But what actually is investing?
Investing is allocating an amount of money, your notional or principal amount, to assets with the expectation of making a profit. You may put money into the stock market, into bonds, cryptocurrencies, or (virtual) property, all with the hope that what you buy today can be sold at a higher price later. When investing, in theory, the entire notional amount you invest is at risk, meaning you may lose all of it. Investments can create better returns than (risk free) savings accounts, especially with interest rates at near zero.
So, what are very common and liquid (meaning you can buy and sell quickly and easily) assets to invest in? Bonds and stocks.
Bonds. What are they?
Bonds are loans issued by governments or businesses (the borrowers) for any period from 1 to 100 years. The borrower pays the lender (you) an interest on the issued loan. This interest payment is called a coupon and is paid at regular intervals. Investors in bonds will have to assess the credit status of the borrower before buying its bond. The better the credit status of the issuer, the lower the risk for the buyer. The credit standing of a borrower is expressed as a rating, ranging from AAA (best) to CCC, not unlike school grades. The ratings are provided by independent, impartial, agencies.
But a low risk also means a low coupon. For example the German government (rated AAA) pays you a 0.0% coupon on a 10 year bond; the UK government (Rated AA) pays a coupon of 0.25% and your mobile phone company Vodafone (Rated BBB) a coupon of 5.9%, all for the same 10 year period (expiry 2032). Vodafone is clearly a higher risk than the German government and hence needs to pay up to attract investors. Buyers of Vodafone bonds may think a 5.9% annual interest is worth that risk.
Bonds can be bought and sold easily, like stocks. Although a bond coupon is fixed, its price is not. If a coupon is 5.9%, like Vodafone’s and interest rates in the UK are 0.25%, do you think the price of the Vodafone bond – set at a 100, called ‘PAR’ at the time of issue – today is worth more than a 100 or less? Would you buy it?