I Don't Get It. Investing: How Does it Work?

[Zalo]

Recently I tried explaining investing to a friend, and I eventually realized that I only know the broad-strokes of investing, not how to actually go about it. This is what I came up with, I am likely wrong in some instances, but I can learn:

------------------------------------------------

I know the fundamentals about investing, but I'm extremely more knowledgeable when it comes to the saving aspect, since I've actually practiced that in real life. Anyway, investing is just a fancy word for lending out your money to somebody, whether it's a business, a person, a bank, a government, or another entity, expecting that money to be paid back, with interest. In life there are two people: the creditor (who lends money), and the debtor (who owes money). You and I definitely want to be the former. This means avoiding consumer debt at all costs, living in a smaller home, living close to work, using a scooter or road bicycle as primary transportation, buying inexpensive clothes & learning how to sew, buying healthful food in bulk and learning how to cook, purchasing used tools and doing your own repairs/maintenance, etc. The general trend is to find inexpensive, quality alternatives to life's necessities and wants, and to gain skills; because the more skills you have, the less you have to pay someone to do things for you, and the higher your potential income becomes.

If you follow this strategy of living way below your means, without a drop in quality of life, and doing things yourself, you will hardly ever have to depend on someone else lending you money, and you'll definitely have a surplus of money once you attain a decent income stream from a job, self-employment, or whatever.

At that point you may start lending this surplus expecting a return with interest. There are various ways to go about 'investing' your money out, three of the most popular include, as I mentioned, lending it to companies through stocks, to governments through bonds, or to purchasing real estate to rent out or re-sell at a profit (if you cannot buy the house in cash, you will be indebted to whoever is lending you the money to make the buy, usually the bank).

You may do these investments on your own, only using your money, or you can opt in to a mutual fund, which are collective investment groups. Essentially, a bunch of people gather together, pool their money, and the mutual fund management lends it out, taking a cut of the interest paid by its debtors, in addition to charging other fees to its fellow investors. There are mutual funds for stocks, bonds, real estate (these funds are called Real Estate Investment Trusts or REITS), and every other form of money lending. My favorite type of mutual fund are Index Funds, because they have almost negligible fees and follow the market average; so you'll get steady return, not above the average, and not below, AND, like any mutual fund, you don't have to keep up with the specific stocks/bonds/whatever you're investing in, because the Index Fund managers take care of that for you. In short, mutual funds are good for people that are only using investment as a means to an end, such as early retirement; they offer decent returns and a less time intensive form of investing, but watch out for the fees.

The general idea is to turn your income into savings, invest them, and retire on the interest.

------------------------------------------------

So, keeping all of this in mind, let's say I just got a great paying job, 70-80k a year: how do I turn those paychecks into investment income that will last me for a lifetime? What do I do with 401Ks, IRAs, Roth IRAs, Stocks, Bonds, Mutual Funds, Real Estate, etc. Step by step.

Please write as if you're speaking to someone who has no idea what investing is; the simpler, the better.

[marty998]

It boils down to 2 choices. Spend now or spend later, which gives you "utility". In economics, utility is broadly the happiness you get from spending a dollar. And the reasonable man or woman would like to maximise their utility.

Spending now is generally accepted to provide more utility than spending in future. If you choose to spend later, you want to be compensated appropriately for the decision to not spend now. The investment return you require is that compensation.

Now it comes down to a trade off. Risk vs return.
If you require a higher return to compensate you for the utility difference, you need to be prepared to take on higher risk of losing your money.

The risk scale is generally (from low to high): Cash, bank deposits, fixed interest, property, equities, international assets (due to additional FX risk). Risk is simply the chance of not getting your expectations.

Geddit? From there we can easily jump to Markowitz portfolio theory and efficient frontiers, which is second year university Finance. But that is a lesson for another day.

Now you need to find a "financial intermediary" (a bank, a broker, a market maker) who is going to link your surplus cash to the investment markets.

When you enter the market, you line up on the "bid" side (buy side). The other side is the "offer" (sell) list, which is the price at which sellers will sell you their shares, the interest rate that a bank will give you on your savings, the FX rate offered on currency exchanges etc.

If the bid and the offer prices match, a transaction occurs and your cash is swapped for whatever asset you have bought, less in most cases, a transaction fee taken by the intermediary (e.g. brokerage).
.
.
.
How you actually go about investing? Thats a personal question, and the answer will be unique for everyone. As I said before, what you choose to invest in comes down to how much risk you are willing to take. The answer is not Vanguard in 100% of cases.

[slugsworth]

I am not any kind of guru, but of investing as anything that allows you to achieve a return in investment. Passive investment are usually by lending to someone as you indicated, or by purchasing equity. Debt and equity are very different things. Then there are active investments, such as purchasing real estate directly, buying/starting a business, etc. In sure someone is going to recommend a good book, but those are the two ways I differentiate things, equity vs debt and active vs passive.