What is Investing?

Investing comes in all shapes and sizes, but the goal is always the same — to grow your wealth over the long term. It sounds simple enough, but it can be an intimidating concept. How does investing work? And which types of investments will help you reach your financial goals? These are big questions.

Understanding how it all works can help you come up with an investment strategy that feels just right. In the end, it’s about finding ways to make your money work a little harder. Let’s dig into the nitty-gritty details so you can invest with confidence.

What is investing?

There are lots of different ways to invest that aren’t super complicated. They each involve putting money into an investment that you hope will net a return over a period of time. As the old saying goes, sometimes you’ve got to spend money to make money. To be clear, that doesn’t mean pouring your life’s savings into the hot stock of the moment or your best friend’s new business venture. Instead, it’s about being intentional with your investment strategy and making decisions that are aligned with your financial goals. Those might include:

• Saving for retirement

• Helping your children pay for college

• Buying a home

• Starting a business

• Growing your savings

Your time horizon is an important factor here. While retirement could be decades away, you may be hoping to have a down payment for a home within the next five years. These details can affect the types of investments you choose and where you decide to park those assets (we’ll explain more shortly).

So how much money do you need to start investing? The good news is that the barrier to entry is pretty low. Acorns lets you start investing with as little as $5, but your ideal number will depend on your financial situation. One rule of thumb is to lean on the 50-30-20 rule. That breaks down your monthly take-home pay like this:

• 50% for essentials: Like your rent/mortgage payment, utilities, phone bill and the like

• 30% for wants: Think discretionary spending like eating out, shopping and so on

• 20% for saving and investing: Such as building your emergency fund or funneling money toward investment accounts

This formula may feel unrealistic if your budget is already stretched thin. After all your bills are accounted for each month, see if you can squeak out even a small amount for investing. You can dial it up if your income increases. 

How does investing work?

Now for the nuts and bolts of investing. You can buy and sell securities (investments) through investment accounts. You fund the accounts and then choose your investments. Some of the most common investment accounts include:

Retirement accounts

This includes 401(k)s and individual retirement accounts (IRAs). These are called tax-advantaged accounts because they can offer some nice tax perks. Traditional IRA and 401(k) contributions, for example, can reduce your taxable income during your working years. The catch is that you’ll be taxed on any money you take in retirement. There are also annual contribution limits and early withdrawal penalties. 

Roth IRAs, on the other hand, are funded with after-tax dollars, so you can tap your contributions if needed with no tax penalty. You can also withdraw investment gains tax-free if you’re at least 59 ½ and have had the account for five years or more. 

401(k) plans are employer-sponsored retirement accounts. The account provider should give you a menu of different investment options — from exchange-traded funds (ETFs) to mutual funds to index funds. (We’ll explain what these are and how they work shortly.) You can decide how much of your balance to invest in each one. Most providers have a default setting based on your age and may choose your investments on your behalf.

Brokerage accounts

You can open an IRA or regular brokerage account through a brokerage firm. From there, you can select your investments and the firm will execute them on your behalf. Think of the firm as the middleman between you and the stock market. Brokerage accounts don't have the same tax benefits that other ways to invest, like retirement accounts, have, but you can access your funds whenever you want. This liquidity can be attractive, especially if you’re hoping to tap your balance to meet your financial goals.

Let’s say you’re starting a business and need $10,000. If you’re younger than 59 ½ and take a non-qualified withdrawal from a 401(k) or traditional IRA, you’ll pay taxes on the withdrawal — and a 10% early withdrawal penalty. Brokerage accounts are different. You could withdraw that $10,000 with no penalty.

Just keep in mind that you’ll owe capital gains tax on investment gains. When you sell an investment for more than you paid for it, that’s a gain (and the whole idea behind investing). The amount you owe Uncle Sam is based on your income, tax-filing status, and how long you held the investment. If you have a brokerage account, you’re expected to claim investment income on your tax return. That includes income from dividends and interest (uninvested cash in your account typically earns interest). One other thing: you can also deduct losses on your return. If you have a mix of capital gains and losses, the difference between the two is considered your net capital gain. Taxes on investment accounts can be confusing, be sure to speak with a licensed tax advisor for information specific to your situation.

Savings vs. investing

Saving and investing are two different, but equally important, parts of financial well-being. Your savings account holds cash reserves. This money isn’t invested. Instead, it’s there to see you through financial hiccups or help you meet short-term financial needs. That can include:

• Job loss

• Medical emergencies

• Home or car repairs

• Home renovations

• Unexpected bills

Experts recommend keeping three to six months’ worth of expenses in your emergency fund, but you might want to bump that up if you have irregular income. Savings accounts usually earn interest, which can help your money grow. Some high-yield savings accounts have APYs exceeding 2.50%, according to DepositAccounts.com. If you prefer a hands-off approach, the Acorns Emergency Fund allows you to build your savings automatically in a demand deposit account.

6 types of investments

Now that we’ve got the basics out of the way, let’s get into different types of investment.

• Stocks: Buying stock gives you an ownership stake in publicly traded companies. Individual stock picking is considered risky, given the volatility of the stock market. Investing in well-diversified funds that hold stocks, among other securities, is considered a lower-risk alternative.

• Bonds: When you purchase a bond, you’re essentially lending money to the issuer. That’s usually a government entity or corporation that’s obligated to repay you, with interest, over a predetermined period of time. Bonds are rated based on the issuer's financial strength, or its ability to repay a bond's principal and interest on time. 

• ETFs: These funds trade like stocks but include a variety of investments. ETFs typically hold a group of assets, such as bonds or stocks.

• Index funds: These are ETFs and mutual funds that are tied to a specific market index, such as the S&P 500 or Dow Jones Industrial Average. They seek to match the performance of the index they track.

• Mutual funds: Similar to an ETF, a mutual fund gives investors more options. They can hold a variety of stocks, bonds and other securities. Money is pooled together from investors and most are actively managed by a fund manager who makes investment decisions on the fund’s behalf.

• Real estate: Real estate can be lucrative, but it’s a risky game — and not every investor is keen on being a landlord. Real estate investment trusts (REITs) offer an alternative. They allow you to invest in companies that own or operate income-producing real estate properties.

Risk tolerance with investing

Your risk tolerance, along with your financial goals and time horizon, will likely shape your investment strategy. Riskier assets may have the potential for larger returns — and bigger losses. Individual stocks and cryptocurrency are great examples. It’s possible to make a fortune or lose a lot of money. That’s why taking an all-or-nothing approach to investing probably isn't your best bet.

Diversifying your portfolio can help mitigate risk. That means investing in a wide variety of securities across different sectors, industries, and geographic locations. It’s also about investing in a mix of high- and low-risk assets. Investment gains in one area can help insulate you from losses in others. With that said, your personal risk tolerance is always a factor. 

Folks with a higher appetite for risk might feel more comfortable wagering riskier bets in their investment portfolio. For example, a portfolio made up of 90% stocks and 10% bonds would be considered aggressive. A 60/40 split is more moderate, though you can dial it up or down based on your goals, age, and risk tolerance.

Investing strategies

Successful investing usually requires having a game plan. On top of diversification, here are some common investing strategies that might resonate with you:

• Short-term vs. long-term: Your investment timeline is important. Go back to your investment goals and consider when you’d like to achieve them. With retirement, for example, you’ll probably take on more risk when you’re younger and have more time to potentially recover from market dips before leaving the workforce. For goals with a shorter time horizon, you might want to play it a little safer. For example, if your child is a year away from graduating high school, you probably don’t want to put their college fund into high-risk investments.

• Active vs. passive: This has to do with how you manage your investments. Folks who prefer to be more hands-off might like a passive strategy. Index funds and ETFs fit the bill. If you want to be more involved, you can actively manage your investments and use a brokerage firm to execute them on your behalf.

• Value investing: This involves seeking out stocks that are actually worth more than their current stock price. The goal is to buy in now before the market takes notice and stock prices go up. Value investing isn’t an exact science. Determining a stock’s intrinsic value can be tricky — another reason why diversification is so important.

• Dollar-cost averaging: With this strategy, you invest a set amount of money on a regular basis, regardless of what’s happening in the stock market. It’s straightforward, discourages emotional investment decisions, and doesn’t require you to try and time the market (which is usually a losing game). If you’re making a set contribution to your 401(k) every paycheck, you’re already practicing dollar-cost averaging.

How to start investing

In addition to retirement accounts and brokerage accounts, you can also start investing with a robo-advisor. You answer questions about your investment goals, risk tolerance, and time horizon. The platform then uses an algorithm to generate an investment strategy. It basically automates investing so you don’t have to put in much effort. Acorns Invest takes it a step further and sets up automated investments using your spare change. That’s about as easy as it gets.