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It's actually pretty simple: investing means putting your money to work for you --actually, it's a different way to think about how to make money. Growing up, most of us were taught that you can earn an income only by getting a job and working. And so that's what most of us do. But there's a limit to how much we can work and how much money we make out of it --not to mention the fact that having a bunch of money is no fun if we don't have the leisure time to enjoy it.
So, since you cannot create a duplicate of yourself to increase your working time, you need to send an extension of yourself--your money--to work. That way, while you are putting in hours for your employer, sleeping, reading the paper, or socializing with friends, you can also be earning money elsewhere. Quite simply, making your money work for you maximizes your earning potential whether or not you receive a raise, decide to work overtime, or look for a higher-paying job.
There are many different ways you can go about making an investment. This includes putting money into stocks, bonds, mutual funds, real estate, gold etc. The point is that no matter the method you choose to invest, the goal is always to put your money to work so it earns you an additional profit. Even though this is a simple idea, it's the most important concept for you to understand.
What Investing Is Not
Investing is NOT gambling. Gambling is putting money at risk by betting on an uncertain outcome with the hope that you might win money. Part of the confusion between investing and gambling, however, may come from the way some people use investment vehicles. For example, it could be argued that buying a stock based on a "hot tip" you heard at the water cooler is essentially the same as placing a bet at a casino.
A "real" investor does not simply throw his or her money at any random investment; he or she performs thorough analysis and commits capital only when there is a reasonable expectation of profit. Yes, there still is risk, and there are no guarantees, but investing is more than simply hoping lady luck is on your side.
Obviously, to earn more money.
However, investing is becoming less of an extra thing to do and more of a necessity. For the average person, investing is the only way they can retire and yet maintain their present standard of living.
By planning ahead you can ensure financial stability during your retirement.
Now that you have a general idea of what investing is and why you should do it, it's time to learn about how investing lets you take advantage of one of the miracles of mathematics: compound interest.
Compound Interest
Albert Einstein said that compound interest is "the greatest mathematical discovery of all time."
The wonder of compounding (sometimes called "compound interest") transforms your money into an income-generating tool. Compounding is the process of generating earnings (multiplying your money) on presently invested money. To work, it requires two things: (1) the re-investment of earnings, and (2) time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
To demonstrate, let's look at an example:
If you invest Rs 1,000 today at 6%, you will have Rs 1,060 in one year (Rs 1,000 x 1.06). Now let's say that rather than withdraw the Rs 60 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to Rs 1,123.6 (Rs 1,060 x 1.06) by the end of the second year.
Because you re-invested that Rs 60, it works together with the original investment, earning you Rs 123.6 in total, as against Rs 120 that you would have earned if you had kept Rs 1000 for two years without reinvesting the Rs 60. This is Rs 3.6 more interest than the previous year. This little bit extra may seem a paltry amount now, but let's not forget that you didn't have to lift a finger to earn the extra Rs 3.60. More importantly, this Rs 3.6 also has the capacity to earn interest. After the next year, your investment will be worth Rs 1,191.016 (Rs 1,123.6 x 1.06). This time you earned Rs 191.016, which is Rs 11.016 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on…. It'll continue as long as you keep re-investing and earning interest.
Starting Early
Consider two individuals, we'll name them Ram and Sham. Both Ram and Sham are the same age. When Ram was 25 he invested Rs 15,000 at an interest rate of 8.0 %. For simplicity, let's assume the interest rate was compounded annually. By the time Ram reaches 60, he will have Rs 221,780 (Rs 15,000 x [1.08^35]) in his bank account.
Ram's friend, Sham, did not start investing until he reached age 35. At that time, he invested Rs 15,000 at the same interest rate of 8 % compounded annually. By the time Sham reaches age 60, he will have Rs 102,727 (Rs 15,000 x [1.08^25]) in his bank account.
What happened? Both Ram and Sham are 60 years old, but Ram has Rs 119,053 (Rs 221,780 - Rs 102,727) more in his savings account than Sham, even though he invested the same amount of money! By giving his investment more time to grow, Ram earned a total of Rs 206,780 in interest and Sham earned only Rs 87,727.
Both Ram and Sham's earnings rates are demonstrated in the following chart:
You can see that both investments start to grow slowly and then accelerate, as reflected in the increase in their curves' steepness. Ram's line becomes steeper as he nears his 60s not simply because he has accumulated more interest but because this accumulated interest is itself accruing more interest.
In fact even if Sham had invested Rs. 20,000 at the age of 35 he would have accumulated Rs 136,970, which is still lower than what Ram would have accumulated had he invested Rs. 15,000 only. This clearly demonstrates the power of compounding and the benefits of investing early. So keep your hands off the principal invested and interest earned !
Even though all investors are trying to make money, they all come from diverse backgrounds and have different needs. It follows that specific investing vehicles and methods are suitable for certain types of investors. Although there are many factors that determine which path is optimal for an investor, we'll look at three main categories: investment objectives, timeframe, and your personality.
Investment Objectives
Generally speaking, investors have a few primary objectives: safety of capital, current income, or capital appreciation. These objectives depend on a person's age, stage/position in life, and personal circumstances. A 65-year-old widow living off her retirement savings is far more interested in preserving the value of investments than a 33-year-old business executive would be. Because the widow needs income from her investments to survive, she cannot risk losing her investment. The young executive, on the other hand, has time on his or her side and can therefore risk losing his money simply because he has time to make more money.
An investor's financial position will also affect his or her objectives. A multi-millionaire is obviously going to have very different goals compared to a newly married couple just starting out.
Timeframe
As a general rule, the shorter your time horizon, the more conservative you should be. If your investment is for a long-term objective like retirement planning and you are still in your 20s, then you still have time to make up for losses and can therefore invest in aggressive investment vehicles like stocks. At the same time, if you start when you are young, you have the power of compounding on your side.
On the other hand, if you are about to retire, then the opportunity to recover losses on your investments is limited and therefore it is critical to invest your assets conservatively.
Your Personality
Peter Lynch, one of the greatest investors of all time, has said that the "key organ for investing is the stomach, not the brain." In other words, you need to know how much volatility you can stand to see in your investments. Figuring this out is difficult; but there is some truth to an old investing maxim: you've taken on too much risk when you can't sleep at night because you are worrying about your investments. This is an indicator of your investment personality.
Putting It All Together: Your Risk Tolerance
By now it is probably clear to you that the main thing determining what works best for an investor is his or her capacity to take on risk (to get an indication of your risk taking ability, use our Risk Profiler).
The core factors that define your risk tolerance are:
1. Investment Objectives
2. Timeframe
3. Your personality
Bonds
Grouped under the general category called "fixed-income" securities, the term "bond" is commonly used to refer to any founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.
The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed (or "risk-free" in investing parlance). The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities.
Stocks
When you purchase stocks (or "equities" as your advisor might put it), you become a part owner of the business. This entitles you to vote at the shareholder's meeting and allows you to receive any profits that the company allocates to its owners--these profits are referred to as dividends.
While bonds provide a steady stream of income, stocks are volatile. That is, they fluctuate in value on a daily basis. When you buy a stock, you aren't guaranteed anything. Many stocks don't even pay dividends, making you any money only by increasing in value and going up in price--which might not happen.
Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential: you must assume the risk of losing some or all of your investment.
Mutual Funds
A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which in turn enables you (as part of a group) to pay a professional manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything: large stocks, small stocks, bonds from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks in certain countries, and the list goes on.
The primary advantage of a mutual fund is that you can invest your money without needing the time or the experience in choosing investments. To know more about mutual funds, please visit our learning centre.
Alternative Investments: Options, Futures, FOREX, Gold, Real Estate, Etc.
So, you now know about the two basic securities: equity and debt, better known as stocks and bonds. While many (if not most) investments fall into one of these two categories, there are numerous alternative vehicles, which represent more complicated types of securities and investing strategies.
The good news is you probably don't need to worry about alternative investments at the start of your investing career. They are generally high-risk/high-reward securities that are much more speculative than plain old stocks and bonds. Yes, there is the opportunity for big profits, but they require some specialized knowledge. So if you don't know what you are doing, you could get yourself into a lot of trouble. We would therefore suggest that you start with simpler investment avenues and leave these investment vehicles for the experts.
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