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Infographic: Investing for Beginners – How Investing Really Works
Investing Explained: A Beginner’s Guide to Wealth
Most investing content throws you straight into stock picking, day trading, and P/E ratios, and assumes you already know what all of it means. If it has always felt confusing, let’s fix that.
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years.
Here’s a jargon-free explanation of what investing actually is, how your money grows over time, and how to avoid losing money, starting with the basics.
Why You Need to Invest
Investing is putting your money to work so it earns more money without you having to do anything extra – it’s that simple.
Imagine you have an apple. You can eat it, which is spending, put it in your fridge, which is saving, or plant it, which is investing. It takes time, of course, but one seed eventually becomes a tree that can give you hundreds of apples in the future.
Here’s what separates investing from saving. With investing, you’re trying to grow your money.
For example, you can invest in companies that earn profits and expand over time – so you benefit from their growth.
But when you save money, it’s just sitting in a bank account earning low interest. Depending on where you keep it, you might even be losing money.
This is because of inflation, which means each dollar is worth less over time. For example, a movie ticket in 1990 cost about $4, but today it costs around $15 because of inflation.
To avoid losing buying power in this way, and also to grow your wealth for goals like college education, you need to invest.
But what actually makes your money grow and beat inflation?
The Most Powerful Force in Investing: Compounding
The answer is compounding, which is basically earning returns on your returns. Here’s how it works.
If you invest $1,000 and it grows by 10%, you make $100. Next year, that growth happens on $1,100 – not your original $1,000 – so 10% gives you $110.
The extra $10 in year 2 doesn’t look like much. But if you give it enough time, earning returns on your past returns becomes the single most powerful force in investing.
Think of a snowball rolling down a long hill. Over time, the snowball gets larger and starts growing faster, without you doing anything.
Say you invest $10,000 in the stock market when you’re 20 and then just forget about it. By the time you’re 30, it’ll be worth $28,000 – which almost 3 times your investment in just 10 years.
But the real magic happens when you retire at around 65. Your $10,000 will be worth over a million dollars!
You didn’t add another penny – time did all the work.
Here’s the big takeaway: The best thing you can do when investing isn’t picking the perfect investment – it’s starting early.
Your returns increase exponentially the earlier you start, so it’s better to start today with less money and confidence than wait 10 years and lose out on that compounding.
Now you might be wondering: where do I actually put my money to get these returns? And more importantly, how do I make sure I don’t lose it?
Many people assume the answer is paying a professional to pick stocks for them. But surprisingly, over 90% of the “experts” actually do worse than the market – more on that later.
First, let’s look at your actual options, and why one of them beats almost every professional investor on the planet.
The Investing Options
There are many options for investing, but here are some of the most popular ones.
Stocks
Stocks represent ownership. When you buy a stock, you own a tiny part of a company.
So if the company does well, your stock increases in price, but if it does poorly it decreases in price. You can buy and sell stocks in the stock market.
Bonds
Bonds are a loan you make, usually to a company or the government. You get regular payments of interest over time, and get back your original investment after a set number of years.
You can also sell the bond to someone else if you want the money sooner. Bonds are generally a lot less risky than stocks, but they also have lower returns.
Mutual Funds (MF)
Mutual funds pool money from many investors, and then invest it. This can be in stocks, bonds, a mix of both, or a specific industry, like tech or healthcare.
Mutual funds often have fund managers that choose the specific investments. Their goal is to get the highest possible returns for investors like you and me.
Exchange Traded Funds (ETF)
ETFs – or Exchange Traded Funds – are similar to mutual funds, but are easier to buy and sell since they are traded just like stocks.
A popular type of ETF is an index fund, which is actually a great choice for most beginner investors.
Index Funds
An index fund holds hundreds or even thousands of stocks that make up a specific stock index – which is a set of companies that represent the entire stock market.
So instead of choosing just a few companies, you own a tiny piece of all of them. When one of them fails, you don’t lose much because the others are probably still doing well.
And because the stock market goes up around 11% per year in the long run, you get consistently high returns without needing to worry about picking individual stocks.
Professional Fund managers and Actively Managed Funds
Most people assume professional fund managers can get higher returns than the broad stock market. After all, if they’re getting paid so much they have to be doing something right!
But while studying for the CFP® exam, I learned that surprisingly, over 90% of active fund managers actually underperform index funds in the long run.
Before you actually start investing, you need to understand one more thing to avoid losing money.
How to Manage Investment Risk
All investing has risk, but all risks are not the same. You need to understand the two types.
Short-term volatility means prices go up and down day to day or week to week. Long-term loss of capital means your investment permanently goes down in value, or even goes to zero.
Let’s look at an example.
The stock market fluctuates a lot day to day, which is short-term volatility. It might feel scary, but it’s completely normal.
This is not a problem because the stock market has consistently gone up over the long run, so there is a low risk of long-term loss of capital.
You manage risk in two ways.
The first is diversification, which is not putting all your eggs in one basket.
Index funds are great here because they give you automatic diversification. They allow you to own hundreds of companies at once, at a fraction of the cost of buying hundreds of different stocks individually.
Next is time horizon. If you won’t need the money for say more than 10 years, the short-term volatility just doesn’t matter that much.
But if you have less time before you need the money, like if you’re investing to buy a home in 3 years, then you’d want less volatile investments like bonds.
But even after knowing about compounding, investment choices, and risk, beginner investors are still making some easy-to-avoid mistakes.
Check this out to find out how to avoid 4 common beginner investing mistakes, and build more wealth over the long run: 4 Investing Traps You’re Falling Into (And How to Escape)