Investing can be smart. Seeing your money working for YOU feels ‘hallelujah’ good. You can even earn money from your investments. But how does that work? There are basically 3 ways to make money with investing and it is important to understand the differences. We briefly explain the three different ways.
1. The value of your investment increases
You can make money when your investments increase in value. For example, the market price of a stock will fluctuate over time – ideally, the company grows and makes more money, increasing its stock value overall. Since that total value is then distributed among all of the company’s stock, the market price per share would increase to reflect the company’s value.
Suppose the market price of Company X’s shares is €5, and you buy ten shares of it. The value of your investments is then 10 x 5 €50. Let’s assume Company X is doing well and you can now sell these shares for €6 each. So you own ten shares, which means that the value of your investments is now 10 x 6 = €60.
You paid €50 when you bought it, so if you sold those shares now, you’d have €10 more than you started with, meaning you’ve earned €10 in returns.
2. Dividend or interest
Dividends are a company’s profit that is given to shareholders of a company. Thus, shareholders are rewarded for their investment in the company. Dividends are basically nothing more than a reward for the shareholder for his confidence in the company. There are usually two conditions that companies must meet in order to pay dividends over the long term. First, companies need to make profits that they can distribute to shareholders, because without profits, there is often no money to pay the dividend. Duh! The second condition is that the company has no other, better goals for the money.
The most common form of dividend is payment in cash. When paid out in cash, shareholders receive an amount for each share they hold in the company. Companies can also choose other rewards for shareholders.
You can also receive interest on investments, such as bonds. Bonds are loans that you provide to a company or state, and in exchange for that loan you receive interest. With shares you are co-owner of a company, whereas with a bond you help the company by giving them money, a loan.
With bonds you will receive a coupon. Let’s say you buy a bond for €100 that pays 3% interest for 10 years. Every year you will be paid €3 in interest on your loan amount. At the end of ten years you will also get your €100 back (it is a loan after all) and you will therefore receive a total of €30 in interest.
3. When your money becomes a money machine
Your money will become more money, that is the secret behind investing. How can this be? This is due to the so-called compound interest effect. Albert Einstein called this mathematical effect: “Compound interest is the eighth wonder of the world. He who understands it earns it; he who does not, pays it.”
Historically, compound interest has been incredibly powerful. When you invest your money, it will hopefully yield returns, and then the returns you’ve earned can produce their own returns as well. Of course, this can also go the other way during bear markets, but in the long run, the markets have been on an uptrend*.
* from 1900 till 2017 the stock market grew 8% on average each year. It never had a drop it didn’t recover from.
Compound interest: an example
But how exactly does this work? Well, like this:
Suppose you invest €100 and the return in year 1 is 5%, then your €100 will be worth €105 after year 1.
So in year 2 you start with € 105 and the return is 5% that year too. Then your money will not grow to € 110, but to € 110.25. A small difference, but that difference is going to change your life. Take a look at the numbers below if you continue this example:
Year 1: €105 / Year 2: €110.25 / Year 3: €115.76 / Year 4: €121, 55 / Year 5: €127.63 / Year 6: €131, 1 / Year 7: € 137.66 / Year 8: €144.53 / Year 9: €151.76 / Year 10: €159.35
Even small amounts like €100 have become worth more than €60 more after 10 years. And every year the interest on your investment that you receive is higher.
Imagine that you invest an amount every month, for example €100, and you do this for 20 years, with an average of 8% return on investment. You invest €100 x 20 years x 12 months a year = €24.000. But because of compound interest your end result is not €24.000, but €59.308. More than double the initial investment!
In short, there are 3 ways in which your money can increase and become more money. Please note: investing always involves risk. Historically, there is a very good chance that the value of your investments will increase, but you can never be 100% sure. That is why we say again: a healthy savings account, no debt and only invest with money that you only need in the long term.