How Does Investing Work?
How investing works puzzles many people until they gain experience. This overview can help you get started.
By Kristina Russo | American Express Credit Intel Freelance Contributor
6 Min Read | February 1, 2022 in Money
“Invest early and often.” That was the enduring advice of my college freshman finance professor. Easily said. Easily remembered. But not so easily done.
The first part of the advice, to start investing as early in life as you can, encourages maximizing the combined power of time and compounding. Investing often, the second part, accomplishes two investing goals at once – establishing the routine of regularly putting money away and “dollar-cost-averaging” the price of your investments. But how can you actually implement this advice? Read on for the nuts and bolts of investing and how it works.
Investing is the purchase of financial “instruments” with the goal of growing your money. Growth comes from:
- Selling the instrument for a higher price than you paid.
- When that instrument pays a dividend or interest.
- Or both.
Financial investment instruments – stocks, bonds, mutual funds, exchange-traded funds (ETFs) – all have some level of risk, unlike savings accounts, which are insured by the Federal Deposit Insurance Corporation (FDIC). As you might guess, bigger potential investment rewards come with higher risks. Investments can lose all or part of your money.
Investing timelines tend be long, especially compared to savings timelines. It’s generally accepted that it takes an average of five or more years to weather day-to-day market fluctuations. That timeline may or may not match your financial goals. Sometimes you may have a short-term goal, like purchasing a house or a car. Other times your goals might be longer term, like your child’s education or retirement. For small, even shorter-term goals, when your tolerance for risk is lower and you may want immediate access to your money, savings is a better strategy.
Stocks, bonds, mutual funds, and ETFs are common types of investments.
- Stocks: When you invest in stocks, you’re buying a small ownership piece in a public company. Stocks are also called equities. Stock shares are traded on different exchanges, or markets, like the New York Stock Exchange and the NASDAQ.
- Bonds: Bonds are debt instruments. When you purchase a bond, you are actually lending money to the bond issuer. Bonds pay interest over their life and repay their principal – aka “face value” – on the bond maturity date. Bonds can be issued by the government (federal, state, municipal) or by private companies.
- Mutual Funds: A mutual fund is a professionally managed fund that pools money from many investors to purchase financial securities. When you buy a share of a mutual fund, you’re buying a small piece of a basket of those securities. Each fund has a stated investment strategy, which is outlined in its prospectus. For more, see “How to Invest in Mutual Funds.”
- Exchange-Traded Funds (ETFs): Think of these as mutual funds that can be bought and sold on a stock exchange. See “What Are ETFs & How Do You Invest in Them?”
Mutual funds and ETFs can be made up of equities, bonds, or a mixture of both.
The way you make money by investing depends on the financial instrument.
Stocks, mutual funds, and ETFs: Investment growth usually comes from capital appreciation, which is a technical way of saying that you sell at a higher price than you paid. Their prices are constantly fluctuating, getting many investors excited by market spikes and dips, but it’s important to understand that you do not actually make (or lose) money unless you sell your investment. Until that point, it’s just a “paper gain/loss” or, as the pros would say, an “unrealized gain/loss.” For stocks, mutual funds, and ETFs, there are two main ways you can grow your money:
- Dollar-cost averaging: With dollar-cost averaging, you buy the same stocks regularly over time – say, $500 worth every month or week. Doing that, you’ll sometimes be buying at high prices, sometimes low, and sometimes in between. The theory is that this approach helps reduce the impact of market volatility on your long-term investments by smoothing out the ups and downs of the market.
- Dividends: Some stocks, mutual funds, and ETFs pay dividends. This is when the underlying company represented by the investment periodically shares a bit of its profit with shareholders. Dividends can be paid in cash or reinvested as additional shares, depending on the specific arrangements.
Bonds: The primary way to grow your money is from the interest payments that the bond issuer (debtor) makes. These payments are usually made every six months. Additionally, the face value of the bond is repaid on its maturity date. Sometimes, you can buy a bond at more or less than its face value, which can create a second source of investment income (or loss). Bond prices may fluctuate from a bond’s face value based on how the bond’s interest rate compares to market interest rates and on the creditworthiness of the bond issuer.
After identifying your investment goal, setting an investment budget, and researching investment options, you may be ready to start investing. How does investing work, mechanically?
You’ll need to open a brokerage account to hold your investments. You’ll buy and sell stocks, mutual funds, bonds, and other types of financial instruments through this account. Brokerage accounts offer various levels of investment help, for a fee:
- Managed brokerage accounts provide advice, research, and guidance from a financial professional and generally have the highest trading and commission fees.
- Online brokers often provide robo-advisors – software programs that make recommendations based on your preferences and risk tolerance.
- Self-managed accounts are the lowest-cost option, where you make all the trades – and decisions about what to trade, when – yourself.
If your investment goal is for retirement, a tax-advantaged brokerage account may be a good option. These accounts include individual retirement arrangements (IRAs) and 401(k)s through an employer, and they allow your investments to grow tax-free. See “Tips for Retirement Investment Options.”
Regardless of which type of brokerage account you select, none are FDIC insured – even those offered by banks.
If you determine that you’re going to invest in stocks or ETFs, you’ll need to understand how the purchasing works. There are two basic types of purchase orders:
- Market orders: Directs your brokerage to immediately buy a certain number of shares of a stock at the current market price.
- Limit orders: Directs your brokerage to purchase a specific number of shares at (or below) a set price, at some time in the future. There is no guarantee that this order will ever be triggered unless your conditions are met.
Both types of orders can also be used to sell stocks and ETFs, too. Mutual funds are bought and sold directly with the fund manager, and you typically buy government bonds directly and corporate bonds through brokers.
Unlike savings, where you set aside money that is easily accessed for short-term needs, investing takes a bit more planning and is meant as a long-term endeavor. Identifying your investment goals and selecting investment instruments based on how they can grow your money are the initial steps. Next comes getting to work on the actual investing, by opening a brokerage account, determining what level of advice you’re willing to pay for, and initiating the right market orders. Then it’s up to the markets to work their magic.