Investment is the purchase of something of value to earn more money. Although the term “investment” is usually applied to stocks, bonds, and other financial instruments, investments also include real estate, artwork, antiques, and even wine. There are often risks associated with investing, but these risks regularly attract many investors around the world.
How do investments work?
Investments are an important part of the economy and a crucial aspect of personal finance. For individual investors, investments can allow you to grow your wealth over different periods.
One of the most important parts of investments is compounding. Compounding is a term that refers to how your investments increase in value over time.
To gain a better understanding, here is an example: Suppose you have $1,000 and invest it in a stock market index fund that earns 10% over the first two years. While a quick calculation might say that you will earn $100 each year, you will actually earn more because of compounding.
After the first year, your investment will be worth $1,100. But after another year growing at 10%, your original investment of $1,000 grows by 10%, and the $100 you earned last year also grows by 10%. By the end of the second year, your investment will be worth $1,210. The additional $10 you earned comes from the growth of your investment. If you left this investment and it continued to grow at the same 10% rate, you would have $17,449 after 30 years.
Of course, you can’t expect to earn 10% every year forever. There are some good years and some bad years. You might end up earning 5% or 50%, or more or less, depending on the investments you choose and the timing of your buying and selling. Some investments may lose money, which is why it’s important to understand what you are investing in and why.
To protect investors from predatory investment firms acting with bad intentions, the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and other governmental bodies and entities impose important laws, regulations, and industry standards regarding investments available to the public.
When you decide to invest, it’s important to work only with reputable investment firms that adhere to investment regulations and work to protect your best interests.
Types of Investments
While anything of value can be an investment, here are some of the most common investments in the financial markets that all investors in the United States should know about:
Stocks
When many hear the word “investment,” the stock market comes to mind. A share of stock represents a small piece of ownership in a company. If the company is successful, its stock price is likely to increase. Some companies also make cash payments to shareholders, called dividends.
Bonds
Bonds are a type of debt issued by governments and corporations. Bonds typically offer a cash payment called a “coupon,” in addition to the repayment of principal. Because bonds are often issued in large denominations, individuals and families often buy bonds through mutual funds.
Mutual Funds
A mutual fund is a type of investment that allows you to buy a share of a pool that holds many stocks, bonds, or other investments. For example, if you buy shares in an S&P 500 index fund, your invested money is combined with other investors’ funds to purchase a portfolio of stocks that reflects the S&P 500 index. Mutual funds typically charge fees but give you the opportunity to invest in an index or a professionally managed portfolio.
Exchange-Traded Funds (ETFs)
ETF stands for “Exchange-Traded Fund.” An ETF is similar to a mutual fund, but you can buy and sell them almost instantly, just like stocks. ETFs also generally have lower fees on average than mutual fund investments, making them a better option for many investors.
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Do You Need Investments?
Most people do not need investments to survive in daily life. However, investments are often essential for achieving long-term financial goals such as a secure retirement. To understand why, let’s take a look at another example.
Let’s say you want to live on $40,000 a year in retirement. In a regular bank account that pays 0.05% interest, you would need $80 million. But if you rely on earning 5% annually from investments, you would only need $800,000.
It is easier to save $800,000 for retirement than to save $80 million, but it is still a significant achievement. If you save $1,000 a month at the current bank interest rate, it will take you over 66 years to save that amount. But thanks to the power of compounding in investment, at a rate of 7% annually, it would take you about 26 years to reach $800,000.
The growth of compound investment is a powerful tool, making investments a necessity for many families striving to achieve any significant financial goal.
Alternatives to Common Investments
Options
Options are a riskier type of alternative investments that are not always suitable for everyone. Originally created to hedge current market risks in the underlying instruments they are based on, options can also be used to speculate or take directional positions.
Essentially, options give you a contract that allows you to buy (or sell) a specific investment at a set price on a specified date in the future. Option prices can be extremely volatile, so they should be reserved for experienced investors who understand the mechanics of options contracts.
Futures
Futures are similar to options in that they focus on the price of an asset at a specified future date. However, unlike options, futures contracts require the owner to exercise, meaning they must buy or sell, based on the agreement. This makes them riskier than options and suitable only for experienced traders.
Commodities
Commodities are assets you can own, like stocks. However, instead of representing a share in ownership of a business, they represent a physical commodity, such as corn, gold, oil, cattle, or coffee. Many investors trade commodities through options and futures, as explained above. These assets often have high volatility and carry risks that may not be suitable for most individual investors.
Foreign Exchange (Forex)
Foreign exchange, or forex, is an investment in the currency of another country. For example, you can trade the US dollar for euros, Japanese yen, British pounds, or other major currencies worldwide. Forex is considered a volatile and high-risk market for ordinary investors.
Cryptocurrencies
Bitcoin, Ethereum, and Litecoin are examples of cryptocurrencies. These are digital currencies not backed by any government or company. They derive their value solely from the community that supports them. Cryptocurrencies are informally regulated, if at all, and are very high-risk.
Other Alternative Investments
Although cryptocurrencies, commodities, and forex do not belong in an investor’s portfolio
Source: https://www.thebalancemoney.com/what-is-an-investment-5090542
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