Why is it worth to invest?
The most straightforward answer is to live better in the future. Everyone wants to be financially independent, to be able to afford the things they have always dreamed of, to retire early eventually, and to spend all their free time on their hobbies. Money means security and the freedom to do what you like.
In particular, by investing, you will be able to accumulate the right amount of money for personal goals such as educating your children or buying a home much faster.
It is essential to look ahead and think about the fact that in old age, you will be financially totally dependent on a state pension. How will you live if your retirement is less than the minimum monthly cost or if the state cannot pay your pension at all? To avoid this, you need to think about it today. It would be best if you started investing to secure a bright and independent future.
Finally, the worst thing is to have no money anywhere. That money is becoming more and more devalued every day due to inflation. In other words, if you keep your money in a sock for ten years, you will be able to buy far fewer goods than you could have bought a decade ago. So it is worth investing in keeping your savings in value.
Compound interest: how money makes money?
To calculate how much you will need to save to achieve your financial goals, you first need to understand how money makes money and compound interest. Compound interest can be considered the eighth wonder of the world. The benefit of compound interest depends on time. The longer your money works, the more profit it will bring you. Compound interest multiplies your money to amounts you never dreamed possible.
Compound interest makes money make money, and it’s not just the money you invest that makes money for you. It’s the money you earn from the money you invest. Let’s say you have saved €1,000 and you have made a deposit in a bank at 10% interest per annum. So next year you will receive €100 in interest (€1100 in total). If you reinvested all this money next year, you would earn 110 litai, because not only the old 1000 euros will work for you, but also the 100 euros of interest you made last year. So after two years, you would have €1,210. If you put €1,210 in the bank, you will earn €1,331 in the third year. It might not sound like a considerable income, but if you let the money work for a long time, you’ll get some impressive numbers. After twenty-five years, your €1,000 will have turned into €10,000, and after forty-nine years, you will have accumulated €100,000.
Of course, having €100 000 when you are seventy years old is not such a great joy. But if you save and invest €100 every month with a 10% return, that €100,000 will be in your account twice as soon – in the twenty-third year of funding. And if you can invest €200 every month, you will have saved the same amount in 17 years.
You can see the power of time in investments, which is why you need to start saving and investing as early as possible because money only makes money over time. The earlier you start, the earlier you will achieve your financial goals. If you invest €200 a month in securities at the age of 20, giving a 10% capital gain, you will have accumulated €1 million more by the time you retire at 64 than if you begin your investment at the age of 30 (€1,649,945 in 44 years and €620,591 in 34 years. (see figure)
Suppose you don’t take advantage of compound interest instead of reinvesting all your capital gains each year. In that case, you spend them on your daily needs (without taking advantage of compound interest). Forty-four years of investing will give you a profit of €105,600 – precisely what you have saved. The graph above shows how the power of compound interest increases in each successive year and how modest the amount saved and invested looks concerning it over time (see figure).
If you are committed to your financial goals, compound interest will help you achieve them. Don’t make time your enemy. Make it your ally – invest today, invest for the long term!
Investment strategy
So you know you want to invest, and you understand how investments can make you money. The question remains what to invest in, when to invest and when to sell those securities. This is the advice that every beginner wants, but not many people share it, and if they do, you never know if your advisor is correct, so you have to know yourself.
How what and when to buy and sell can be summed up in one word: strategy. An investment strategy determines the risks, the composition of the investment portfolio, and the guidelines for buying/selling securities. Each investor sets their strategy according to their character and financial goals.
All investments are risky. The more profitable the acquisition, the riskier it is. In the simplest terms, risk can be defined as the probability of a decrease in the value of an investment. The more you risk, the more you can make or lose. There are many different types of risk, ranging from inflation risk, currency risk to systematic and unsystematic risk. Investors use risk management models to limit their losses: they use derivatives (options, futures), they diversify their investment portfolio by investing in different asset classes, they set limits to the fluctuations in the value of their investments, etc. Each investor is unique and therefore tolerates various risks. A 20% drop in the value of a security may seem like a natural market correction to one investor but a catastrophe to another. It is not worth taking on too much risk as it will keep you awake. You will always be thinking and worrying that your investments may depreciate. Finally, very high risk can be equated with gambling, as making a profit is meager.
Investment instruments
Every investor has an investment portfolio consisting of various investment instruments. Investment instruments have different characteristics, so you need to know which investments are best for achieving your financial goals.
Bonds. Governments and companies issue Bonds. When you buy a debenture, you are put money on a company or a government. For these borrowed funds (bonds), the companies (the state) undertake to pay you interest for a fixed period and, at the end of the period, redeem the bonds for the same amount of money for which they were sold. The yield on your investment will be higher if you invest in bonds than if you deposit in a bank because you will be paid more interest. Bonds are attractive to investors because of their relatively low risk. Bond risk is defined as the possibility that a company will fail to deliver you the interest it has written down, or if the company goes bankrupt altogether, your bonds will not be redeemed, and you will lose all your money. Some bonds are riskier than others. The riskier the company bond you buy, the higher the return you can expect.
Shares are securities that give you a right to a company’s assets and profits. In other words, when you own shares, you are a co-owner of the company. If the company is profitable, dividends (a share of the company’s profits) are paid to shareholders. Shares are a much riskier financial instrument than bonds. Unlike bonds, shares are not a fixed-income instrument and do not guarantee income at all. Some companies do not even pay dividends, in which case investors earn from the change in the value of the shares on the stock exchange. However, in the long term, the return on investment from shares is higher than that from bonds, but you must also consider that investing in shares involves a much higher risk, so it means you can get a loss of some part or all of your investment.
Investment funds are a mix of shares and bonds. People who do not have the knowledge, experience, and time to search for promising companies entrust their investment money to professional investment fund managers. Investment funds invest the money they collect from people in shares, bonds, and other securities. Mutual funds have a defined investment strategy: in which region, industry sector, how much of the fund is invested in stocks and bonds, etc.
By entrusting their money to a mutual fund, the average investor can invest in many promising companies at once, with a portfolio that is diversified and managed by professionals. Even a small amount of money can be invested in investment funds. You can start investing from €100. On the other hand, you have to pay fees to the fund managers to manage your investments.
Real estate investments include investments in land, rental properties, and commercial real estate. Real estate is attractive to many investors because it is a tangible, material asset that you are proud of. It sounds like a blunder to think that real estate investment is risk-free. The value of real estate fluctuates but less than that of shares or bonds. On the other hand, real estate is not as liquid as shares or bonds, so it can be challenging to sell, and the process of selling it is much more complicated than that of a stock.
Alternative financial instruments such as options, futures, FOREX currency trading, commodities trading, investments in art, etc., are hazardous but offer high-profit opportunities. The value of many of these instruments is directly linked to fluctuations in the value of stocks and bonds and are therefore also known as derivatives. These instruments are complex, require specific knowledge, and are the tool of speculators rather than investors.
Perhaps the most complex part of the strategy is the buy-sell guidelines. The investor’s plan must include which securities will be bought, how often, and under what conditions. Some investors look for the cheapest stakes, and others look for promising companies that will grow in value. Others buy and sell securities continuously to try to take advantage of market sentiment. Still, others buy securities and want to hold them forever. Thus, buying and selling guidelines can vary. They depend on the knowledge and experience of the investor. Here we will briefly look at the two main types of investment – active and passive.
An active investor tries to invest in companies whose shares will appreciate more than the market average. In other words, the analyses the balance sheets, management, prospects, compares the price of the companies with other similar companies and tries to find the gold nuggets – the shares with the best chances of appreciation. But not everything that glitters is gold. Active investors who misjudge a company’s value and prospects may also buy a worthless stock, which they then sell and look for new nuggets again. These investors also try to buy shares when they are cheap and sell when they are expensive, often changing the structure of their portfolios by increasing the proportion of some securities in their portfolio and decreasing the ratio of others. By buying and selling securities in this way, they actively manage their investment portfolio to achieve returns above the market average.
Active investors are further divided into value and buy-side investors. Value investors seek to buy large, stable, reliable, and well-performing companies on the cheap. These investors expect the value of the shares to rise to the level of what the company is worth. The value of these investments fluctuates little and grows steadily over time.
Growth strategy investors prefer small companies with high growth potential but may have low or negative profits and unstable financial ratios. Growth strategists are primarily looking for promising companies. The value of these investments is subject to significant volatility, as some companies may go bankrupt. Still, if at least one company meets expectations, the investor can be rewarded with a definite bonus, and the losses are well recouped.
So you can see that value and growth strategies are fundamentally different. Still, they can both be equally successful, as there are always undervalued stable companies and undervalued companies with great potential.
This plethora of different investment strategies do not always help even the world’s best investors distinguish the gold nuggets from worthless securities. The possibility of your great deal of effort will not be rewarded with a return on investment that is higher than the market average.
Passive investors do not waste time searching for the best investments, nor do they try to determine when stocks are cheap or expensive. These investors are satisfied with the average return of their investment portfolio. They, therefore, often invest in exchange-traded funds or index funds. This way, their portfolios include both good and bad companies. These investors do not try to predict when a stock is overvalued or undervalued but invest at fixed intervals, for example, every month. In this case, they buy some of the securities at a high price and some at a low price – so they pay an average price for the protection. Passive investors pay much less in commissions to financial intermediaries when they trade little insecurities, and the return on their investments is usually no better than that of active investors.
Causes of fluctuations in the value of investments
No one can be sure that they have made the right choice of investment and yield high returns in the future. Assets, like the economy, are unpredictable. On the one hand, nobody knows what will happen in the future. On the other hand, economics itself is not an exact science like chemistry or physics. People can develop economic theories, but nobody can put economics in a laboratory and carry out experiments. Economics is a social science that depends directly on the actions of each individual.
No one can determine what a person thinks in one situation or another and how that situation will lead him to act. Predicting the actions of a million or a billion people is even more difficult. People react differently to different economic and financial news. They have other emotions and various thoughts about the same information, leading to further actions. For example, when an investor learns that the profits of company X have doubled, one investor may sell the shares because the company has failed to live up to expectations. In contrast, another investor may want to buy the shares of that company because they believe in its prospects and is in an excellent position to purchase X at a lower price. Humans are emotional, and no matter how hard we try to think that we are acting rationally, most of the time, our actions indicate otherwise.
Finally, the value of investment instruments can also fluctuate for political reasons: favorable legislation, tax reform, elections, regime change, war, etc. Governments can severely restrict a business’s ability to expand, hold back the economy, and stimulate it. This affects the profitability of companies, their expansion, people’s purchasing power, and investor sentiment. So it is not surprising that a few political decisions can suddenly knock the stock market down or push indices to unprecedented heights.
As you can see, investment returns depend on many different factors, from the macro and micro economy to psychology and politics. Knowing how one or other of these factors can affect the value of your investments will help you make successful investment decisions on time.
Finally,
We hope you have found this introduction to investing exciting and valuable. Investing is about making money. The basics of investing – knowing how money makes money – are essential for every beginner investor. Let’s briefly summarise this lesson:
Investing starts with saving.
Money makes money because of the compound interest effect. By reinvesting your profits, you can benefit from the power of compound interest. Debt is an investment in reverse. The return on investment depends on risk. A strategy consists of risk management, an investment portfolio, and buying and selling guidelines. There is no one right investment strategy. Investment returns depend on microeconomics, macroeconomics, psychology, and politics.
