In personal finance, learning how to make your money grow over time is a point constantly stressed over by financial professionals. Putting money into your savings accounts is an excellent strategy for creating a rainy day fund, but that money will never grow. Adding investing into the mix can help you grow your money over time beyond your rainy day fund.
What is Investing?
Investing is the process of buying assets with the goal of their value increasing over time. In the long term, the goal of this increase in value is to provide the investor with a return on investment in the form of income payments, dividends, or other types of returns.
For example, you may highly enjoy using a product a company offers and choose to buy some of their stock. Say their stock was trading at $5/share when you bought in and you purchased 10 shares. On a cost basis, you have $50 invested into that company.
Now imagine that it’s been a few years and that company has grown significantly to the point where their shares trade at $20/share. For one reason or another, you decide you’d like to sell your shares in the company. When you make that sale, you will receive $200, even though you only originally invested $50.
Regardless of what type of asset class a person is investing in, the goal is always the appreciation in value of that asset.
What Are The Different Types of Investments?
On the topic of investing, you may have heard people discussing strategies such as ways to diversify your crypto portfolio, how to dollar-cost average into alternative investments, and more. This can be confusing to anybody under the impression that investing only involves the stock market. Here are some of the most common asset classes today:
- Stock market
- Bond market
- Alternative investments (art, commodities, etc.)
- Real estate
- Cryptocurrency
Investment Data and Stats
- According to a study by Vanguard, the average annual return for the S&P 500 index, including dividends, was approximately 10% from 1926 to 2020.
- A study by J.P. Morgan Asset Management found that globally, less than 25% of individual investors outperform their benchmark index over a 10-year period.
- According to a study by Dalbar Inc, the average annual return for individual investors in equity funds was 6.5% from 1994 to 2018, compared to the S&P 500’s annual return of 9.2% over the same period.
- Research by Morningstar found that actively managed funds underperform their benchmark index over long periods of time, with only 24% of actively managed U.S. large-cap funds outperforming the S&P 500 over the 15-year period ending in 2019.
- A study by Vanguard found that a portfolio diversified across different asset classes, such as stocks, bonds, and real estate, has historically had a lower level of volatility and has provided higher returns over the long-term compared to a portfolio invested solely in stocks.
- According to a study by BlackRock, investors who stayed invested in the stock market during times of volatility, such as during a recession, were able to achieve higher returns over the long-term compared to those who sold their investments during a downturn.
Liquidity Matters
Liquidity refers to the ease with which an asset can be bought or sold in the market without affecting the asset’s price. Cryptocurrencies, for example, can be highly illiquid due to their volatility and the limited number of buyers and sellers. Investing in a highly illiquid asset can make it difficult to exit the investment if necessary.
It’s important to consider the liquidity of the investment in relation to your own investment horizon and risk tolerance. It’s a good idea to invest only a small portion of your portfolio in a highly illiquid asset and make sure to have a clear exit strategy in place.
Word of Caution
Another aspect to consider when evaluating investment opportunities is the potential for fraud or scams. The cryptocurrency market, in particular, has seen a number of fraudulent projects and scams in recent years. It’s important to be vigilant and thoroughly research any investment opportunity before investing. Some red flags to watch out for include unrealistic or overly-promising returns, lack of transparency, and a lack of information about the team behind the project. Additionally, be aware of projects that are marketed as “guaranteed” or “risk-free” investments, as all investments carry some level of risk.
Tax Implications
It’s also important to be aware of the tax implications of your investments. Cryptocurrency investments, for example, may be subject to capital gains taxes. It’s important to consult with a tax advisor to understand the tax implications of your investments and to ensure that you are in compliance with the tax laws in your jurisdiction.
The Basics of Evaluating an Investment
When evaluating a new investment opportunity, use the following three metrics for determining if it may be right for you:
- Determine the background of the investment
Always look into where an investment is coming from. If the investment is into a company’s stock, take the time to research their management team and performance history. For cryptocurrency, do everything you can to learn about the specific coin and what it aims to do.
- What will the impact be on your cash flow?
With any investment, you need to consider how much money you are going to drop into the investment, and if you will continue to invest over time. Naturally, this will reduce the amount of money that is going towards expenses or your savings account each month. Find a balance with your cash flow at a point where you are comfortable and can still meet all your ordinary expenses.
- What is the possible return on investment?
The average annual return on investment will change from asset to asset. In the stock market, for example, the average return on investment is 13.8% annually, whereas the real estate market only has an average yearly return of 8.8%. Understand the average return for the asset you’re considering prior to making the investment.
Create a winning investment strategy
No matter how safe you consider an investment to be, there is always a risk of loss. Only invest what you are comfortable potentially losing to avoid widespread personal financial impact. With that in mind, always research an investment, along with its potential return, before putting money into it.
Evaluating investment opportunities, including those in the cryptocurrency market, requires a thorough understanding of the risks and potential returns, the regulatory environment, the market size and growth potential, the team behind the investment, the technology behind the investment, performing due diligence, diversifying, liquidity, fraud prevention and tax implications. It’s important to consult with a financial advisor and tax advisor before making any investment decisions.