Why invest?
Investing can feel intimidating, but the basics are simple. Learn what investing really means and how the return-on-return effect grows your money over time.
You probably have a rough idea of what investing means — but let's start with a quick explanation. When you invest, you buy something you believe will increase in value over time, with the aim of selling it at a profit. You can invest in all kinds of things, from property to barrels of oil. Most people invest in stocks and bonds.
Stocks | A stock is a small ownership stake in a company. As an investor, you benefit when the company's share price rises, and you lose out if it falls. |
Bonds | A bond is essentially a loan to a company or government. As an investor, you receive interest on that loan, and you can also sell your bonds — sometimes at a profit. |
You'll learn more about shares and bonds in module 2.
What makes investing interesting?
The potential for positive returns
The goal of investing is to grow your money over the long term. You're hoping for a positive return — meaning your investments have increased in value and can be sold at a profit. Unfortunately, returns can also be negative, meaning your investments have lost value and you'd sell at a loss.
The potential for positive returns is what makes investing appealing — particularly because investing typically offers higher returns over time than leaving the same amount sitting in a savings account.
The return-on-return effect
There's something else worth knowing. If you reinvest the returns you earn, you start generating returns on your returns — causing your money to grow exponentially. This is known as compound interest.
Here's an example:
A simple example assuming 10% return every year
Value at year start | 10% return | Value at year end | Return-on-return | |
|---|---|---|---|---|
Year 1 | €100 | €10 | €110 | €0 |
Year 2 | €110 | €11 | €121 | €1 |
Year 3 | €121 | €12.10 | €133.10 | €3.10 |
Year 4 | €133.10 | €13.31 | €146.41 | €6.41 |
Year 5 | €146.41 | €14.64 | €161.05 | €11.05 |
Explanation of Fig. 1
- At the start of year 1, you invest €100. That year, you achieve a 10% return, earning €10 — leaving you with €110 at the end of the year.
- You leave that €110 invested and head into year 2. Again, you earn 10%, this time making €11 — ending the year with €121. The return-on-return effect has already earned you an extra €1.
- In year 3, you start with €121. Another 10% return earns you €12.10, bringing your total to €133.10 — with €3.10 attributable to the return-on-return effect.
- This continues through years 4 and 5, and you'll notice the amounts generated by the return-on-return effect keep growing. Your money compounds because your returns are themselves being reinvested.
One important note: this is a simplified example to illustrate the concept. In practice, you'll never earn a neat 10% every single year. Returns vary — sometimes high, sometimes low, and sometimes negative.
Warren Buffett and compound interest
Even legendary American investor Warren Buffett has credited the power of the compound effect. He once said: "Time is your friend; impulse is your enemy. Take advantage of compound interest and don't be captivated by the siren song of the market."
Investing with a goal — or just seeing what happens?
The primary reason to invest is the return you can generate. Keep in mind:
Takeaways:
- Investing means buying something in the hope it will increase in value over time
- Investments worth more than you paid for them have generated a positive return
- Investments worth less than you paid have generated a negative return
- Thanks to the return-on-return effect, your invested money can grow exponentially