WHAT ARE INVESTMENTS? (AND HOW TO GROW YOURS!)

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Overview

We hear “savings,” and we feel pretty good about it. After all, many of us grew up being taught some basic savings principles (even if we didn’t exactly follow them…). But then we hear the word “investments,” and suddenly things get a little scarier. I mean, exactly what are investments anyway? I know that for me personally, this was a question I needed answered when I wanted to start getting serious about finances.

In simple terms, an investment is something purchased for the express purpose of earning money. In the short-term, an investment may earn you money by creating an income source. Over the long-term, an asset may earn money by increasing in value.

Now that’s the “plain English” version, but I’d like to dig a little deeper into this definition and see if we can beef it up a little with a few more “technical” terms.

Assets As Investments

Let’s take the first phrase of our definition above: “An investment is something purchased for the express purpose of earning money.”

We call the something here an asset.

So what makes an asset different from other types of purchases? Basically, it’s about what you do with it.

Most of the items you buy are probably purchased with the intent to use them personally, or “consume” them.

Now I don’t mean you are going to literally eat that new book you just bought. But you did buy it for the purpose of using, and then probably setting aside until the day you decide to use it again or get rid of it. From a financial perspective, you don’t expect to get that money back.

Contrast that with an investment asset like a collectable. I don’t personally dabble in the world of collectables, but it makes for a simple analogy. Maybe instead of buying a book to read, you get your hands on a first edition, signed copy of something that already has significant value. You probably won’t read it. You’ll want to keep it in great condition. So, you set it aside for years hoping the value goes up. Then, when you sell it, you profit at the sale. This is an investment.

See? Two different books, two very different purposes.

When you purchase something specifically for the purpose of generating income or hoping it’s value increases over time, that item becomes an asset.

Appreciating Assets As Investments

When the value of your assets increase over time, we call that increase appreciation. We say these are appreciating assets. Why do we care if our assets increase in value? Because that’s one of the ways we make money investing.

Take, for instance, your house. This is probably your largest asset. But, it does not create an income for you. In fact, if you have a mortgage, it actually costs you money to live there. But, over time, your home value will hopefully go up. How does something that generates no income and has a permanent tax attached to you get classified as an asset?

Let’s say you buy your house for $250,000 on a 15-year mortgage at age 35. You pay it off at 50. By then, it’s already worth $125,000 more than you paid for it, so even after interest on your mortgage you’ve made some money. But, you decide to live there until retirement at 60. Now it’s worth $200,000 more than you paid for it, and it’s paid for. When you sell your house, you’ll have $450,000 cash.

Disclaimer: Those are completely fabricated, easy to grasp numbers used as an illustration.

Appreciating assets help you build wealth by increasing in value over time and earning you money when sold.

Income Generating Assets As Investments

If we stick with the real estate example, it’s pretty easy to understand what an income-generating asset looks like as well. Just think rental property.

Let’s say that you’re able at some point to purchase an inexpensive, small house to use as a rental. Each month, you’ll receive an income from this property in the form of rent. Assuming you don’t have a mortgage on the property, you can pocket that money. If you have a mortgage on the rental, you’ll keep the difference between the rent and the monthly mortgage cost. Either way, this asset generates income.

And, bonus, it’s also an appreciating asset! Because, like your home, it will also go up in value over time.

Any asset that earns money on a regular basis by creating an income stream is an income-generating asset.

Other Asset Types

Above, I focused on tangible objects that were easy to visualize in hope that I could make something that can be confusing a little easier to grasp. But, there are many types of investments that are not physical items like collectables and real estate. The one we hear discussed the most frequently is undoubtedly stocks.

When you invest in a stock, you are purchasing a “share” of a company. Essentially, you own a small portion of that company. When the company does well, your stock value goes up, and so your investment goes up in value. When the company does poorly….well, you can guess.

Some stocks generate dividends that are paid out to share holders (you) on a periodic basis. If you own enough dividend stock, you can create an income stream here. In this regard, stock investments can be income generating.

More often than not, though, real gains in the stock market are made by buying and holding stocks in a diversified portfolio over time until, through compound interested, the investment grows to the point that you can draw an income off of the gains.

What Is Compound Interest?

Whoa. Lots of words in that last paragraph. Go back and read it slowly, it’s not as hard to grasp as you think.

Basically, you buy some stock at a given price, say $1,000. Over the next year, the value goes up by 10%, so without buying any more stock, your investment is now worth $1,100. Already winning. Say you don’t buy any more, and the next year the value goes up 10% again. Well, 10% of $1,100 is more than 10% of $1000. See, now your interest is gaining interest for a total value of $1,210. Another year, another 10% and you’re up to $1,321. The interest is compounding.

You can see how, with a larger investment value, if you continued to invest on top of this compounding interest you could get to a point where you could generate a good income from the interest alone without touching the principle balance.

What About Retirement Investments?

So how does all this relate to 401ks, 403bs, Roth IRAs and all those other numbers and letters?

Honestly, that’s another post all it’s own. Here’s the abbreviated version.

All these things are not actually investments themselves. They are forms of tax protections you can put around actual investments to help ensure you’re ready for retirement.

So, instead of buying a bunch of stock on Robinhood or another type of trading platform where you can access the money through selling at any time, you open a Roth IRA. You then choose what investment to put inside it. To keep it diversified, you probably want to think mutual funds. Now, because this is Roth, you’ve already paid taxes on the money. That means it grows tax-free and you can access it at the age of 59.5. If it’s well-funded, you should be able to draw a good income from the interest.

Conclusion

Whew! That’s a lot to chew on. Let’s review.

In simple terms, an investment is something (an asset) purchased for the express purpose of earning money. In the short-term, an investment may earn you money by creating an income source. Over the long-term, an asset may earn money by increasing in value (appreciating).

When we’re dealing with stock market based investments with a larger investment value, if you continue to invest on top of compounding interest you could get to a point where you could generate a good income from the interest alone without touching the principle balance.

And that’s the general idea behind investments!

Remember, regardless of your money goals, you can “Bank on a Budget” to get you from where you are to where you want to be!

An investment is something purchased for the express purpose of earning money.

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Alex

Hello, my name is Alex! I'm a public school teacher who has achieved some big financial goals just by getting control of my money using some simple strategies like using a monthly budget. Now I'd like to share what I've learned with you. Welcome to "Bank on a Budget!"