Investing is where you use money to (hopefully) make more money.
You could run a business.
You could put the money in the bank to earn interest.
You could buy something valuable, such as an antique or a rare coin, with the hope that in the future it will be worth a lot more.
You could buy a share in a company (such as on the stock exchange):
- They can pay dividends (regular payments to you based on their profit).
- AND you can sell the stock later, maybe for a higher price.
You could ... well there are LOTS of options for investing money.
But how do you tell which are good and bad investments?
Risk and Reward
Unfortunately there is always RISK when investing.
- The company you put your money in might go bankrupt.
- When you try to sell that rare coin, you may find no one wants to buy it, except at a very low price.
- And that wonderful business might suddenly face big competition.
Often the investments that promise the biggest profits are also the ones with the biggest risk.
As Reward goes up, Risk usually increases too.
Example: banks pay low interest, but they are also low risk.
And that wonderful investment in a gold mine that promises 30% profit? It may work out well, or it may not!
And remember: risk is risky! The more risk you take, the higher the chance that you will end up losing.
How can you tell how risky an investment is? Ah! That is the million dollar question.
Do research! Find out all you can about how previous investments have worked out. Think about the future of the investment (things that are good now can turn bad), and also ... can you trust the people involved?
Before you hand over any money, stop being excited by the idea of profits and think what might go wrong. A wise friend once said it was the investments he didn't make that led to him being rich.
OK, you have some possible investments. The risks are about the same. How to tell which is best?
The basic idea is to add up all the money you receive, and subtract all the money you spend.
But you also need to think when you spend or receive the money.
Money now is more valuable than money later on.
Why? Because you can use money to make more money!
Example: A bank pays 10% interest on your money.
So $200 now can earn $200 x 10% = $20 in a year.
Your $200 now can become $220 in a year's time.
In fact, at 10% interest, $200 now is the same as $220 next year!
Learn more at Present Value
So money is not as valuable in the future, so we reduce the value of future payments.
Example: Two investments that both cost $200: one pays $220 next year, the other pays $230 in 2 years time.
Even though the $230 looks better, it is in 2 Years time.
The first investment pays $220 in 1 year. Reinvesting that $220 for another year might get you more than $230 by the 2nd year.
There are many ways to compare investments, but two of the most popular ways are:
Once you have compared the possible investments, and thought about the risks, you will be better prepared to make a decision.
Example: you run a Bakery, and want to improve its income. You could:
- Move the bakery to a busier street nearby (more customers)
- Renovate the kitchen (bake better things at less cost)
You estimate the costs and benefits, and then calculate the "Internal Rate of Return" of each to be:
- Move: IRR = 12%
- Renovate: IRR = 9%
So "Move" is best.
But hang on ... there are different risks!
- Move is more risky: will you really get more customers? What about the customers you lose? What if someone opens a bakery where you were before, they will take business away from you.
- Renovate is much less risky, you know it will save money for your present operation.
If the Move goes bad you could lose your whole business.
So choose carefully!
To "diversify" means to have different types of investments ("diverse" means "different").
Why diversify? It reduces the risk of losing everything!
Example: If the whole economy goes bad, then your business and stock market investments will be in trouble, but (hopefully) the money you have in the bank or with government bonds will still be OK.
There is an old saying: don't put all your eggs in one basket.
Some people advise:
- one-third of your money into cash investments like a bank account or bonds,
- one-third into property, and
- one-third into the stock market.
But that is only a guide, you should decide for yourself what the best "spread of investments" is (and it can change, depending on how the economy is going).
One last thing ... good luck and good fortune!