How Investments Make Money
Published on December 29, 2017
By John Foley CFP®
Many people are afraid to start investing because they don’t have a basic understanding of how it works. And that’s smart. You don’t want to invest your hard-earned money in something you don’t understand.
But it’s also not smart to sit on the sidelines. Because, well, simply socking money away in your savings account probably isn’t going to earn you the kind of returns you need to achieve your big financial goals.
If you’ve ever wondered how, exactly, investments make money, we’ve put together this guide to clear up the confusion. Read on to learn about the different types of investments out there and how each of them can work for you.
How Do Investments Make Money?
Basically, investments make you money in one of three ways:
• Income: Cash paid to you periodically from your investments (as interest and/or dividends)
• Capital Appreciation: Owning things that could go up in value over time (like stocks, gold, or real estate)
• Pass Through Profits: Investing in private businesses and real estate, which may pass through the profits from their operations.
What Kinds of Investments Are There?
Bonds are loans you make to either a company or a government for a fixed period of time. The specific terms of the deal change, but essentially: You give someone money, they promise to pay it back in the future, and they pay you interest until they do.
For example, you might lend General Electric money for 20 years at 4% interest. For each $1,000 you invested, you would get $40 per year until 2017; then you’d get your $1,000 back.
There are four broad categories of bonds available to most investors:
• Treasury Bonds: Bonds issued by the U.S. government.
• Corporate Bonds: Bonds issued by a corporation.
• Municipal Bonds: Bonds issued by a state or local government or agency (for example, airports, school districts, and sewer or water authorities).
• Mortgage and Asset Backed Bonds: Bonds that pass through the interest on a bundle of mortgages or other financial assets such as student loans, car loans, or the accounts receivable of companies.
The difference between them is risk (and thus, the expected return). For example, the U.S. government is less likely to go bankrupt than a single company is, so T-bond returns are typically a conservative bet. Corporate bonds are riskier, but typically have higher returns.
Either way, bonds are a relatively safe investment, compared to other types of assets, and also provide investors with regular, fixed income. Both of these things are especially important in retirement.
A stock is a single share of ownership in a public company. (Public companies are those that trade on stock exchanges; companies that are not traded this way are privately owned.)
When you buy stock, you own a tiny piece of the company. This can make you money two ways: you might get dividends if the company decides to pay out part of its profits, and the stock might go up in value and you’ll have a capital gain when you sell it.
People invest in different kinds of stocks for different reasons. Most investors are looking for stocks that will go up in value so they can sell the stock for a gain. They are looking for the value of their portfolio to grow because they’re saving for retirement, a house, or some other long-term goal.
There are two strategies for capital appreciation. “Growth stocks” are companies with sales and earnings that are growing year-over-year. They usually do not pay a dividend because management wants to invest the profits in continued growth. Another way is to find “value stocks” whose price has been cut by events outside its control. At some point, these stocks may become an attractive buy because people think they’re undervalued and may go up.
Other investors want additional income and don’t want to rely only on bonds, so they choose stocks for their dividends. These are often companies in mature industries that are not growing much and return profits to shareholders as higher dividends. Value stocks may also have good dividends.
It’s easy to focus on the price appreciation that comes from growth and value, because it feels good to see your stock’s price go up and not so good to see it go down. However, from 1930 to 2012, almost 42% of the total returns on the S&P 500 have been from dividends.1
All three ways stocks make money can work for you, but the market tends to favor each one for a time, and then move on to one of the others. This is why a long-term investor should probably have a mix of all three.
As your portfolio grows, you might consider moving beyond stocks and bonds. Most of these “alternative investments” generally provide some combination of growth potential and income. Unlike stocks, they usually pass most of the profits they make through to their owners. They are less likely to move up and down in sync with the stock or bond market, so they can give you an additional dimension of diversification.
The most common types of alternative investments include:
• Real Estate Investment Trusts: REITs invest primarily in real estate or real estate loans and are traded like stocks.
• Direct Investment in Real Estate or a Business: Wealthier investors may own investment real estate or a private business.
• Limited Partnerships: Entering into a limited partnership with other real estate investors limits your legal exposure and offers the ability to diversify with a smaller investment.
• Master Limited Partnerships: MLPs are a type of limited partnership that is publicly traded, so you can sell it whenever you want.
• Gold: You can invest in gold and other precious metals directly by buying the metal as coins or bars, or using ETFs that invest in bullion.
• Peer to Peer Investing: New regulations have made it easier for private companies to raise money from individual investors.
By cash, we don’t mean stacks of twenty dollar bills in a safe. It’s the money you keep in bank accounts, certificates of deposit (CDs), cash management accounts, and money market funds. In each of these cases, you lend money to the bank or financial institution, and you get interest on those loans. Since these deposits don’t go down in value and you can get your money out any time, as opposed to bonds, which need to be sold and can lose value, they are considered a different class of asset than bonds.
Currently interest rates are so low that you earn very little interest on these deposits. You should consider only keeping in cash the money you need quick and easy access to—for example, your checking account, your emergency fund, or a savings account for a purchase you plan to make within the next couple of years.
Financial advisors recommend that people invest in a combination of these asset classes tailored to help them reach a specific financial goal (for example, buying a house or retiring). The specific mix of assets is primarily determined by how long they have to reach their goal.
Of course, most new investors don’t have the cash to spend on all these different types of investments. That’s where mutual funds come in.
Mutual funds and exchange traded funds (ETFs) can make it easier for you to invest in stocks, bonds, REITs, MLPs, gold, or most other legal investments. Think of mutual funds as suitcases filled with different types of investments, such as stocks and bonds. Buying a share of the fund can invest you in hundreds of individual securities the fund holds.
The benefit of mutual funds is instant diversification. If you invest in one company’s stock, and that company goes bankrupt, you’ve just lost your money. If you invest in a mutual fund that contains that stock, you may have lost something, but not everything.
There are over 20,000 mutual funds that cover every investing strategy you can imagine—even securities that trade outside the US. They make it easy and inexpensive for a new investor, just starting out, to build a well diversified portfolio of stocks, bonds, and alternatives with just a few thousand dollars.
We hope this article demystified investing a bit. While there are no guarantees, investments can make money many different ways. But, they can’t do any of them if you don’t get started. If you’re not sure what to do next, we can help. A SoFi Wealth account makes it easy: Our technology helps you determine the right asset allocation mix for you, while advisors are available to offer you complimentary, personalized advice if you need it. Consider working with a SoFi Wealth advisor today.
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