What exactly is investing?

April 10, 2018

As a financial planner, one of my biggest challenges was making sure people were realistic about their investment return expectations. I always tried to temper people’s hopes that I was providing a magic secret to making them rich, but many if not most potential investors continued to expect me to make them wealthy, even if they didn’t admit it. I think it is important, as you are learning about investing, to be able to define investing, in the most basic terms and gain a realistic expectation of what those investments are going to accomplish.

Investing is the act of committing money to an endeavor which will produce a rate of return, or in other words, will hopefully return to you more than what you put in. Investing generally starts with an idea. An entrepreneur takes that idea and begins to build a money-making venture but needs financing to get started or to expand and is willing to give up some ownership stake and some of the future potential profit.

An investor, on the other hand, is someone with some savings that wants to take a risk, but not in their own venture – they want to let the entrepreneur take the risk for them.


Based on this definition, any activity that you spend money on which has the potential to return to you more than you spent could be considered an investment. But, that return is not guaranteed. In finance, we think about stocks and bonds, or even real estate or gold. But there are other ways to invest money for the future. I think the best example is to further your education. Someone making $30,000 a year could spend $50,000 on a college degree. How long would it take to make back the $50,000? If the degree leads to a $20,000 a year increase in pay, you would make those funds back in 2 ½ years, and every dollar beyond that is pure profit. That sounds like a great investment to me.

Invest in yourself, or invest in someone else?

When deciding how to invest your money, you’ve got a choice, investing in yourself, or invest in someone else. If you have some money to invest for the future, I think this is the first question you need to answer. I often counseled business owners about the decision on whether to invest savings in the stock market, or use the money to expand their businesses. What would give you the lowest risk rate of return on your money. Almost always, by the way, the answer ended up to be to invest back into their businesses.

Any investment not related to furthering your education, or betting on your own ability turn a profit in business or real estate, is going to entail investing in someone else’s ability to accomplish the things that you cannot do yourself. That is the catch of investing. You are betting on someone else’s ability, not your own. If you invest in a start-up, you are placing your money and your faith in another person’s ability to create something new which will lead to profit. The business owner is willing to let you invest because they feel they can expand their business more rapidly by raising capital beyond what they can put up themselves. Maybe they need to build a factory, or a ship, or buy an airplane? What you need to remember is that business owner needs to get paid; the company that packaged the investment needs to get paid; the broker who pitched you on the idea needs to get paid; on and on.

What I am getting at is simple, all invests have fees and expenses. No one is going to work for free, and no one is going to try to make a profit for you out of the goodness of their heart. They want something from you and you need to ask yourself if you trust them to do what is in your best interest, or are they working for their own best interest.

You need to think about risk.

Go back to the college degree example above, just because you went back to school to get a degree, was the $20,000 a year in extra income guaranteed? Absolutely not and that is risk. One of my biggest challenges in representing investments was trying to explain to potential investors the reality of potential gain versus potential loss.

Everyone wants to know how much they are going to make. Honestly, I’m more interested in how much I can potentially lose. Small losses hurt you more than big gains help you.

I hear all the time that “the stock market averages about 10% annually”. Then, when planning, investors assume that they can get a consistent 10% return over time. Many investors convince themselves that risk in irrelevant, but they will repeat clichés to themselves such as “I’m a long-term investor”. Look at this simple illustration and think about how risk affected the actual outcomes of the investment.

I see people doing this all the time. The chart shows actual annualized returns for the S&P 500 for a recent 10 year period. I purposely picked a volatile period here to prove the point. If you add all 10 percentages up and divide by 10, you get a return of 4.94%. So inexperienced investors use 4.94% as their assumption on what they will get going forward.

The problem with this assumption is that the market is volatile. Returns come is large positives and negatives which change the actual result, in this case yields just $132,827 rather than $161,899, a real rate of return of just 2.88%, not 4.94%.

Another thing to consider is the emotional impact of how you would feel at various points on this 10-year time scale. Take the first year – the end of 2002. 12 months ago, you handed a broker $100,000 expecting to end up with around $105,000 based on historical averages. Instead you are sitting on $78,159. Are you really going to tell that broker, “it’s OK, I know it wasn’t your fault,” or are you going to search for a new broker? What about 2007 to 2008 where you went from $141,790 to $89,966? From your perspective at that time, you are 7 years in, and you are down over $10,000 overall. How are you going to react?

Investing always seems simple when you read a book, or you go to some seminar and the fast-talking presenter claims to have a system, or a way to beat the odds. Unfortunately, it’s never that simple, there is always risk and there are always fees and expenses that will affect your long-term results.