Investing 101: 9 Things You Need To Know

You already know that the interest rate on a savings account today is so low, that you won’t make any money off of it. That doesn’t mean saving is a worthless endeavour - putting money aside for the future is a very good idea. Whether the interest rate is high, or low.

But with the interest rates so low, saving is not very attractive, right? A lot of us therefore start thinking about investing, rather than saving. But what is investing, really? And what about all of us who don’t have a degree in finance?

If we strip down financial investing to a few core concepts, we see it is actually quite simple. And we also realize it doesn’t take a finance degree to invest smartly. 

Concept #1 - Investing

Yes yes, you know this - but I just want to lay the foundation here, so we’re all on the same page.

When you’re putting money into something with the expectation of getting a profit in return, you’re investing. 

Concept #2 Asset portfolio

Your asset portfolio is simply the collection of financial assets that you own. For example, my asset portfolio could be that I own 3 shares of Amazon, 2 in General Motors, and 1 in Shell. That's it!

Concept #3 Risk

When you invest your money in something, you have the risk that you will not get all of your money back. That’s what makes many people a bit nervous about investing, and rightfully so. Therefore - when we invest, we have to manage the risk we’re willing to take. 

It totally depends on where you invest your money, how much risk exposure you have. If you invest in a new tech startup, it’s very hard to predict whether or not they’ll be successful. Therefore it’s a risky investment. If on the other hand you invest in a big, more established company like Amazon for example, this is considered less risky of an investment compared to the new tech startup.

Concept #4 Return

Ah, the fun part! 

Suppose you invest €100 in let’s say, 1 share in a company’s stock. After a year, it could be that this share is worth €110. That means you’ve made a profit of €10. We also say that your return is 10% (€10 is 10% of €100). It could also be that the value of the share has dropped to €90, which means you’ve made a loss of €10, or a negative return of -10%.

We can compare this return on investment to the interest rate on your savings account. Right now, the latter is close to 0% (and even negative in some cases). 

Concept #3 +#4 Risk & Return

In financial investing, we also speak of a risk premium. It’s the extra reward you get for the extra risk you’re taking with your investment, compared to a risk-free asset. Money in your savings account can be considered a risk-free asset. And this risk premium is therefore exactly what makes the potential return on investing higher than what you can make on your savings account. 

Typically, the higher the risk of an investment, the higher the potential return. If you choose a very safe investment, you should not expect a return of 20% in one year. The safer your investment, the closer the return will be to the interest rate on your savings account, aka, your risk premium goes to zero.

What else you need to know

Don’t put all your eggs in one basket

If you put all your easter eggs in one basket and then you drop it, you break all your eggs. If you spread your eggs over a few baskets instead, and then drop one, you only break a few eggs. By spreading your eggs, your decreasing the risk that you lose them all. 

You may have heard diversify, diversify, diversify when it comes to investing. It basically means: spread your eggs (assets) over as many different baskets (investments) as you can. If you do this, you’re creating a diversified asset portfolio. 

The great news is that spreading your assets over a very diverse set of investments dramatically reduces your risk, without sacrificing your expected rate of return. 

Suppose we have 5 companies: A, B, C, D, E. They all sell shares at €10 per share, with an expected yearly return of 10%. And let’s say you have €100 to invest.

You could put your full €100 to buy 10 stocks in company A. Your expected rate of return is 10%, because all shares have an expected return of 10%. Cool. But if company A goes bankrupt, you’ve lost all your money. Quite a risky endeavor, if you ask me. 

What you could also do is buy 2 shares in each of the 5 companies. Because all shares have an expected rate of return of 10%, your expected rate of return is 10% - the same as when you put all your money in company A. However, if company A now goes bankrupt, you only lose €20, aka 20% of your money. For you to lose all your money, would require all 5 companies to go bankrupt. That’s much more unlikely. So spreading out your money over the 5 companies doesn’t cost you any profits, but it dramatically reduces the risk of you losing your money.

Conclusion: having a diversified asset portfolio is therefore a very, very good idea.

Don’t try to beat the market

You’ll hear many people who spend a lot of time on managing their investments, because they try to outsmart the market and choose investments that have a relatively high rate of return compared to the risk. I’m not one of these people.

If there’s one thing I’ve learned in my finance economics classes, is that it’s been proven over and over again that even the financial ninja’s find it hard to do better than the market overall, over a long period of time. The media portrays a different picture - showing people who’ve gotten insanely rich by picking “the right stocks”. But they don’t report on all those people who choose “the wrong stocks”. And they don’t report on those winners if the lose all their wins the next season.

Instead of trying to beat the market, pick an asset portfolio that is a good reflection of the market. Diversify, diversify, diversify - and then all you have to do is make sure you keep your portfolio up to date by doing a touch up every year or so. You do not need to monitor and trade assets on a daily basis. Did you know that trading assets costs money? If you do this frequently, not only are you trying to do something that’s near-impossible (beat the market), but your also spending a lot of money on transaction fees - money that could instead have worked for you and earning a profit in your assets portfolio.

Know what you invest in

It may be tempting to let someone else handle your investments. Many banks offer a service like this. All you have to do is say how much risk you’re comfortable with, and they’ll take care of the rest. Okay, I’m simplifying things but this is what it boils down to. Even if you do this, I think it’s very important that you understand where the bank is putting your money towards, and why they think it is high/medium/low risk. Also, you’d want to know how they spread out your assets across and within asset categories, aka how much they diversify your portfolio.

Don’t invest money that you can’t afford to lose

Because investing is not risk-free, don’t invest money you can’t afford to lose. What that means will look different for everybody. If you have kids, a mortgage, and the only savings you have is €5,000 for example, perhaps it’s better not to risk losing this financial buffer. Just think carefully: what if I lose all this money? In what kind of situation would I be in then? If that’s a very undesirable situation, don’t invest.

See - investing is not as complicated as some people like to make it seem. You now know the basics already!

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