Five Investment Basics Everyone Should Know

Five Investment Basics Everyone Should Know

If you’re ready to start investing and building a nest egg for yourself decades down the line, this is the article for you. We’ll cover the most important concepts every novice investor needs to know to make the most of their money. Let’s begin with a definition.

 

Investing, at its most basic, means buying shares or ownership stakes in an asset that makes money. Examples include a company, a piece of rental real estate, or a loan for which a borrower must pay you regular interest at a predetermined rate.

 

Suppose you own 100 shares in Bob’s Spaghetti Sauce Company and they cost $20 a piece. That means you have a $2000 investment in Bob’s business. If he has a good year this year, and sells more jars of sauce than expected, investors will look upon the company more favorably and bid the share price up, say, to $25. Your investment would then be worth $2500, including a %25 profit from your initial contribution. But if Bob’s employees go on strike for a few months and impact production, shares will drop in reaction and with it the value of your investment.

 

Now that you have a workable idea of how investing works, let’s explore a few ideas that will help you become successful at it:

 

Understand the Effects of Inflation

Inflation can be summed up as the tendency of prices to go up over time. It’s the principle behind the refrain, “A dollar today is worth more than a dollar tomorrow”, and the main reason why investing is so important to your long-term financial health.

 

Too see inflation in action, simply consider the price of a soda. Half a century ago, you could have walked into a pharmacy and bought one for 5 cents. Today, you’ll struggle to find one for less than $1. Inflation increases the prices of every product we consume—currently around 2% per year in developed countries—and the only way we can beat it is by earning more money than prices go up. Thankfully, a diversified investment portfolio can be expected to outpace inflation at an average return of 7% per year.

 

Understand What You’re Paying For

The most common way to invest nowadays is through index funds. Index funds are investments designed to track a group, or index, of assets, usually companies in financial markets across the world. You could buy shares in a global index fund that owns a small piece of every major company in the world. Owning your shares allows you to participate in the industrial progress of humanity just like you did earlier with Bob’s Spaghetti Sauce Company.

 

The great thing about index funds is that they have very low fees. This is because, unlike actively-managed funds, which seek to own companies that will do better than a given financial market as a whole, index funds simply own every company in the market and call it a day.

 

The benefit of low fees, of course, is that you keep more of your money in the end. An actively-managed fund may charge you 1% of your invested money per year to account for research and trading costs, which represents over 14% of your long-term average 7% return. Conversely, an index fund will seldom charge you more than 0.2% per year, because owning every company in a given market is simply a matter of buying into them and holding on to the shares.

 

 

Sidestep Behavioral Biases

Another point in favor of index funds is that they help investors avoid behavioral biases that come with buying and selling shares to beat market returns. These biases result in hasty financial decisions and wasted money. Here are three of the most pervasive:

 

  • The endowment effect is when we show a greater preference for something simply because we own it. You may love a sweater you’ve been wearing for 20 years, regardless of the multitude of holes in it. The same scenario often occurs with losing investments.

 

  • Recency bias occurs when we place greater weight on recent results and expect them to continue into the future. An example would be to think that your favorite sports team’s championship form over the last five years will continue for the next five. Buying recently successful investments in this way is a risky proposition.

 

  • Loss aversion refers to how it feels twice as bad to lose an amount of money as it does to win the same amount. In other words, losing $40 feels as bad as winning $80 feels good.

 

By contributing, month after month, to a portfolio of index funds that track the global financial market, you’ll do away with these biases for good. You won’t have to worry about whether or not you own the best companies at any moment in time because you went ahead and invested in them all!

 

Set Your Expectations

To be a successful long-term investor, you need to brush up on financial history and educate yourself on how far share prices can fall. It isn’t uncommon for global markets to drop by 50% over a two-year time frame, taking up to a decade or more to fully recover.

 

How would you feel if your portfolio dropped by half in such a short span? Would you be tempted to sell your funds and be done with this investing stuff altogether? If so, consider upping your allocation to bonds—i.e. loans to companies or governments—to meet your risk tolerance, add stability to your returns, and stay invested for longer.

 

The Role of Saving

It’s fun to think about your investments gaining in value over time until you have enough to buy a house, work less, retire, or meet the goal of your choosing. But if you’re in the habit of spending more than your income, the benefits of investing will surely disappear.

 

To take advantage of compound interest, you must contribute regularly to your investments, ideally over a decade or more, without dipping into them for any reason other than your investment goal. Spending your savings frivolously would simply turn the clock back and erase all your progress.

 

So long as you live within your means, keep fees low, and have a clear idea of what you’re investing for, all that stands between you and wealth accumulation is the discipline to save money until you hit your number. There’s no time like the present, so start investing today!