What is investing?
Investing is expending money with the expectation of achieving a future profit.
Money put into a savings account, CD, or other savings vehicle offers low rates of return in exchange for high levels of safety and security. However, individuals often seek higher rates of return and are willing to accept higher levels of risk in order to gain such returns.
Different types of investments offer varying rates of expected return, and higher rates of expected return are generally associated with higher levels of risk. Investing is often, though not always, targeted towards the medium- or long-term.
How do I start investing?
As with all financial decisions, it’s incredibly important to do your research and develop a plan before you start investing. The following are some important considerations to keep in mind as you think about investing:
- Evaluate your financial position. Most financial experts recommend that you have an emergency savings fund with three-to-six months of expenses saved before you start putting money into riskier or longer-term investments. One exception to this is if your employer matches contributions to employer-sponsored retirement accounts—if you can, you should take advantage of these matching opportunities.
- Know your financial goals. Different types of investments are appropriate for different financial goals. Think about what you are investing for (retirement, education, etc.) and what your investment timeline is.
- Know your risk tolerance. Investments that offer higher rates of expected return entail greater risk of financial loss. There is no right or wrong level of risk tolerance. However, one rule of thumb is that, as your investment horizon shortens (e.g. as you get closer to retirement), you should move towards less risky investments.
- Diversify. Diversifying your investment holdings to balance risk and return is an integral part of maintaining a successful financial portfolio. Several types of investment vehicles are described below.
Types of investment vehicles
Stocks, mutual funds, and exchange traded funds (ETFS)
Stocks, mutual funds, ETFs, and the like are known as equity assets. They are securities in which the holder holds a share in a company or other account. These are riskier than bonds or cash equivalents, and therefore generally offer higher expected rates of return.
Bonds
Bonds are a form of debt, also known as fixed income investments. You, the bondholder, are giving money to a company or government in exchange for a fee (the interest). Bonds offer a defined cash flow over a set time, and are therefore generally less risky than stocks or other equity investments. Bonds generally offer rates of return higher than savings accounts and CDs. Bonds are often the most popular investments among older and/or more risk-averse investors.
Real estate
Homeownership can build wealth by allowing you to build equity. Home equity is defined as the market value of your home minus the amount you owe on it. As you pay off your mortgage and as your home value increases, your equity increases. Building home equity can be equated to a long-term investment.
Like any investment, homeownership comes with risks. Because real estate is a long-term investment, property taxes, home repairs, and regular maintenance must be factored into your costs and may cut into your investment returns. Home equity can also go down if home prices decline.
Building home equity is often described as a slow climb, but investing in real estate may make sense in some situations and can offer diversity to your portfolio.
Further reading:
6 ways to build home equity [Nerdwallet]
