Investing is all about putting money to work so it can grow. Warren Buffett has a fantastic definition for investing: “the process of laying out money now to receive more money in the future.”
One of the biggest goals of investing is the concept of “compounding”. A lot of people like to pretend this is a magic concept and they are letting you in on some little known secret when they write or talk about it. Compounding is very simple though. It is the phenomenon of exponential growth achieved by reinvesting income, which attracts future income on both the initial principal and the constantly growing income. Nothing magic, just math.
Also math, and not magic, is a neat shorthand mechanism for calculating the amount of time it will take a compounding investment to double is the “Rule of 72”, which provides that dividing 72 by the rate of return (as a whole number) gives a very good estimate of the number of years required to double an initial investment.
A numerical example shows the virtue of both compounding and the Rule of 72. Imagine Investor A invests $1,000 at 8% interest, but does not reinvest the income, while Investor B invests $1,000 at 8% and does reinvest the income. It will take Investor A 12.5 years to earn $1,000 on their initial investment ($1,000/$80 earned annually = 12.5). By comparison, It will take Investor B only 9 years to double their initial $1,000 investment (72/8).
The rate of return of any particular investment is generally strongly correlated to the riskiness of the investment, all else being equal (e.g. skill, exclusivity, liquidity). There are simple and safe products offered by banks and other financial institutions, riskier and more rewarding products offered on the stock and commodity markets, and various other opportunities beyond even those.
The safest investment of all is probably the humble savings account, an arrangement where a financial institution will hold onto your money in exchange for interest paid at a fixed rate at fixed intervals. The interest rates on these accounts will generally be low, but you have complete access to your money and the bank will generally never miss a payment. Furthermore, in many countries, savings accounts are covered by government insurance, usually to some maximum amount ($250,000 in the U.S. and $100,000 in Canada).
Moving up from savings accounts, financial institutions also offer guaranteed investment certificates, or GICs, arrangements where you “lock in” an investment with a bank in exchange for a better rate of return. GICs can range from months to years, with longer durations correlating to larger returns because investors are giving up liquidity in the arrangement.
Beyond the basic products offered by financial institutions, investors searching for better returns will generally turn to the financial markets, a place where there is a product for every risk appetite and level of expertise.
The building blocks of the stock market are stocks and bonds of publicly traded companies. Stocks, also called shares, are really pieces of ownership and/or a bundle of legal rights that entitle a person to vote on certain matters, receive dividends, receive assets on liquidation, etc.
At least on a theoretical level, stocks on the stock market generally come in two types: common shares, which, because of their bundle of rights, fluctuate with the fortunes of the company, and preferred shares, which generally have a fixed redemption amount and a fixed dividend rate attached to them. In practice, the values of both of these shares will fluctuate with the performance of a corporation. Which makes sense, since a company performing phenomenally will increase the demand for its fixed value, fixed dividend preferred shares because that stream of income has become more secure.
Operating in a manner similar to preferred shares, bonds are instruments issued by companies that want to raise funds but don’t wish to issue shares (for any number of reasons). A bond will typically have a face value that it is purchased for (e.g. $1,000 or $100) and “coupon” payments payable at set intervals (e.g. monthly). Once the bond matures the company will “buy it back” by paying out the face value of the bond to the owner. As with stocks, bonds are traded openly on the stock markets and their value fluctuates with the performance of the issuing company. As a note, sometimes bonds can be issued without a coupon, but instead at a discount to the amount it will be repurchased upon maturation.
Governments also frequently issue bonds, though they sometimes have different names (e.g. treasury bills issued by the Government of Canada or U.S. Treasury Department). These bonds are traditionally of the coupon-free, discounted variety.
Beyond the stock market, there are countless other investment opportunities. Real estate is a popular one, either speculating on property that might increase in value, buying real estate to repair and “flip” it, or buying properties to rent out. Some people enjoy speculating and trading foreign currencies. For high net worth investors, there are also vehicles that let you invest in farmland or more exotic things like gambling algorithms. As this website grows, we hope to add more of these things to our endeavors.
We hope you’ve enjoyed this crash course on traditional investing. Join us next week as we take a deeper dive into the stock market!