what is investing?

Before you actually invest your money, it’s a smart idea to understand the basic concepts of investing. We’ll explain what investing is, common types of investments, and the difference between investing and saving. We’ll also explain how inflation can reduce your earning power, and how compounding can make your money grow.

The basic idea behind investing is to put money you’ve saved into things you think will increase in value over time. There are lots of possible investments. Two examples are stocks and real estate. The trick is to buy when the price is low, then try to sell when the price is high. That’s how you make a profit.

Any time you sell an investment for a profit, your earnings are called capital gains. If you lose money when you sell your investment, you’ll have what’s called a capital loss.

Keep in mind that with investing, there’s always a risk of losing some or even all of your money if the investment doesn’t perform well. That’s why you should never invest money you can’t afford to lose.

In general, the greater the risk of a loss on an investment, the greater the potential return. The lower the risk of loss, the lower the potential return.

saving vs investing

Some people wonder if saving is better than investing, since there is no risk to putting your money in a savings account. We have many resources that go through reasons to invest. For now, here’s a chart to compare some differences between saving and investing.

SAVING

Ready cash
Gives you ready cash; provides funds for emergencies; often used for specific purchases in the near future (usually three years or less).

Minimal risk
Minimal or no risk (if money is in a savings account).

Earn interest
You earn interest, but savings accounts generally earn a lower return than do investments.

INVESTING

Achieve major goals
Can help you achieve long-term, major financial goals.

Always involves risk
You may lose some or all of the money you invest.

Potential for profit
Investments have the potential for higher return than a regular savings account. Your investments may appreciate (go up in value) over time.

jars with coins and growing plans

types of investments

Before you invest, it’s important to understand the basics about different types of investments. Click a type to learn more.

When you invest in stocks, you’re investing in businesses. These could be small, medium, or large companies in the U.S. or around the world. Buying stock gives you part ownership in a company. That’s why you should only buy stocks in companies you believe in — and believe can do well.

Stocks are usually bought and sold in units called shares. A share’s value, or share price, rises and falls based on how much people will pay for a share. People will pay money for the stock if they think the company will be successful. If it is, its stock will increase in value. Sometimes the company will also pay its investors a dividend. That’s when the company pays the shareholders a part of its profits.

There is no guarantee that you will make money in stocks. Making your investments pay off takes a lot of work. You need to follow the financial news, use the market indices such as the Dow Jones Industrial Average , S&P 500, and the NASDAQ Composite to watch market trends, and thoroughly research companies you want to invest in.

A mutual fund is a professionally managed collection of money from a group of investors. Instead of deciding for yourself what stocks or bonds to buy, a mutual fund manager makes these decisions for everyone in the group—deciding what to buy or sell, and when.

Some mutual funds will be higher risk than others, and no mutual fund is a sure thing. But because the fund invests in a variety of stocks, bonds, and other products, there is usually greater potential reward than many low-risk investments, and less risk than buying individual stocks and some bonds.

ETFs are investment products holding a basket of assets. Some ETFs are designed to track the performance of a specified index, sector, or commodity. Others are actively managed. ETFs trade like stocks on an exchange. When you purchase an ETF, you are purchasing shares of the overall fund rather than actual shares of the individual underlying investments. ETFs carry the risk of their underlying investments and there are no guarantees that they will meet their stated objectives.

Corporations, governments, and municipalities issue bonds to raise funds. In return they typically repay the bond owners with interest. In this way, a bond is like a loan. When you purchase a bond, you are lending money to a corporation or to the government for a certain period of time called a term. The bond certificate is a promise from the corporation or government that they will repay you on a specific date, usually with a fixed rate of interest.

Bond terms can range from a few months to 30 years. The longer you hold your investment in bonds, the better the return — so consider bonds a long-term investment. Government bonds are low risk because they are backed by the U.S. government. Corporate bonds, though, have a higher potential risk. You should research the company before you invest to make sure it has the ability to repay the loan.

Low-risk investments enable you to earn interest on your money while maintaining some liquidity — in other words, flexible access to your cash. The odds of losing your money through these investments are extremely low, but they have lower potential return compared to higher-risk investments like stocks.

Here are two common examples of investments that fall into the low-risk category:

  1. Certificates of Deposit (CDs) can be opened with an initial deposit of as little as $1,000. With CDs, you agree that you won’t touch the money you deposit for a specific period of time (from a few days to a few years). Generally, the longer you keep your money in the account, the greater your rate of return.
  2. A Money Market Deposit Account (MMDA) is a form of savings account that requires a larger balance than CDs or regular savings accounts, usually $10,000 or more. MMDA accounts offer a better interest rate than regular savings accounts and allow you more flexible access to the funds in your account.

Many people invest in real estate, such as a home or property. One positive aspect to investing in real estate is that it usually increases in value over time without the daily ups and downs that happen in the stock market. Like stocks, you earn money when you sell real estate for more than what you paid for it. Keep in mind that it can take time to sell a home or property, and that there are costs involved in buying, selling, and owning real estate.

COMPOUNDING MONEY GROWS

It is important to understand the power of compounding, why it pays to start investing early, and how to use an earnings calculator.

The length of time you invest is a key factor in meeting your financial goals. The earlier you start, the easier it will be to achieve them. Many investors lose out because they wait too long to get started or invest too little. If you don’t start early, it can be difficult to catch up. It pays to start investing as soon as you can, and to take advantage of the power of compounding.

Compounding occurs when your earnings on an investment are added to the amount you originally invested. As your total investment grows larger, your earnings have the potential to grow larger, too. (The same principle applies when you earn compound interest in a savings account.) How fast an investment grows over time depends on the rate of return you earn each year.

Use this calculator to estimate the future value of an investment based on different rates of return. Fill in the sections of the calculator, then click Calculate. If you want to try another example, click ‘Reset’ and start again.

Value of an Investment

$
Contribution Frequency  
 
 
 
$
%

Note: The sooner you start investing, the more time your money has to grow and the harder your money works for you. Get started investing as early as you can!

stock arrow moving up

INFLATION ERODES PURCHASING POWER

You’ve probably noticed that the prices for lots of things have gone up over the years. When the general price level of goods and services goes up, that means the purchasing power of your dollar goes down. It’s called inflation, and it can really eat away at your future purchasing power. It’s important to understand that if your money isn’t growing at a rate at least equal to the rate of inflation, you’re losing money

Here’s an example: Let’s say you stash $1,000 in a safety deposit box and leave it there for 25 years. Assuming an inflation rate of 4%, when you take the money out, your original $1,000 would only be able to purchase $368 worth of goods! So, try to make sure that your money is always growing at a higher rate than the rate of inflation. This graph shows how inflation affects your money over time.

chart showing the decline in purchasing power over time based on inflation rates.

Saving and investing money can help you counteract the effects of inflation.

the rule of 72

Now that you see why it’s important to do more than just save your money, here’s a helpful way to estimate the amount of time or the interest rate you would need to double your money on savings or an investment. It’s called the Rule of 72.

The rule of 72 in action
Let’s say you have an investment that’s earning 8% per year. Start with the number 72 and divide it by the interest rate, eight. 72 divided by 8 equals 9. This means it would take about nine years for your original investment to double.

You try!
You can use the calculator on this screen to try it for yourself. Type in an interest rate and you’ll see how many years it will take your original savings or investment amount to double. Or if you want, type in the number of years, and you’ll see how high the interest rate would need to be.

Rule of 72
Solve for
%

Now that you have seen what inflation can do to your spending power, hopefully the Rule of 72 inspires you to earn as much interest on your own savings as you possibly can.