Guidelines to Investing

 

You don’t know the first thing about investing. You’re a complete beginner. And you want a general overview of what, exactly, this whole “investing” thing is all about.

Well, you’ve come to the right place. Here’s a basic, introductory overview of investing.

What is investing?

Investing, at its most basic definition, is the act of giving up the present utility of some asset — such as money — for the potential to grow that asset in the future.

All investing carries risk. An investor will give up the present-day use of money so that there’s a chance that she might make a gain on that asset in the future. But there’s also a chance that she might not receive any gain on that asset in the future — which means she will not receive any reward for giving up her present-day use of that asset. And in some investments, there’s even the risk that she may lose her initial investment, also known as principal.

Sound confusing? Here’s an example

Karen has $1,000. She could spend it today — buying groceries, taking a trip to Paris, purchasing a dishwasher. Instead, she chooses to put that money into an S&P 500 Index Fund. She is giving up her present-day utility of her money for the chance that she might make a gain on her money in the future.

But the following week, the stock market drops. Karen’s initial investment (her principal) of $1,000 falls to only $950. Karen has realised some risk — the risk that she might not receive any gains on her investment, and, in fact, the risk that she might lose some or all of her initial principal.

The week after that, the market rallies, and Karen’s index fund is worth $1,000 again. She decides to withdraw the money, figuring that she “broke even.” But did she really?

No. Karen still sacrificed two weeks’ worth of utility, and she was not compensated for that sacrifice. In other words, she could have spent that money two weeks ago. Instead, she delayed her ability to spend it, AND she also subjected the money to the risk of loss. Ideally, if an investment goes well, the investor is compensated for those two things. But Karen was not compensated for the risk that she carried or for the delay that she endured.

Risk and reward

When a bank lends you money, they’re making an investment and taking a risk. They’re investing $200,000 into giving you a mortgage — they’re sacrificing their ability to use that money to do anything else (opportunity cost). They’re also exposing themselves to the risk that you might not pay them back (the risk of principal loss).

In return, you pay the bank some interest. That interest compensates them for both the risk that they carry and for the present-day utility that they sacrifice.

Are you having a hard time feeling sympathetic to the banks? Let’s look at this same analogy in a different light.

When you — a normal, average Joe — buys a corporate bond, you’re giving a company a loan. You are the lender. The company is the borrower.

You’re giving up some of your hard-earned cash. You’re sacrificing your ability to spend it today. You’re sacrificing the opportunity cost of doing other things with it. And you’re exposing yourself to the risk of loss.

To compensate you for that, the company pays you interest on that bond. It’s fundamentally the same situation as you borrowing money from a bank to buy a house. In both cases, the situation has a borrower, lender, risk, and interest.

(Bonds are different in that they’re publicly-traded, but that’s a different topic for a different day).

By the way, bonds aren’t just given to companies. You can also buy government bonds, which means you’re issuing a loan to your city, your state or your federal government. That’s right — if you own federal government bonds, a portion of the national debt is owed to you!

The interest that you get on these bonds relates to how likely the borrower is to pay you back. This is called default risk. Government bonds pay the lender (you) a low interest rate, because the US government is viewed as highly likely to pay you back. Large, stable companies will generally pay higher interest rates than the US government will, but they’ll still pay relatively low rates because they have a solid track record of paying back their loans. Newer or shakier companies (“junk bonds”) have the highest risk of default, and therefore compensate their lenders with the highest interest rates.

This is an example of how risk and reward are correlated. (You could also view the reward as just compensation for the level of risk).