What does investing mean? A beginner’s guide
October 28, 2022
Defining the concept of ‘investment’ is not just a matter of economics: it is about goals, time and risks. Profit is only a possible consequence of a well thought-out strategy. So, let’s try to understand what investing means: we will find different definitions, one for each type of investor.
The meaning of investing
Money is the economic core of society: fiat money is a medium of exchange and unit of account, but above all a store of value. Preserving your spending capacity (or purchasing power) is essential to maintain desired standards of well-being. However, if we ask whether it is better to invest or save, we will find out that accumulating money is not enough to protect the ‘value of money’. To counter its erosion, in the event of inflation, saving must be accompanied by conscious investment.
Thus, we have a first definition of ‘investment’: to generate profit from the capital at your disposal, so as to compensate for the devaluation of the currency caused by rising prices. According to another definition, investing also means multiplying your assets and increasing your income. When this is achieved, the ‘wealth cycle’ begins: constant income increases savings (cashflow), which in turn provides new liquidity to invest, and investment closes the circle by generating new income.
Investing has a strong operational component, so let’s define the most common practices for conscious investing.
This word is not chosen at random: awareness in personal finances is fundamental to finding the right direction for your particular case. If you know your financial situation, your risk profile, and have goals, you will have already found your purpose. Let’s now understand how to achieve this awareness in 3 steps.
1. Define your objectives: why do you want to invest?
As we have seen in the two definitions in the first paragraph, investing can have different meanings, depending on the investor’s purpose and approach to finance. Do you simply want to preserve the value of your capital (purchasing power), or improve your lifestyle? Many people want to create a supplementary pension plan for themselves, a source of income for when age prevents them from working. Building capital for your children, generating liquidity to pay off debts, obtaining a steady income to fulfil your desires, what does investing mean to you?
2. The time horizon: short, medium or long-term investments
To achieve your goals, you will have to define the actions to be taken considering the time you have available. Time is a precious resource and in order to make use of it, we must place the objectives and corresponding actions along a realistic and functional time horizon:
- Long-term (or period) investments – the longest time horizon, the lower end usually being recognised at 5 years. As long-term investments, the minimum duration is of no particular relevance: the projection is into the distant future, it can span a lifetime!
- Medium-term investments – a period of 2 to 5 years: apart from personal perspectives, variability depends on the maturity of the securities purchased. This duration should encompass an entire market cycle, i.e. a complete swing between the upswing (bull market) and downswing (bear market) phases.
- Short-term investments: an interval of no more than 2 years, more specifically an average duration of 12-18 months. This does not exclude much shorter periods, monthly or even daily, as in some forms of trading (day or swing).
The upstream definition of objectives and time horizon is important because it moderates the influence of psychology on investing. It counteracts panic and FOMO by learning more about behavioural finance.
3. Risk appetite
Let’s turn to the human side that defines investment. The market is made up of real people: each investor has his or her own goals and will have to oppose those of others or find compromises to achieve them, as is reflected in the law of supply and demand. However, not everyone applies awareness to investing: this is one reason why the market is often unpredictable and not behaving as it logically should. The unpredictability of the market translates into risk, a factor we need to start being aware of and recognise.
The golden Rule
‘Only invest what you are willing to lose’. Study and strategy, unfortunately, are not enough to ensure success, although they are an advantage.
Everyone is characterised by a different risk appetite, i.e. the ability to bear the uncertainty associated with investment. There are two main aspects that define your risk profile:
- Risk capacity – an objective estimate, a mathematical calculation that returns how much an investor can actually lose without changing his or her standard of living.
- Risk tolerance – a subjective quality, indicates the psychological ability to bear an economic loss. Any investor, subjected to price pressure, may lose his or her lucidity. Critical market conditions make emotional and, ironically, even riskier behaviour likely.
Defining your risk profile is fundamental to understanding what kind of investor you are and the financial instrument best suited to you. Each asset class has an intrinsic level of risk, according to its economic nature: financial instruments can be distributed in a ‘risk pyramid’.
Choosing the right instrument for your risk profile must take into account the time factor and your goals. As in a balance, if your time is limited but your goals are ambitious, the solutions to achieve them will inevitably be risky. This is because returns and risks are directly proportional: the highest gains are accompanied by great unknowns, while safe profits are always of minimal value.
The intersection of goals, time and risk defines the investment: find your personal balance between these variables to discover what kind of investor you are!
What does investing mean for you?
We can identify 4 types of investor, derived from the alignment of specific financial instruments, risk levels and time horizons. The categories are indicative. Each investor is autonomous in his or her choices, but it is likely that he or she can be aggregated to one of 4 classes: let us analyse them together to explore what investing means in practice.
The most common economic actor is the ordinary saver who seeks to protect the value of his capital. The ‘Basic’ investor has little time to devote to studying the market and above all, does not have the tools to do so. Therefore, they seek solutions that can delegate the management of their money to third parties, at low cost and minimising risk. ETFs are the right tool for this category: passively managed funds that replicate the performance of a market index, simply by holding the underlying securities.
Diversification within Exchange Traded Funds (ETF) moderates risk by distributing capital among various financial products, but this depends primarily on the instruments that this ‘economic box’ contains. Equity ETFs are riskier than bond ETFs, for instance. A ‘Basic’ investor, therefore, might choose an ETF or safe haven assets, commodities such as precious metals, or invest directly in these assets. The ‘Basic’ investment is medium- or long-term, to give the market time to resolve cyclical crises.
The ‘Comfort’ investor does not have time to monitor market trends, but accepts a higher risk than the ‘Basic’ investor. The ‘Comfort’ investor usually relies on mutual funds, which differ from ETFs in that they actively manage money. In a nutshell, they buy and sell securities on the market in search of profit: this activity is riskier, but could achieve higher returns than the reference index (benchmark).
Experts manage their capital autonomously, investing in financial instruments such as shares, bonds and government securities, or commodities (such as oil or agricultural products), or the real estate market. These financial instruments have different levels of risk, but it is in the ‘Expert’ investor’s interest to limit loss opportunities by diversifying and thus mediating between return and risk.
Expert investors participate in the market themselves, so they have to study a personal investment strategy. This is why the time horizon is variable, as is the choice between asset classes.
Trading is by far the riskiest form of investment: the trader spends a lot of time on technical analysis to anticipate market movements. However, trendlines, supports and resistances, or the other tools used do not predict the future, they can only make assumptions based on past trends. The trader has the possibility of high returns by making bold or counter-trend choices, but the chances of losing the entire ‘prize’ are high.
Strategies usually aim to generate high profits in a short time by participating in the forex market, buying alternative assets, such as cryptocurrencies, or investing in start-ups. Derivatives can protect against the risk inherent in trading: you can invest both on the upside and the downside with margin trading.
There are derivatives with much more complex mechanisms, adopted not for protection but as very profitable and equally risky investments. Hence, derivatives are present at every level of the risk pyramid.
If you have recognised yourself in one of these combinations, you should have understood what investing means, at least for you. If not, find your own formula: these are only guidelines, you are allowed to try alternative ways. The only rule is DYOR: find your own definition of investing.