One of the best decisions you can make as an investor, especially if you’re new, is to learn about the basic concepts in investing. You don’t need an MBA in economics or finance to learn these things as they are actually simple and easy to learn. Better yet, they are also simple to apply.
In this article, we’ll present a straightforward explanation of basic investing concepts/ideas. These are useful when you have to make decisions regarding stocks, bonds, bitcoins, real estate, starting your own business and any other investment opportunity that comes your way.
#1 – Inflation
There are a lot of things that we can talk about regarding inflation, but right now, we’ll simply talk about the parts that are important to investing.
The basics though is that inflation is the gradual rise of the prices of goods. If a certain item right now costs P100 and inflation averages at 5%, then that item will most likely cost around P105 next year.
Generally, inflation is seen as an enemy, as it increases the cost of the items you need/want. And it is a strong enemy, as it is a natural occurrence in any economy and there isn’t much you can do to stop it.
How can you use knowledge of inflation for investing?
The first way is simply just realizing that you need to invest your money. If you don’t, inflation will happen, and the cost of goods you need/want will continue to increase, while your money stays the same. There will come a time where your saving will feel inadequate, even if you save up regularly.
You can’t stop inflation, but you can minimize its effect on your wealth by investing your money!
The second use of inflation is as something to compare to ROI, which we’ll talk about below. That’s also where we explain more about using inflation against ROI, so read on!
#2 – Return on Investment
Return on Investment, or ROI, is the profit you get on your investment. It is expressed in a % form and usually is for the year.
If you want to compute ROI, the basic formula is just net money earned for the year, divided by total investment made so far.
So, let’s say you started your own business where you invested P1,000,000 in total for all years. At the end of the current year, the business made a total of P200,000 in net profits after deducting your expenses (Sales – Expenses). The ROI for the year is 20% (P200,000 / 1,000,000).
(If you have a specific investment that you want to know how to compute returns for or the ROI, let us know!)
How can you use ROI?
The cool thing about ROI is that they are comparable to other ROIs, even if they are not the same investment. Which means you can choose the better investment depending on their past or expected ROI.
Say, you are given the opportunity to buy 1 of the 3 investments in your local area. Investment #1 is a real estate investment partnership that has a return of 20%, business #2 is a bakery that has a return of 30%, and business #3 is an online selling gig that has a return of 5%.
Even though these are different investments that have different operations and amount of money needed, we can still compare their ROIs. Also, if all else is equal (especially risk!), the right choice is obviously business #2 as it has the highest return.
Another IMPORTANT use of ROI is to make sure you’re not investing in something that is giving too low of a return. A common way to determine this is to use the average inflation rate of your country. (This is what I was talking about in the inflation part above.)
The rule is that the expected/average ROI of your investment should be higher than your country’s inflation rate.
In the Philippines for example, inflation usually plays around 3% to 4% per year. Given these numbers, investors in the Philippines most probably should invest only in investments that give more than 5% per year. But why is that?
You can think of inflation as something that lowers the value of your money, while investing increases it.
The illustrations below assumes that there is an item that you want to buy years from now (for some reason). The item costs P100 right now, but it will increase in costs by 4% every year, since that is the inflation rate.
In the above, we assume that you do not invest the P100 you currently have. After just 1 year, the item’s price increases to P104, but the money you saved stays at P100, as you did not invest it. Therefore, your savings can no longer afford it. This goes on for all the rest of the years that you are not invested. Needless to say, not investing definitely produces the worst results.
The illustration above assumes that your P100 is invested and it earns about 4%, which is the same as the inflation rate. In this case, you can afford the item at any year, but there is no extra money you receive from your investment! Good, but not great…
Finally, we assume you invest it at 5%, which is 1% higher than inflation. In this case, not only can you afford the item at any given year with your investment, but you even have extra money to buy some other thing as well!
Since investing is about making more money, only the investments with a return that is higher than the inflation rate is acceptable. Again, that is because it is the only way to generate excess money, considering inflation.
As an investor, your goal will always be to beat inflation so that your money can afford the things you are saving for, and also have extra to buy even more things you need or want in the future! So only invest in things that have a higher return than the inflation rate.
#3 – Risk
Risk is the chance that the investment will not produce the expected return, or worse, it will result in a loss. Higher risk means that there is a higher chance for the unfavorable result, and lower risk means that the unfavorable result is less likely.
All investments have risks in them, even if it’s not obvious. Though it’s also very difficult to quantify risk, or assign a number or % to it. So there is no such thing as a 25% risk, unlike in ROIs.
Usually, we just use words to describe risk such as “low risk” and “high risk”, and even “moderate risk”, as an example.
How much risk you take depends on you. Low risk investments usually have low returns, and high risk investments have high returns (But there are many cases where this is NOT true). Also, since you’re money is hard-earned, then make sure you don’t risk it too much!
Thankfully, there are investments that can be low/moderate risk investments with high returns, if you know what you are doing! These are usually in stocks, real estate, and starting your own business. But again, you need to have the knowledge to actually turn these into low/moderate risk investments with high returns!
How can you use knowledge of risk?
Since you know that investments always have risk associated with them, that means that with any investment, you need to do safeguards like diversifying, learning more before investing, and making use of time (lots of time even!)
The more risk an investment can have, the more of the stuff above you have to do. So diversify more, study more and spend more time invested!
So… What is diversification? It’s simply “putting your eggs in different baskets”.
If you are a stock market investor for example, instead of putting all your money in a single stock, maybe have 3 – 15 stocks instead. That way, even if one or two stocks become terrible investments, you still have the other stocks that will get you the returns you want.
If you have a lot of money, you can even invest in multiple types of investment, instead of just one. So, you’ll have some investments in stocks, some in local businesses, some in real estate and maybe some in bonds (or any combination of those).
Another way to reduce risk is by studying the item you are investing in. Since you are already reading our blogs, you are at the right track. But there are a lot of other good sources like books, other websites, and of course, YouTube videos! (Just make sure they are reliable)
Knowing an investment, especially its advantages and disadvantages, will arm you with knowledge to minimize risks!
Just be aware that there are a few videos in YouTube, and a few other blogs as well, that are not teaching the right things! Just be vigilant, especially if they are trying to sell you something.
For spending time on investments, we have the next section for that!
#4 – Proper Investments Take Time
It’s unfortunate that most people expect their investments to just produce a LOT of profit immediately. But that’s not how this works … unless you are extremely lucky! (But like most people, you probably aren’t)
The stories of the super-rich are often similar. They came from nothing, but then they started a small business. Then they start more business and/or expand the ones they already have. Then after a couple of decades they now find themselves in the top 20 richest people in the Philippines.
Of course, hard work, determination, and skill came into play to influence their success. But there is another important aspect as well: time.
In 2006, Henry Sy was worth $4 Billion. But 10 years after that, in 2016, he was worth around $14 billion. He did get richer by a lot, but it did take a decade.
How can you use time in investing?
For the most part, the lesson here is to just know that being an investor is pretty much a career. This is in a sense that you’ll be spending a lot of time learning and actually being an investor. You simply can’t just be an investor for a few months, or a year or two.
There are a lot of great investments, like the stock market and starting your own business, that takes years to decades before you can really profit from them. But if you work hard and wait for that time to pass, you’ll most likely be rewarded with great profits.
(Another quick lesson I just want to inject here is that money generated from investments should be invested again. Since you’re going to be investing for a long time, you’ll be receiving some profits along the way. When you receive some profits early on, re-invest them. Only stop investing when you finally reach your goal of a large sum of money.)
And That’s The Basics!
You’ve just read, and hopefully also understood, some of the basic concepts there is to investing. There are a few more items we could have talked about, but that would make this article longer than expected.
How should you proceed? I’d start by learning more about the specific investment you want to invest into. We have a lot of articles teaching about the stock market here on this website, so checkout our past articles!
We will also be posting more articles about the stock market, bonds, REITs, real estate and other investments as well!
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