gives the buyer the right but not the obligation to buy or sell a security at a fixed price within a specific time period. Derivatives usually employ leverage, making them a high-risk, high-reward proposition.
Commodities
Commodities include metals, oil, grain, and animal products, as well as financial instruments and currencies. They can either be traded through commodity futures—which are agreements to buy or sell a specific quantity of a commodity at a specified price on a particular future date—or ETFs. Commodities can be used for hedging risk or for speculative purposes.
Comparing Investing Styles
Let's compare a couple of the most common investing styles:
Active versus passive investing: The goal of active investing is to "beat the index" by actively managing the investment portfolio. Passive investing, on the other hand, advocates a passive approach, such as buying an index fund, in tacit recognition of the fact that it is difficult to beat the market consistently. While there are pros and cons to both approaches, in reality, few fund managers beat their benchmarks consistently enough to justify the higher costs of active management.
Growth versus value: Growth investors prefer to invest in high-growth companies, which typically have higher valuation ratios such as Price-Earnings (P/E) than value companies. Value investors look for companies that have significantly lower PE's and higher dividend yields than growth companies because they may be out of favor with investors, either temporarily or for a prolonged period of time.
How to Invest ?
Do-It-Yourself Investing
The question of "how to invest" boils down to whether you are a Do-It-Yourself (DIY) kind of investor or would prefer to have your money managed by a professional. Many investors who prefer to manage their money themselves have accounts at discount or online brokerages because of their low commissions and the ease of executing trades on their platforms.
DIY investing is sometimes called self-directed investing, and requires a fair amount of education, skill, time commitment, and the ability to control one's emotions. If these attributes do not describe you well, it may be smarter to let a professional help manage your investments.
Professionally-Managed Investing
Investors who prefer professional money management generally have wealth managers looking after their investments. Wealth managers usually charge their clients a percentage of assets under management (AUM) as their fees. While professional money management is more expensive than managing money by oneself, such investors don't mind paying for the convenience of delegating the research, investment decision-making, and trading to an expert.
The SEC's Office of Investor Education and Advocacy urges investors to confirm that their investment professional is licensed and registered.
Roboadvisor Investing
Some investors opt to invest based on suggestions from automated financial advisors. Powered by algorithms and artificial intelligence, roboadvisors gather critical information about the investor and their risk profile to make suitable recommendations. With little to no human interference, roboadvisors offer a cost-effective way of investing with services similar to what a human investment advisor offers. With advancements in technology, roboadvisors are capable of more than selecting investments. They can also help people develop retirement plans and manage trusts and other retirement accounts, such as 401(k)s.