How does investing work?

Having worked hard to save the money, wouldn’t it be great if you could get your money to work for you and provide additional income? This is where investing comes in.

Investing can be a complicated topic with lots of jargon and plenty of opinions. While becoming an investment expert could take a lifetime, everyone can learn the basics and give it a go.

What is investing?

Imagine you have $100. You could save that $100 by putting it into a jar at home, at the end of the year you will still have $100. But if you put that $100 into a bank account that pays 5% interest per annum, at the end of the year you will have $105. When your money is growing, you are investing, and your money is starting to work for you!

The dictionary defines a financial investment as “putting in capital with the expectation of future return”. Some examples are depositing money in a bank to earn interest, buying property, buying a business or a share of a business and buying collectibles such as art.

The key part of the definition to note is the “expectation of a future return”. Investments do not always guarantee a future return, it is just and expectation and some investments can even result in a loss. A lot of the complexity around investing is around maximising return while minimising risk.

Why investing is important

You might think that saving money is enough and you don’t need the hassle and risk of investing. However a fundamental reason to invest is to combat the reduction in buying power that occurs due to inflation. Inflation is the increase in the cost of goods and services over time – think about what has happened to the price of food, petrol and power over the years. Because the prices of goods and services increase over time, cash savings effectively decrease in value over time as more money is required to purchase the same amount of goods or services. Take the example of the $100 in a jar, as each year passes, your $100 buys fewer and fewer goods and services.

Returns from investments can offset or overcome the negative impact of inflation. Additionally, if you have saved and invested enough, the income from your investments could sustain your lifestyle (this is what it means to be a self funded retiree) and open up lots of interesting opportunities.

Know your investment objectives

Investments play a role in achieving financial fitness much in the same way as exercise plays a role in achieving physical fitness. So while generally exercise is good, if you have a particular fitness goal you are able to tailor your exercise to achieve that goal. If you are trying to build muscle for example, resistance training is more appropriate than swimming.

When investing it is important to have a goal in mind so that you can ensure that you choose investments that best match your objective. The goal could be to save enough money for a house deposit, to have funds to pay for your child’s school fees or to fund your lifestyle in retirement.

When considering your objectives, you should think about the timeframe as well as the amount of money you are aiming for. Generally investment time frames are short term 1 -3 years, medium term 4 – 6 years or long term 7+ years.

The MoneySmart website has a useful guide for preparing an investing plan.