Table of Contents
Objectives of investing
Evaluating and understanding investments
Types of investments
4 different investing styles
Understanding risk tolerance and diversification
Investments vs. savings
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Sep 9, 2022
8 min read
An investment is a financial or physical asset purchased with the goal of generating income. Types of investments include stocks, bonds, ETFs, mutual funds, and more.
An investment is a financial or physical asset purchased with the goal of generating income or gaining value.
For individuals, investments can include a wide range of assets and activities. People might invest money to enroll in school and earn a degree or certification that can increase their earning potential. Or they might buy securities such as shares of a publicly traded company, which could generate income in the form of dividends, or potentially appreciate in value.
All investments inherently come with risk. Whether an investor is investing in themselves or purchasing financial instruments, there’s a chance of losing rather than making money.
While all investments have the broad objective of making money, investors often have more specific financial goals:
One common investment goal is to save for retirement. Tax-deferred retirement accounts, such as a 401(k) or individual retirement account (IRA), are designed specifically for this purpose.
Some people save up to spend on tuition, a form of investment, while parents often set aside and invest money in a college fund for their children.
Investors may have a specific large purchase in mind and invest their money to save up for a down payment on a new home, vacation home, vehicle, or business.
Some invest with the objective of increasing their income. Stocks that pay dividends and a rental property is a good example of an investment that can generate monthly income.
Some investors want to use their money to drive social change while also making money. This is known as impact investing or SRI (socially responsible investing). An investor passionate about climate change might invest in alternative energy, or an investor who cares about diversity and inclusion may invest in companies with diverse leadership.
Some investments are intended to preserve rather than increase wealth. These are low-risk investments, such as government bonds, whose goal is to earn enough to offset inflation.
Setting objectives can be an important first step when investing. Additionally, savvy investors research their options, understand the potential risk and reward of each, and choose investments that align with their values and goals.
Some considerations include:
These might include buying a home, funding retirement, paying off debt, or sending a child to college.
An investor’s tolerance for risk is the degree to which you can absorb financial outcomes that are different from what you expect.
Time horizon is how long you plan to hold an investment before selling. It can be connected to risk tolerance. Investors with a shorter time horizon may have a lower risk tolerance, whereas those with a longer time horizon might be willing to tolerate price fluctuations in the short-term in exchange for the chance of higher future gains.
Investors may be able to use a regular brokerage account or a tax-advantaged account, depending on what they plan on using their invested capital and gains for. Understanding the tax implications of different accounts and investments can be important for maximizing gains.
Investing fees can eat into returns. These could include fees for managers who make decisions on behalf of investors or manage a pooled investment vehicle like a mutual fund or exchange-traded fund (ETF). Some investment accounts also charge fees for buying or selling securities.
Additionally, investors can choose from a variety of investment types.
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Here are some of the most common financial investment categories, or asset types:
Buying stock makes someone a partial owner of a publicly traded company. The value of the stock may increase or decrease depending (in part) on how well the company does and the demand for its stock. Shareholders may also earn income if the company distributes dividends.
This instrument represents a loan from an investor to a borrower, typically a corporation or government. A bond investor acts as the lender and receives interest payments, which are called coupon payments.
A mutual fund pools investors’ money together to purchase a bundle of assets. Mutual funds can have different focuses, such as growth, income, or social responsibility. Investors can buy mutual funds from a mutual fund company or through a brokerage firm.
An ETF is a pooled form of investment that is designed to track an index, sector, or commodity. These trade just like stocks.
Commodities are physical goods, such as oil, gold, and grains. People can invest in commodities in different ways, such as buying mutual funds or ETFs that track commodity prices.
Investors can buy residential or commercial property or purchase in the shares of real estate investment trusts (REITs), a type of company that owns and manages real estate.
Other types of investments can include lending money through a peer-to-peer lending platform, buying annuities, or purchasing cryptocurrencies.
Investors may favor different investment styles or types of investments based on their goals. The preferred style may also change over time as the investor accomplishes one goal and moves on to the next. Four common investments styles include:
Passive investing or index investing tries to track an existing index. For example, many mutual funds or ETFs passively track the S&P 500—an index of the 500 largest publicly traded companies in the US.
Active investors pick investments in an attempt to outperform a benchmark index, such as the S&P 500. Investors also can buy an actively managed mutual fund or ETF, and the fund managers will make decisions based on their research.
Growth investors focus on companies they believe will grow faster than the overall market. These businesses often don’t pay dividends because they invest as much money as possible in the company.
Value investors look for companies that may be worth more than their stocks’ current price indicates. Investors try to make money by buying these (relatively) cheap investments and benefiting from their dividend payments or long-term increase in value.
Investors and fund managers can use different financial metrics to evaluate investment options. There can also be overlap between these styles, such as an actively managed mutual fund that focuses on either growth or value investments.
Every investment involves risk, and investors may want to consider their personal risk tolerance before making an investment decision. An investor with a high risk tolerance might be willing to risk most or all their money if they can potentially get a big return. An investor with a low risk tolerance would prefer a lower return if it means they’re less likely to lose money. Measuring risk tolerance isn’t an exact science, and risk tolerance can change over time.
There are different strategies that investors can use to attempt to increase their returns while maintaining or decreasing the risk they take on. One common approach is to diversify a portfolio, or invest in a variety of asset types. A well-diversified portfolio can decrease risk when the assets are likely to move in opposite directions. As a result, an event that leads to one portion of the portfolio losing value might increase the value of another part of the portfolio.
While investing and saving can both lead to having money to spend later, they’re not the same. Investing involves taking a risk with the goal of increasing wealth. Saving may involve a little risk and can also lead to increased wealth over time, but the goal is often to set aside and preserve money.
Cash savings accounts have very low risk. Investments always come with risk, although the risk can vary depending on the type of investment.
Savings grow slowly as they accrue interest. Investments have the potential to grow more quickly.
Savings are often for short- to medium-term goals. Investments are often for longer-term goals.
Savings can often be instantly accessed as cash. Investments may need to be sold if the investor needs cash.
Generally, people invest when they have some cash savings, and are looking ahead at medium- to long-term financial goals. These may include a child’s college savings fund, a down payment for a home, and retirement. Investors are willing to take on more risk in exchange for the potential to greatly increase how much money they will have in the future.
Savings are often for shorter-term goals, such as buying a car, traveling, or this year’s holiday gifts. Many people also set aside savings for an emergency fund—money they can use to cover unexpected setbacks and crises. Savings are often kept in low-risk accounts, such as a high-yield savings account or certificate of deposit, and the accounts can grow as more money gets set aside and interest accrues.
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