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How Do Investments Make Money?

By Sylvia Kwan

You may have heard that investing has historically been a good way to earn more money over the long term than by simply saving up. And that could be brilliant news for your long-term goals — things like retiring or building wealth.

How Do Investments Make Money?

Soooo … how does investing work, exactly? And how might it make you money? Good questions. Here’s a quick rundown of the most common types of investments and what they do.

The most common types of investments

Most investment portfolios are composed primarily of two things: stocks (aka “equity”) and bonds (aka “fixed income”).

Stocks

When you buy a company’s stock, you actually own a very small slice of the company itself, and you can call yourself a shareholder. Most stock is “voting” stock, which means you’d be able to vote on big decisions like who’ll serve on the company’s board, aka shape the way the company is run — that’s why executives are so concerned about keeping shareholders happy.

The company might also share a percentage of its profits with shareholders — aka paying out dividends. For most shareholders, dividends aren’t guaranteed. Companies can choose to pay them if that year’s profits were good and they want to keep shareholders happy. This info’s usually shared by the company via press release after they finalize their income statements.

The value of a share of stock is a reflection of how much investors think the entire company is worth. So if a company is estimated to be worth $10 million and there are 1 million shares of stock in existence, each share would be worth $10. (This is a simplified example because there are often different levels of stock you can buy for a single company, but that’s the gist.)

Bonds

When you buy a bond, you’re doing something very different. Instead of owning a piece of a company, you’re actually loaning your money to the company over a period of time. Whoever issued the bond (like the US government, for example) promises to pay you back after that time, along with regular interest payments along the way. That’s why you’ll often see bonds called “fixed-income” securities.

How investments can earn you money

When the value of your investments goes up

You can earn money when your investments increase in value. For example, a stock’s market price won’t stay the same price forever — ideally, the company grows and makes money, and it becomes more valuable overall. Then, because that total value gets spread across all the company’s shares, the market price per share usually goes up.

For example, let’s say the market price of company X’s stock is $5, and you buy ten shares of it. The value of your investments is 10 x $5 = $50. But then let’s say company X performs well, and its stock is now selling for $6. Well, you still own ten shares of it. That means the value of your investments is now 10 x $6 = $60.

You only paid $50 originally, so if you were to sell those shares, you’d have $10 more than you started with. That means you’ve earned $10 in returns.

When you get paid because you own the investment

You can also earn money from an investment by collecting payments. For stocks, those payments are usually dividends.

For bonds, you get those interest payments we mentioned. Let’s say you buy a bond for $100 that pays 3% interest for 10 years. Each year, you’d be paid $3. At the end of ten years, you’d get your $100 back and have received a total of $30 in interest.

Then, the money you’ve made could make you even more money

That’s thanks to compounding returns, which have historically been super powerful. Basically, when you invest your money, it hopefully earns returns, and then the returns you’ve earned can also earn returns of their own. This can also go the other way during down markets, but over the long term, markets have historically trended upward. Here’s a more in-depth explanation of how compounding works.

Ellevest invests in stocks and bonds using ETFs

At Ellevest, instead of purchasing stocks and bonds directly, we almost always invest online clients’ money in exchange-traded funds (ETFs). An ETF is a big pool of many different investments, and you can own and trade shares of an ETF similar to the way you can own and trade stocks.

So if your Ellevest investment portfolio is made up of 89% stock and 11% bonds, that almost always means 89% of your funds are invested in ETFs that contain stocks, and 11% of your funds are invested in ETFs that contain bonds.

ETFs can pay dividends, too. When you invest online with Ellevest, payments like these will go into your Ellevest account, and then we’ll reinvest that money when we rebalance your investment portfolio. That helps to give your portfolio a boost without you having to really think about it, which, again, has the potential to be great for your bottom line over the long term thanks to compounding returns.

Another nice thing about ETFs is that they come with built-in diversification — because they’re composed of a lot of different securities, there’s less of a risk that any one thing (like a company going under) will affect every single security in that fund. That makes investing in ETFs less risky than investing in a single security. ETFs also typically have low fees, which is good for your bottom line. Here’s some more info on how we build Ellevest portfolios (and why).

And here’s the good news

Stocks go up and stocks go down — like really up and really down. The “stock market” is is just the collective value of all the stocks investors own, so it goes up and down, too. In fact, the market’s biggest one-year gain since 1928 was 52.6%, and its biggest one-year loss was -43.8%. But. (And this is a big but.) The market has, on average, returned 9.7%. 10-year government bonds have returned an average of 4.9%. In comparison, the average savings account currently pays 0.09% per year. That’s why investing can help investors get to their goals faster than saving alone.

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Disclosures

© 2019 Ellevest, Inc. All Rights Reserved.

Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.

Past performance does not guarantee future results. Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

The practice of investing a fixed dollar amount on a regular basis does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.

Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

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Sylvia Kwan

Sylvia is the Chief Investment Officer of Ellevest. She researches and oversees Ellevest portfolios and develops the algorithms behind Ellevest’s investment recommendations.