Most people want to build wealth to improve their lifestyle, cater for their future e.g retirement and so many other reasons. Knowing where to begin to earn the most out of your money can be quite the challenge. This guide will cover the basics of what is investing, why you should invest, popular investment types, how to build a collection of investments also known as a portfolio and useful tips to investing.
Table of Contents
What investing entails and why should you do it?
Investing is allocating money to a venture with an expectation that the allocated money will increase. The net increase from the money that is invested is called a return or profit. Returns vary differently based on the type and performance of investment chosen by the investor. It is therefore a good practice to think through and research your choice of investment by analyzing the performance trends i.e what level of returns has the investment yielded over a substantial period of time, the risks involved, the accessibility of the returns earned as well as the investment etc.
The most common type of investments include; forex, real estate, shares, commodities, cryptocurrencies, index funds, bonds, exchange traded funds (ETFs), retirement plans, options, certificate of deposits and annuities. We have expounded on each of these later on in the guide.
Why you should learn to invest?
- You will observe that prices of various items change over time due to inflation. The cost of a pair of shoes today will not be the same cost in 8 years time. That is also the same concept with money, the value of money you have today will not be the same value in the future. It decreases with an increase in the level of inflation. You therefore do not want your money to just sit around in cash either at hand or in the bank. You will need to invest it in an asset that will earn you a return that is more than the level of inflation. Depending on the level of net return, this will preserve your money or more often than not earn you more.
- Investment is a critical part of all human adults who rely on an income stream for their survival or wish to grow their wealth. Investment is letting money work for you to get more money as a return.
While making a decision on what to invest in, the rate of return and the risk involved should not be the only determinant. A person should also consider why they are investing, what investments they already have and the current state of the economy. To make the best decision, you can consider consulting a credible financial advisor who can help in coming up with an investment plan that is within your risk appetite.
- Good investments provide stability to the investor even in times of economic instability. By having several income streams, an investor is able to maintain their quality of life with minor adjustments even when one of the income streams ceases to provide income. People who have invested wisely are also able to meet emergency personal needs with more ease.
- Investing allows wise investors to pursue their passion projects because they are financially secure enough to take bigger risks. Returns or profits directed towards a passion business are approached with more freedom in planning and willingness to learn. This increases the chances of such businesses succeeding due to their ability to easily change in strategy based on lessons learnt as well as willingness to delay in cashing out the profits made.
- To most people who work for an income, investments provide financial security for them after they retire from their work. Failure to make proper investment can lead to longer working years or lack of financial security in old age.
- In real estate investments, contracts such as triple net lease (NNN) provide an investor with passive income. A passive income can grow significantly and allow the investor to grow their portfolio through strategies such as the BRRRR strategy. With this an investor uses returns from one sale to make an investment into the next real estate purchase with an aim of growing their real estate portfolio.
This video gives a good introduction to investing for beginners.
Where should you invest?
There are very many opportunities available today to invest your money in. You can evaluate some of them by yourself depending on your financial goals, your level of risk and the amount you have available to invest. If this is too much for you, you can consult a financial advisor whom you can discuss with the best investment type for yourself.
This guide highlights some common types of investment assets. These are;
A stock refers to a collection of shares. Shares are units of capital ownership in a company. When companies grow, they raise capital in the form of equity through an Initial Public Offering which is a public sale of shares. After this, the company becomes listed in a stock exchange market where the shares are traded.
When you invest in stock, you earn either through dividends or from the sale of shares at a profit (capital gain). Dividends are distributed shares of the company’s profit. Capital gain is the profit realized once you purchase stock at a low price then sell them when the prices are high. Both of these returns are greatly affected by the company’s performance. The better the performance the more the price will improve as well as the dividends paid out. The reverse is also true, it is not uncommon to have shares fail. It is therefore wise to distribute this risk through investing in stocks other than just one company’s shares.
Investing in stocks requires an account with a trustworthy stockbroker. This can be an individual or a firm authorized to carry out trades on your behalf. Stockbrokers can access a different range of assets, have a better knowledge of market trends and therefore advise you best on which stock to invest in. Brokers are paid a fee for their services which may be an upfront flat rate fee, a commission or an hourly consultation charge.
2. Real Estate
This is perhaps the most common type of investment. It involves buying or developing property to sell at a higher value once it appreciates or to earn periodic return in the form of rent.
Another way to invest in real estate is through the BRRRR strategy. This involves slowly creating a real estate portfolio through buying, rehabilitating, renting and refinancing property and then repeating the process.
You can also invest in real estate through a real estate investment trust (REITs) which is a company with a portfolio of different real estate properties e.g commercial forests, apartments, warehouses, hotels, offices etc. REITs are traded as you would trade stocks. The return earned from REITs is from the income generated from the portfolio.
3. Certificate of Deposit
A Certificate of deposit is basically a form of a savings account with a specific term and a predetermined rate of interest that is fixed. The amount to be held in a cash deposit is also fixed. When you invest in a certificate of deposit, once the term matures, you get the amount invested together with the interest earned. The longer the term, the higher the interest earned.
Commodities range from agricultural products such as coffee beans, cotton etc to hard metals such as gold, copper and energy products such as natural gas and crude oil.
You can invest in commodities through physically buying them to resell. However, this can be cumbersome in terms of storage. Some of the commodities have very high prices. Most investors prefer to trade commodities through the exchange market. There are specialized exchanges for commodities that are not affected by other stocks.
Investing in forex means converting different currencies to take advantage of the spread (the difference between the price of buying and selling a currency). An investor is able to capitalize on both rising and falling values of a currency since it is measured against another currency.
Statistics indicate that the forex market is the largest financial market. Being an over the counter market means that the market does not require physical exchanges like in the case of shares and commodities. This also enables the market to run for 24 hours all day except on weekends. However, there are four main centers to trade forex, these are; New York, Tokyo, London and Sydney.
In the forex market currencies are always quoted in pairs. That is, a base currency that comes first and the second is the quote currency. This is because trade happens when you sell off one currency to purchase another. In addition, currencies are named using a 3 letter code that is composed of the currency’s country code for the first two letters and an initial of the currency name for the third code. There are a few exceptions to this norm.
The value of a forex pair is what a base currency is valued against the quote currency. For example if JPY/AUD is valued at 0.12 then that means that one Japanese yen is worth 0.12 Australian dollars.
Cryptocurrencies are decentralized medium of exchange whose existence is unlike the physical paper money. They are digital assets using blockchain technology.
How people invest in cryptocurrencies is through the online purchase of the desired cryptocurrencies and selling later when the prices are high. The most common types of cryptocurrencies are bitcoin, litecoin, ethereum among many others.
Bonds are forms of money instruments in which corporates and governments raise debt capital. They have a par value/face value which is the specific value at which the bond is issued. Bonds have a maturity term and a specified rate of return.
When you invest in a bond, you pay up the face value to the issuer who in return will pay you periodic interest payments. Upon maturity, the bond issuer pays you in full the bond value. Bonds can be exchanged between parties using a market value. This could differ from the face value depending on certain market factors. As an investor, you can decide to trade a bond before its maturity.
8. Exchange Traded Funds
ETFs are investment funds that are traded in stock markets. They can be composed of different investment types e.g bonds, stocks, commodities. Depending on your risk appetite, ETFs are better off than individual stocks since they offer a diversification of risk through averaging the net gains from the fund. However, this may not be desirable when a particular stock outperforms the market since the gains are brought down by other underperforming assets in the fund.
Most Exchange Traded Funds are managed passively through following specific market indexes. They are therefore suitable for investors seeking a passive income or those with a moderate risk appetite.
9. Mutual Funds
While both mutual funds and exchange traded funds contain a mix of various assets they differ in that mutual funds have a fund manager to actively run them by looking for the best investment options that will beat the market hence increase the investors’ returns.
10. Retirement Plans
Retirement plans can also be considered as investment vehicles. The return on most retirement plans is not as high as compared to other investment assets. However, upon maturity, a good retirement plan should have substantial money to be utilized in your golden years. Learn more about these plans in this retirement guide.
Categories of Returns
With interest, you know exactly what you’ll get as profit from the beginning of the investment to the end. There are two common types of interest rates:
Also known as regular interest, this is the fastest and easiest method of calculating interest. Interest earned is on the principal amount only and is definite for a given time period.
For instance: If the principal amount invested is $10,000 and the interest rate is 10% p.a, then the interest earned will be:
$10,000* 10% = $1,000
That means if you have invested $10,000 for 3 years, you will earn $1,000 each year.
With compound interest, the interest earned also earns interest during the agreed investment period. The difference between simple interest and compound interest is that simple interest is only paid on the principal amount. Compound interest on the other hand is paid on the principal amount invested plus all the accrued interest.
If you invested $10,000 earning a compound interest of 10% for 2 years, the return after the first year is:
$10,000*0.1 = $1,000.
On the second year, the interest earned is:
($10,000*0.1)+ ($1,000*0.1) = $1,100
Total interest earned is:
$1000+$1100 = $2100
An investor should ensure that they understand the tax implications of their interest earnings to avoid double taxation as well as to inform their investment decision.
This is a payment made to investors who own stock in a company. The amount of dividend paid is determined by the owners of the company depending on the profit made by the Company. Dividend is paid per share and is therefore dependent on the number of shares owned by the Investor. An investor should always check the tax implications to ensure that their expected dividend is accurate once it's approved. The tax rate is dependent on how much dividend is paid; type of dividend paid; and, the total income of the investor.
3. Capital Gains
If as an investor you decide to sell your stock or any other asset for more than you paid for, then you have gained capital on your investment. However, if you end up selling your stock for less than you paid for initially, then you incurred a capital loss. Once you’ve sold you’ve traded your asset and made money from it, you have to now calculate how much you’ll pay as taxes.
For capital gains tax, the amount of tax is dependent on the amount of profit made and the duration you held your asset. There are two categories of capital gains tax:
- Short term capital gain tax: for assets that are held for a period not longer than year. The tax rate is set based on where the investor’s income falls under in the federal tax bracket.
- Long term capital gain tax: for assets that are held for a period longer than one year. The tax rates for long term capital gains are lower than the rates set for short term capital gains tax.
Real estate income has a different set of tax rules and an investor should always consult a financial advisor before making decisions that have tax implications.
In case an investor wishes to sell their business, the capital gain will be the difference between the amount paid for the business and the capital amount they invested.
Here is a calculator from Smart Asset to help you calculate the capital gains tax.
A portfolio is a collection of investments belonging to one investor. It can contain assets like real estate, art as well as financial investments such as bonds, stocks, cash equivalents among others.
A key term synonymous with all healthy portfolios is diversification. Diversification means allocating investments within the portfolio to different industries and financial instruments. The goal of diversifying your portfolio is to minimize risk and maximize returns. This is done by holding investments that would react differently to the same event thereby minimizing the possibility of a loss. A good portfolio asset mix reflects the investor’s risk appetite, future goals and an investor’s personality.
Types of Portfolios
Different types of portfolios reflect the different strategies used by money managers and investors. These types include:
1. Hybrid Portfolio
This is a portfolio strategy that diversifies across all classes of assets. This gives an investor a wider range to work with and thus provides a very strong and stable portfolio. However, this strategy if not well executed can lead to losses cancelling out the gains and thus become an unprofitable portfolio. When well executed, a hybrid portfolio can continue to make an investor money even in times of negative economic unrest.
2. Aggressive Equity Portfolio
This is a type of portfolio that assumes more risk in search of big rewards. Investors with this type of portfolio have a greater risk appetite and are willing to take chances on stocks considered risky. Such investors also seek opportunities in IPOs as well as investing in startups that have potential of significant returns in the future.
3. Defensive Equity Portfolio
Investments in this portfolio will in most cases focus on consumer staple companies that tend to remain stable even in times of economic downturns. Such stocks are stable in good and bad economic times. Returns from such stocks tend to be predictable and the stock value in most cases increases in value year after year. However, such a portfolio is limited in terms of the profit generated for the investor. Start-ups equity and investments during IPOs will in most cases not meet the threshold to be added to a defensive portfolio. Most pension funds will prefer to have a defensive portfolio that provides consistent dividends and continuous stock value growth.
It is important for an investor to understand their cash flow needs in order to be able to hold long term investments long enough to make a profit. One of the ways to do this is to calculate their net worth.
Factors Affecting Portfolio Allocations
1. Risk Appetite
An investors’ risk appetite should always guide what type of investments qualify to be in the portfolio. An investor risk appetite is usually determined by an investors’ personality, age, income among others. An investor is either risk-tolerant or risk-averse.
Risk tolerant: An investor who is risk-tolerant can accept high levels of risk even though they do not seek risky ventures. They take a long-term view of their investments and this makes it possible for them to accept short-term losses.
Risk averse: An investor who is risk averse prefers to preserve their capital over undertaking in ventures that might have a higher than average return but carries a higher risk. Such investors avoid investments that have volatile prices to avoid losses even though they forego high returns.
2. Time Horizon
An investor should consider the time period they want to retain their investment positions. As the date for investor exit nears, they should move their investments to more conservative positions to ensure they protect the portfolio’s profit. For instance, an employee who is going to retire within five years should start shifting their portfolio from volatile stocks to more conservative investments such as bonds and cash equivalent. For a young person who’s just been employed, they can have their entire portfolio composed of stocks promising high earnings at a higher risk. This is because they can handle short term losses in pursuit of long term returns and growth. However, the young investor should ensure that as they grow their portfolio changes to reflect the stage that they are at in life. This will mean starting to add more conservative investments gradually when they near the end of their working years.
- The simple formula to building wealth is make money, spend less that you make, accumulate savings, invest the savings in something that will generate returns or appreciate in value.
- Unmanaged debt will erode all your hard work. Always evaluate any debt you get into to ensure it aligns to your long term financial goals.
- Take more calculated risks while you are younger and reduce your risk exposure as you get older.
- Avoid the crowd - This is a golden rule for investing. Smart investors do not follow the crowd.
- Albert Einstein called compound interest the 8th wonder of the world. Learn how compound interest works magic for your money.
- Diversification is always a good thing in investing. Always try to diversify without making your portfolio unmanageable.
- Consistency in investment will work magic in the long term.
- Tax Implications: Before deciding what to invest in, you should research on the implication it’ll have on your tax status. Investments can be a good way to get tax benefits for an investor. Failure to declare income while filing one’s taxes either by an error of commission or omission can lead to an investor getting heavy fines or even jail time.
- Real estate investments are taxed differently from other financial investments. You should always consult a business advisor before investing in real estate. Real estate tends to attract Federal and State taxes which can be difficult to calculate for someone who is not experienced in filing taxes. For instance, if you are investing using the BRRRR Strategy, the period that you hold the property after you’ve finished the renovation can determine how much taxes you pay for the property.
- While making long term investments, investors should not determine the health of their portfolio based on day to day price volatility. That is because in most cases the stock will grow in value gradually and the short terms losses in value will be reversed with time. However, an investor should understand the industry trends for the businesses that they have invested in to ensure that stock value is not because of the business’ bad operations strategy.
How does investing differ from saving?
Sometimes people tend to use the terms saving and investing exchangeably even though they are different. From the guide on how to manage my money, we stated that saving is a key element to achieving your financial goals. Simply put, saving is setting aside some money through cutting down on your expenses so that your spend does not exceed your income. Saving should be a short term but regular habit to grow your emergency fund, help you meet a future expense/purchase etc.
Investing is buying an asset anticipating that you will make more money in the future. Unlike saving, investing is long term and more often with a higher return. Savings should also be easily accessible and have a low risk.
For beginners, saving money can help you accumulate good money to start an investment. If you are doing neither of the two, now is the perfect time to start.
When should I start to invest?
The choice of investing is a decision that everyone should make sooner than later. Today, with so much information available, very many people, especially young people starting out to invest, tend to fall prey to over analyzing and thinking too much about what type of investment to choose. This can make them develop a fear of making the wrong decision and deter them from investing.
While it is good to carry out research on what, when and where you want to invest your money, have in mind that you do not have to go all out at once in the first move. You can start small and slow on a basic asset that you feel confident in, even if the return is small then warm yourself steadily into taking bolder steps and risks as you grow. You will realize that you gain experience with time and make new learnings as you progress that will enable you to build a diversified portfolio and make wiser decisions.
How can I track my investment portfolio?
To be in control of your investment portfolio, you might need to have a method of tracking all your investment assets. This will not only give you useful insights but also have you up to date on how best to manage your investments.
One of the tools to use is excel or google spreadsheets. These give you an allowance to customize your arrangement in a best fit. You can also use available software and tools such as Quickbooks, Mint.com, Personal capital etc.
In sum, although the ultimate goal of investments is to make a profit, investors should be very cautious on the investments that they make. An investor should set the goal that they are seeking to achieve from their investment strategy based on their risk appetite, amount of capital and the type of returns they expect to get. By understanding all this, an investor can then proceed to create a portfolio diversified enough to meet all their personal preferences. An investor who fails to manage their risk falls into the mercy of the market which doesn’t guarantee future profits. It is important to ensure that an investor creates a portfolio that serves their objective based on what their future needs will be while at the same time ensuring their portfolio is diversified enough. Portfolio allocations should take into consideration the investors risk appetite as well as the time period they plan to hold the position. An investor can either be risk averse or risk tolerant on their approach to the investment opportunities that they select.