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How Does Investing Work?

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, buying a house, or general wealth-building.

A line graph, a bar chart, a pie chart, a stack of cash. Illustration.

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.

What is investing?

Investing is the practice of contributing your money (or capital in general) toward a larger asset, pool, fund, business, or project. 

The hope is that that asset, fund, or project will grow in value, in which case your piece of the pie will grow, too — which would mean profit or income for you. That said, the opposite can also happen, particularly in the short-term — you may lose part or even all of the value of your investments if and while the asset, fund, or project shrinks in value.

The most common types of investments

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

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 pay 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. They usually share this information 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 from buying stocks. Instead of owning a piece of a company, you’re actually loaning your money to the company (or government) 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.

Alternatives

An alternative investment is any sort of investment that doesn’t fall into any of the other portfolio categories (stocks, bonds, and cash). They can range from things like commodities (ie raw materials that have value, like gold) or real estate to venture capital and collectible art. These have become increasingly popular lately because they help diversify a portfolio — their successes or failures aren’t dependent on the same factors as, say, the stock or bond market.

Assets like crypto or NFTs

(These are technically alternatives, but since they’re such a popular trend right now, it’s worth talking about them specifically.) “Investing” can feel like a bit of a misnomer when it comes to assets like cryptocurrency, NFTs, and similar nontraditional assets — “gambling” might fit better. Technically, the action is the same, but the results can be a lot more unpredictable. Take crypto: When you purchase a set amount of a cryptocurrency, you do so with the hope that it will go up in value over time, but the difference is, crypto doesn’t have any underlying asset (like real estate) or cash flow (like a company) to back it up. That makes guessing what will happen next even more impossible than it is with other types of investments (which is already pretty darn hard, tbh). Plus, it isn’t regulated in the same way that stocks or bonds are. This means your crypto investments are much more vulnerable, as we’ve seen this year with brouhahas like FTX, to things like scams and fraud. At Ellevest, we categorize these kinds of “investments” as high-risk and recommend you only invest money that you’re willing to lose.

How do you (hypothetically) make money investing?

When the value of your investments goes up

You can earn money on your investments when they increase in value. For example, a stock’s 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 (excluding taxes).

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 your investments earn 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

When you invest online with Ellevest, instead of purchasing stocks and bonds directly, we almost always put your 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).

Investing can work where saving falls short

Stocks go up and stocks go down — like really up and really down. The “stock market” is just the collective value of all the stocks investors own, so it goes up and down, too. In fact, the S&P 500’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 9.6% a year. 10-year government bonds have returned an average of 4.8% a year. In comparison, the average savings account currently pays 0.23% per year. That’s why investing can help investors get to their goals faster than saving alone.

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Disclosures

© 2023 Ellevest, Inc. All Rights Reserved.

All opinions and views expressed by Ellevest are current as of the date of this writing, are for informational purposes only, and do not constitute or imply an endorsement of any third party’s products or services.

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

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 past performance is not predictive of future results.

Ellevest, Inc. is a SEC registered investment adviser. Membership fees and additional information can be found at www.ellevest.com.

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Sylvia Kwan

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