Introduction to Investment Theory

There are a few concepts that you're going to have to master - eventually - but you don't have to do that right away. For now, just browse through this brief description of what they are. We'll be coming back to them often as we move through the rest of the lessons.

The most basic concepts of investing are:

• risk
• time
• compound interest
• asset allocation
• cost

Risk. If you choose not to invest, and instead seek the safety of a savings account, there’s a cost. By not keeping up with inflation, you’ll lose purchasing power. Your monthly living expenses will be increasing faster than the value of your savings, so you’ll be getting poorer as time goes by.

The only way to stay ahead of inflation is to invest your savings in things that pay a rate of return that’s higher than the inflation rate. Stocks, bonds, real estate, gold, artwork, collectibles, and many other types of investments (also known as asset classes) have the potential to grow in value at a faster pace than the inflation rate

But the critical difference between saving and investing is that investing involves taking risk with your money. There is always a chance that you could lose part or all of your investment. It’s this possibility of loss that accounts for the additional return that these asset classes offer to investors. It’s called the ‘risk premium’ in economic parlance. The investor’s job is to make sure that the risk premium they receive is high enough to justify the amount of risk they are taking.

Time. All investors are ‘up against the clock.’ The critical point is the date in the future when you stop contributing to your investments, and begin to live off of them. Economists call these two time periods the ‘accumulation phase’ and the ‘distribution phase.’ The amount of time you have until your distribution phase begins is the single most important consideration in how you invest.

Compound Inerest. Albert Einstein famously said that compound interest is the most powerful force in the universe. Compound interest means that the interest you earn each year gets added to your account, and from that point forward, it begins to earn interest. Interest on interest. Very powerful. And as time goes by, the interest on interest begins to snowball, until you end up with very large profits in the later stages of your investing career.

Asset Allocation. This key investment concept refers to the way you choose to spread your investments among the various asset classes that we described above. An example of a simple (but very effective) asset allocation scheme would be 60% stocks and 40% bonds. The benefit of splitting your money between different asset classes is that it reduces the total amount of risk you’re taking. This happens because stocks and bonds move up and down at different times (usually). So when the stock market is going down, the bond market is often going up. The money you are losing in your stock allocation is partially offset by the money you’re making in the bond allocation.

Cost. It’s very easy to underestimate the impact of costs on your investing results. But a quick review of the arithmetic is revealing. For the typical investor, an average rate of return is about 6% per year. That same investor typically pays about 3% per year in commissions, fees, and other expenses. While 3% doesn’t seem like a very big number, it’s half of the profits you’re making on your investments. That’s the equivalent of leaving a 50% tip every time you go out to dinner. A sharp and knowledgeable investor will be able to reduce the cost of investing to 1% or even less. The impact on long-term results is very significant.

If you are a beginner investor, there are a few things you’ll need to get started: A low cost brokerage account, an asset allocation scheme, and a simple investing plan. We're going to cover each of these things in more detail as the lessons progress.