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Investment Principles and Terminology - How Investments Work

To understand how investing works, you need to understand the following investment principles:

Rate of Return
The rate of return from an investment is simply the % of your initial investment value that you expect to make from the investment. If you put money into a bank account that has an interest rate of 5%pa, the rate of return is 5% pa.

That means if you put $100 into this bank account, you will make $5 in interest per year. Returns of greater than 10% are good. The higher the rate of return, the more money you make from the investment. Which leads me to the next concept…

Risk and Return
If you make more money from investments with a high rate of return, then why not put all your money into high return investments? Well the answer is that the higher the rate of return, the riskier the investment. Betting on a horse at 10:1 is a risky bet, but boy would it return well if it won!

All companies want you to invest money with them. High risk companies really want your money so they can expand or for doing research into their products. But because they are high risk, they know that people are less inclined to invest money with them. So they offer an incentive by offering a higher rate of return.

Investments with a high rate of return are good, but remember that there is a risk that you may lose money on them.

Generally, the older you get, the safer the investments you make – because you’ve got more to lose and less time to regain any losses. The golden rule with investing money in high-risk ventures is to never invest more than you’re prepared to lose – because you might.

The second golden rule is to diversify your investments [that is, invest in a wide variety of investments], so if one fails you don’t lose everything.

Compound Interest/ Growth
You may have seen the episode of ‘Futurama” where Fry checked is old bank account after 2000 years, and it went from 79c to $40 million – well that’s the power of compound growth, which quite simply is when you reinvest a ‘return’ into the same investment.

For example, if you put $100 into an investment that returns 10% every year, you will return $10 every year. If you put this $10 back into the same investment, you will start returning more and more every year as you start making returns on the returns. And the higher the rate of return, the better the result!

Capital Growth
Capital growth occurs when you own something and the value of that something increases over time. For example, if you purchase a house for $100,000 and sell it for $120,000, you have experienced a capital growth of $20,000 or 20%.

The same applies to shares for example, if you purchase shares for $1.00 per share and sell them for $1.20 per share, you have experienced a capital growth of 20c per share or 20%.

Multiple Sources of Income
Most of us earn money through a paid job. We essentially get paid for our time, so to get more money from our job requires us to either get a higher pay per hour, or to works longer hours.

Now the industry you work in probably has a pretty well established pay rate system, so unless you’re a super-stellar performer you aren’t likely to be able to command a significantly higher pay rate (although you may be able to negotiate a moderate increase in your pay if you can demonstrate your value to your employer).

And similarly, there are only 24 hours in a day, and you don’t want to spend all of these at work!

So you can only increase your wealth so much from your job. T

he point here is that, unless you’re in a job that has an astronomical salary, to create real wealth requires multiple sources of income that don’t rely on the typical dollar per hour method of pay.

So investing in mutual funds, stocks, bonds, etc are ways of increasing your wealth, without increasing your time input. This is the concept of multiple sources of income.

Stocks or shares represent an ownership or equity position in a corporation and are the riskiest investment you can make as it is subject to company performance. When you buy stocks you have a share in the company’s assets and profits, which are distributed to shareholders as dividends.

Share prices will grow as the company grows (hopefully), so you can also make a profit when you sell your shares. Stock investments are therefore typically long term investments so you can make a return on the sale of the shares, although you also need to consider the returns as dividends along the way.

Some people trade shares on a daily basis (called day-trading) to capitalise on the daily fluctuations in share prices – this is a highly risky activity, but can be highly rewarding.

Bonds are debt instruments issued for a period to raise capital for the issuer by borrowing money from investors. The federal government, states, cities, corporations and many other types of institutions sell bonds.

With a bond note, the issuer is essentially promising to repay the amount borrowed along with interest on a specified date (maturity date). It’s just like a normal house loan, where you borrow money you’re going to pay off over a period of time with interest.

Therefore, bonds are a much more conservative investment as they have a more-or-less guaranteed return. Because they are lower risk than stocks, they usually have a lower rate of return.

Mutual Funds
A mutual fund is managed by an investment company that invests money belonging to a large number of shareholders in a selection of various assets, so it as a relatively easy form of investment. Mutual funds also give you a diversified portfolio managed by professionals.
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We are not certified financial planners or advisors. The information in this website is general information only. Always consult a licensed financial planner before making any finance or investment decision.

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