Investing is the practice of allocating resources towards a venture or asset with the intention of receiving some benefit in the future.
This can take many forms. For example, some people invest their time in low-paying internships so they can receive experience for their resumés. Most commonly, however, you’ll hear the word “investing” used in reference to buying assets that produce income and/or appreciate in value.
Investing isn’t just a license to print cash, though. In fact, the most lucrative assets come with substantial risks. By the end of this guide, you’ll understand why investors are willing to live with that.
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Why Do People Invest?
Passive income is money you receive with little to no effort on your part. That includes rent from a property or dividends from stocks, REITs, and ETFs (don’t worry if you’re not sure what those are; we’ll discuss in the next section).
Even $100 earned passively each month can help you pay bills and live a little more comfortably. In the case of dividends from stocks and ETFs, some people reinvest that passive income to take advantage of something called compound interest.
“Money makes money. And the money that money makes, makes money.”– Benjamin Franklin (source)
The above quote strikes home at the unfathomable awesomeness of compound interest.
Say you invest $1,000 in an asset that returns 10% annually. At the end of the first year, you’ll receive $100 in interest, bringing your investment to $1,100. The following year, your interest payment will be $110, leaving you with $1,210. In the third year of your investment, you’ll receive $121, bringing your total to $1,331.
The longer you let this process run, the faster it ramps up. In year 40, you’d have a grand total of $45,259. Just 10 years later, your investment would grow to $117,390. At the 60-year mark, you’d have $304,481. And that’s with us making several conservative assumptions, including:
- You never add to your investment beyond the initial $1,000.
- The asset you purchase never rises in value.
While you can take advantage of compound interest in savings accounts, your rate of return (a measly 0.09% on average) will be nowhere near that of good dividend-paying stocks or ETFs.
In many countries, the government reduces taxes for those who invest through specific programs. Canadians who purchase stocks and other assets through their Registered Retirement Savings Plan (RRSP), for example, can deduct that money from their taxable income for the year. Americans have a similar system called the 401k Plan. With either program, you won’t pay taxes on the money you contribute until you retire, at which point you’ll likely be in a much lower bracket.
Some employers will “match” your investments in a 401k, RRSP, or other investment accounts up to a certain limit. This can drastically boost your savings. Think about it; you’re essentially getting a 100% return on those funds right off the bat. Not bad!
Protection From Inflation
The value of currency depreciates over time. That’s partially why groceries cost a lot more today than they did 20 years ago. This isn’t some nefarious conspiracy, either; orderly inflation actually helps countries stay competitive when it comes to international trade.
Currently, the rate of inflation in the United States is 1.5%. Canada’s inflation rate is roughly 2.24%. The low interest rates you get with most savings accounts won’t protect you from that. In other words, if your retirement savings plan consists of chucking $100,000 into a bank account and ignoring it for 30 years, you’re gonna have a bad time.
That’s where investing comes in. The stock market has produced an average annual return of about 10% throughout history. Real estate generally performs within that ballpark as well. Those gains will more than shield you from inflation.
Common Investments for Beginners
Now that you know why people invest, let’s discuss how they often go about doing it.
What Is Investing in Stocks?
When you purchase a stock, you are actually claiming partial ownership of the company behind it. You can only do this with organizations that list these “slices of ownership” on public marketplaces known as exchanges. The most well known of these is the New York Stock Exchange on Wall Street. Others include:
- Nasdaq (also based in New York)
- London Stock Exchange (based in… you get it)
- TSX (located in Toronto)
- Shanghai Stock Exchange
- SIX Swiss Exchange
You don’t need to actually visit these exchanges to invest in stocks. Rather, you place your order with a third party (known as a brokerage) through their website or app. You’ll provide the following information:
- What stock you want to buy (i.e. Apple)
- How many shares you want
- How much you’re willing to pay for each share
Your brokerage will then direct your trade to the appropriate exchange for execution, after which the stocks will arrive in your account. You’ll hold them there until you’re ready to sell or transfer to another brokerage. Buying and selling stocks takes fewer than five minutes once your account is set up.
How Do You Make Money Investing in Stocks?
Some companies distribute a portion of their profits (known as dividends) to shareholders. Stock prices also fluctuate based on market demand, which is fueled in large part by expectations of the company’s future performance. You can make money by selling shares after optimism (often caused by good press) has caused their value to climb.
What Is ETF Investing?
Exchange-traded funds (ETFs) behave quite similarly to stocks. In fact, the process of buying and selling these assets is identical. Instead of buying partial ownership of a single company, however, you are buying partial ownership of several companies at once.
Think of it like adding an entire playlist to your Spotify library instead of a single song.
As with playlists, ETFs come in different themes. If you’re a strong believer in the future of America, you might buy the SPDR S&P 500 Trust ETF, which grants you partial ownership of the 500 biggest companies in the nation. If you’re interested in the cannabis industry, you might buy something like the Horizons Marijuana Life Sciences Index ETF, which contains stocks from several North American pot companies.
Because ETFs offer diversification, they’re generally seen as a low-risk option for investing in the stock market. Think about it. Individual companies go out of business all the time. If that happens to a firm you’ve invested substantial amounts of money in, you’ll lose bigly. You’re much less likely to see an entire industry or country collapse, which is the rationale behind the “diversification” argument for ETFs.
How Do You Make Money with ETF Investing?
As with stocks, many ETFs pay dividends. ETFs also rise in value based on market demand for the assets that they contain.
What Are Mutual Funds?
Mutual funds behave similarly to ETFs in that they are baskets of various assets organized based on a theme. Some key differences set mutual funds apart, however.
For example, consider the trading process.
ETFs can be bought and sold throughout the day, just like stocks. Their prices fluctuate constantly from market open to close (9:30-4:30 EST in the United States), which makes activities like swing trading possible.
Mutual funds, on the other hand, are only priced at the end of each business day. As such, when you place an order for mutual fund shares, it won’t be executed immediately; you’ll have to wait until the next pricing-in.
Many banks offer mutual funds as a convenient way for customers to begin investing without an in-depth understanding of the market. While buying stocks and ETFs can feel a bit ‘technical’ at times, adding to your mutual fund holdings is often as simple as transferring money into an account and letting the bank do the rest. This convenience costs you in the form of higher fees than you’d pay for ETFs.
For more information about the differences between ETFs and mutual funds, click here.
How Do You Make Money with Mutual Funds?
Some mutual funds pay dividends just like stocks and ETFs. You can also make money by selling your shares in a mutual fund after they have risen in value along with the underlying assets.
What Is Investing in Bonds?
When you purchase bonds from a government or corporation, you are loaning them money in exchange for the promise of repayment plus interest. Bonds (particularly ones from stable governments like that of the United States or Canada) are generally considered to be very safe, low-risk investments. These entities have high credit ratings, which (much like individual credit scores) symbolizes reliability as borrowers. Companies and governments with low credit ratings need to offer higher interest rates on bonds to lure investors.
You can buy bonds directly from the issuer (i.e. through Treasury Direct for U.S. bonds) or through a brokerage. There are also ETFs and mutual funds that contain baskets of bonds.
How Do You Make Money by Investing in Bonds?
One way to make money with bonds is to simply hold them until maturity. You will collect interest throughout the term and then be repaid your initial investment upon the maturity date’s arrival.
Bonds also fluctuate in value based on government policy. Say you purchase a bond with a yield of 4%. A year later, the government lowers the interest rate on bonds to 2%. Suddenly, your 4% bond has become more valuable to investors. You may be able to sell it for more than what you paid.
What Is Real Estate Investing?
Real estate investing involves buying properties (i.e. buildings or land) to generate a profit.
With this type of investing, you can take advantage of something known as leverage. You put up a relatively small amount of money (your down payment) and a bank provides the rest in the form of a mortgage. This lets you acquire a much larger asset than you could’ve on your own.
Say you have $100,000 to invest. If you put it in the stock market, you’ll only benefit from $100,000 worth of assets. If you use that money as a downpayment on a $500,000 house, however, you’ll reap the rewards of a much larger pie.
Remember, though: with great power comes great responsibility. We’ll explore the dark side of leveraged investing in the section on risk.
How Do You Make Money with Real Estate Investing?
As a real estate investor, you can rent your properties out, earning monthly income. Property values can also rise based on demand. When the value of your property increases above what you owe on your mortgage (including interest), you can sell it and keep the difference.
What Are Real Estate Investment Trusts?
A real estate investment trust (REIT) is a company that owns and manages properties on behalf of its investors. You can buy REITs on the open market through a brokerage firm much like you would an ETF. They are a popular investment vehicle for those looking to reap the rewards of real estate without owning property directly.
A REIT will typically focus on a single type of real estate. For example, the True North Commercial REIT manages commercial properties throughout urban centers in Canada. The Bluerock Residential Growth REIT, meanwhile, focuses on apartment buildings.
Read more about the pros and cons of REITs in this article.
How Do You Make Money with REIT Investing?
The United States Securities and Exchange Commission (SEC) mandates that REITs pay at least 90% of their taxable income to shareholders in the form of dividends. Because of this rule, many investors view REITs as reliable investments for generating passive income. The value of a REIT on the open market can also rise based on demand, allowing you to sell your shares for a profit.
Many investors have earned their fortunes without ever straying beyond the aforementioned assets. However, understanding the basics of the following more complicated investments can give you a better picture of how markets work in general. Consider this section supplementary information and feel free to skip ahead to the section on investment risk if your head is already spinning.
What Are Options?
An option is a contract granting its holder the right to buy or sell a stock at an agreed-upon valuation (known as the “strike price”) within a set amount of time. The holder doesn’t have to make the trade if it wouldn’t be in their best financial interest; they simply reserve the option to do so before the contract’s expiration date passes.
You can buy and sell options contracts through a brokerage account, much like you would a stock. Not all brokerages allow options trading, however, given how risky it can be.
How Do You Make Money with Options Investing?
There are two types of options: puts and calls. How you make money depends on which of these you choose and whether you buy or sell them. Here are some general principles to keep in mind as you read this section:
- Each options contract controls 100 shares of the underlying asset.
- Options contracts themselves vary in price based on several complex factors. Generally, a contract will cost more the greater its lucrativeness for the holder is likely to be.
- As with real estate investing, options allow you to take advantage of leverage. For a relatively small investment (commissions plus the cost of the contract), you can control a large asset (100 shares of a stock or ETF).
- The following explanations detail the basic mechanisms for making money with options. There are countless complex strategies savvy investors can use but those lie beyond this article’s scope.
Buying a put option allows you to capitalize on an asset’s decline in value. Say you strongly believe (based on your research and analysis) that Corporation A’s stock is going to fall from its current valuation of $200. You could purchase a put option with a strike price of $200 (or any point above where you expect the stock to fall) and potentially benefit from this expected move downward.
Say your analysis proves to be correct and Corporation A’s stock falls from $200 all the way down to $80 within your contract’s term. You could then exercise the option, purchase 100 shares at the market valuation of $80 per unit, and immediately sell them for $200 apiece, netting you a profit of $12,000.
If your analysis turns out to be wrong and Corporation A’s stock stays flat or rises, you can simply let your contract expire worthless. You’ll lose 100% of what you invested, though. It’s an all or nothing bet!
Buying a call option allows you to capitalize on an asset’s rise in value. Because options involve leverage, your gains can be much greater than what you’d achieve by simply buying the stock itself and selling it after it climbs in value.
Say you believe that Corporation A’s stock is going to rise above its current valuation of $200 apiece. By purchasing a call option with a strike price of $200 (or any point below where you expect the stock to rise), you reserve the right to buy 100 shares at that price within the contract’s term.
Imagine that your analysis is spot-on and Corporation A’s stock skyrockets from $200 to $400. You could then exercise the option, purchase 100 shares at $200 a pop, and immediately sell them for $400 each. That’d be a $20,000 gain.
Once again, if your analysis falls short and Corporation A’s stock stays flat or declines in value, you can let your option expire worthless. You’ll lose 100% of what you spent on it.
Selling Puts and Calls
While buying a put or call option sees you acquiring the right to trade a stock at a given price, selling them sees you agreeing to sit at the other of the trade should it be executed, even if that would not be in your best financial interest. In exchange for this, you’ll receive a payment (or “premium”) from the buyer.
One major advantage of selling options contracts is that you benefit from two possible outcomes instead of just one. Remember, the buyer of an option only makes money when the underlying stock moves in the direction they predicted. That’s it. As an options seller, you benefit when the stock’s price moves opposite to the buyer’s preference or when it stays flat. In either scenario, the buyer has no reason to exercise the contract so you keep the premium and walk away scot-free.
If the stock’s price does move in the buyer’s favor, however, your downside as an options seller can be massive. Remember those huge gains we discussed in the sections about buying puts and calls? You’ll be the one handing that money over if your contract is enforced. While there are strategies you can use to mitigate this risk, they are very difficult for beginning investors to understand. Failure to grasp these concepts can lead to theoretically infinite (yes, infinite) losses.
What Are Commodities?
The term ‘commodity’ in investing refers to resources like food, oil, natural gas, metals, and currencies. The value of these assets is directly driven by supply and demand. For example, during the COVID-19 shutdown, oil prices slumped as the commodity’s supply far outpaced demand due to shuttered air travel.
Investing in commodities can take several forms, including:
- Buying the resource directly.
- Purchasing commodity futures. These behave similarly to options but with some key differences. You can think of futures as a ‘stricter’ contract; while buying options allows an investor to back out if the trade would not be in their best interest, futures come with an obligation to fulfil the trade regardless.
- Buying shares of a commodities-focused ETF.
- Investing in companies that produce commodities (i.e. mining or drilling firms).
How Do You Make Money with Commodity Investing?
The mechanism through which you make money with commodities depends on how you purchase them. If you obtain a commodity directly (i.e. physical gold bars), you’ll have to store it yourself then find a buyer, negotiate a price, and arrange delivery. As you can imagine, this proves quite impractical for individuals looking to invest in commodities like oil.
Futures contracts aren’t very practical, either, since they come with an obligation to purchase substantial amounts of the underlying commodity. As such, futures are primarily used by large companies who rely on those commodities and would be buying them anyway. In this scenario, futures are commonly used to ‘lock-in’ a particular price for a commodity.
Individual investors can gain exposure to commodities through an ETF or a commodity producer’s stock. These assets fluctuate in value based on demand for the underlying resource and may also generate dividends.
Investment Risk: An Important Reality Check
Investing can be a great tool for growing your money over time. It’s not just a free-for-all, though. Many investors falter by failing to take something very important into account: risk. Here are a few things you need to consider with the help of an investment advisor.
High Risk, High Reward
Keeping your money in a bank account is very low-risk. While its value will decrease year over year due to inflation, the nominal amount you hold will never decline (unless, of course, you spend it). Consequently, you won’t get much of a return by hoarding your money in this fashion. You’ll just earn whatever paltry interest rate your bank offers (typically around 0.09%, as mentioned previously). High-quality bonds are also low-risk and you won’t get rich holding them, either.
Investing in the stock market carries a higher degree of risk. While stocks typically rise over the long term, they don’t take a straight path upwards. Occasional slumps are inevitable – and they can be substantial. During the 2020 COVID-19 pandemic, the entire market fell by more than 50%. Stock market investors are willing to live with this risk because the potential returns are also large.
Real estate investing arguably carries an even greater amount of risk than the stock market. If you utilize leverage to buy a property that subsequently becomes worth less than what you paid, the bank still expects its money back. You’ll be stuck overpaying for an asset that may or may not recover. This is the dark side of leverage. While it can amplify your returns, it does the same for your losses. It’s possible to end up owing more than you invested in the first place.
Your Appetite for Risk Is Probably Lower Than You Think
Research has shown that investors tend to overestimate their risk tolerance when times are good. If you don’t take this phenomenon into account when designing your portfolio, things can turn disastrous. Say you take on too much risk by buying more properties than you can afford or tying up too much money in stocks. While you’ll make lots of money when the market is rocketing upwards, the ferocity of a downturn will likely catch you off guard. You may end up behaving irrationally in one way or another, such as panic-selling assets at the worst possible time.
Avoiding this is easy if you work with a licensed advisor to determine your risk tolerance and design a portfolio that’s compatible with it. This may seem like the boring thing to do during exuberant times when you can pick just about any stock and flip it for a profit the next day. However, investors who plan wisely based on their risk tolerance have historically survived market downturns in much better shape mentally and financially than those who did not.
Investing Styles: A Key Concept for Managing Risk
Choosing the right investment style is central to the process of designing a portfolio appropriate for your risk tolerance. Here are the general styles any good investment advisor will explain to you before you get started.
Passive investing involves buying and holding assets for the long term. Historically, this has produced the best results for individuals investing over the long haul. One popular strategy associated with this approach is something known as index investing. This is when you purchase an ETF or fund that tracks an index such as the S&P 500. It’s a low-cost, low-hassle investment strategy.
The active investing style involves picking stocks and other assets with the intention of generating greater returns than you would through passive investing. Over the long haul, this is much easier said than done – even for professionals. The investors that do this well (such as Warren Buffet) are highly skilled at analyzing companies and making financial decisions. They also have a massive amount of money, allowing them to survive errors that would wipe out smaller investors.
The Aggressive-Conservative Spectrum
The aggressive-conservative spectrum is a tool advisors use to determine how much risk an investor is capable of withstanding. For example, someone with a high risk tolerance who won’t be retiring for 40 years can invest aggressively; any volatility in the short term will be a distant memory by the time they need their money. Aggressive investing usually involves allocating more of one’s portfolio to stocks.
Conservative investing, on the other hand, is geared towards people with a low risk tolerance and shorter time horizon. It typically involves allocating a greater portion of one’s portfolio to bonds, which are more stable.
Investing vs. Speculation
Another important concept to understand in relation to risk is the difference between investing and speculation. While investing involves taking a calculated risk on an asset that stands a good chance of producing positive results, speculating is more akin to gambling. Let’s look at an example.
Person A truly believes that the American economy is a safe long-term bet. After looking at different available ETFs, they settle on Vanguard’s VOO.IV because they like that fund’s approach to pooling American assets. This person is an investor; they did their research and made a choice for the long term.
Person B, on the other hand, is looking to get rich quick. Rather than researching an asset and purchasing it for the long haul, they regularly trade options in an attempt to capitalize on predicted market swings. This person is a speculator; their strategy relies on short-term market action, which is much less reliable than, say, the American economy continuing to grow as it has for hundreds of years.
Speculation can also involve buying assets like Bitcoin without fully understanding how they work. (On the topic of Bitcoin, check out this article for a thorough explanation along with a few reasons to consider allocating a small portion of your portfolio to cryptocurrencies).
Not all speculation is a complete faux pas, though. Advanced traders can use it to make money. It’s just not something advisors will typically recommend you stake your financial future on, especially as a beginner.
Are You Ready to Begin Investing?
At this point, you should have a relatively solid grasp of investing’s fundamentals. In this guide, we discussed various types of assets, how one might profit from them, and the styles/benefits of investing. This information should serve as a great launching pad for further exploration of investing. Your next step should be to check out my post on the various types of investment accounts. Once you’ve made your pick, you’ll be ready to begin your journey as an investor!
Here are some additional resources you may find useful:
- I Will Teach You to Be Rich by Ramit Sethi
- Total Money Makeover by Dave Ramsey
- The Slight Edge by Jeff Olson
The books by Ramit Sethi and Dave Ramsey offer good breakdowns of what your approach to personal finance as a whole should be. Particularly, they’ll inform you of the best ways to prioritize repaying debt, saving, and investing.
Jeff Olson’s book isn’t investing-specific but it will drive home the importance of chipping away at your goals, no matter how minute your progress may seem. This will be particularly useful if you’ve shied away from investing because you feel like you don’t have enough money to make a difference. Spoiler alert: you do.
Frequently Asked Questions
This largely depends on what asset you’re looking to purchase. If you’d like to buy a property directly, you need at least enough money for a downpayment. You’ll also need to find the right property and work with a mortgage provider.
The bar for entry is much lower in the stock market. Most mutual funds require a minimum initial investment of about $500. When buying stocks and ETFs, your minimum is merely the value of the stock you want to buy plus trading commissions (if your broker charges them; many don’t).
There are also brokerages (like Wealthsimple) through which you can get started investing with as little as $1. These brokerages will split your investment between various assets like ETFs and bonds based on your risk tolerance. While you’ll pay higher fees than you would by simply buying these assets yourself, the ease of entry is hard to compete with.
The exact mechanism through which you earn money as an investor depends on your asset of choice. Generally, however, you make money through the appreciation of your asset (i.e. the home, bond, or stock you own rises in value) and/or regular payments in the form of interest, dividends, or rent.
The earlier you start investing, the better. Because of compound interest, even a mere 10-year head start can leave you with twice as much money when you retire. Investing as early as possible also helps you develop the habits and mindset needed to succeed.
Diversification is a valuable risk mitigation tool. By building a portfolio that contains several companies, industries, and even asset classes, you reduce the likelihood of seeing your entire investment wiped out. This is as much about preserving your wealth as it is about maintaining your sanity.
An investment portfolio is the combined ‘package’ of all your different investments. You can tailor your portfolio towards your risk tolerance and even interests by combining different assets. You can also take a hands-off approach and let an investment advisor choose an appropriate portfolio for you.
There are many possible paths to becoming wealthy as an investor. Consider working with an advisor to determine which path is right for you based on factors like your income and time horizon.