Investing is the act of putting money to work with the expectation of receiving more back in the future. That is the entire concept in one sentence. Everything else is detail.
This article explains the basic mechanics: what you are doing when you invest, where returns come from, and why accepting uncertainty is part of the deal. It is designed to be a starting point, not a comprehensive guide.
This is general educational information, not personal financial advice.
Two Ways to Put Money to Work#
At the most fundamental level, there are two ways to invest: ownership and lending.
Ownership means buying a piece of something. When you buy shares in a company, you become a part-owner of that business. You share in its profits (if there are any) and its growth (if it grows). You also share in its losses and declines. The value of your investment depends on how the business performs and how other investors value that performance.
Lending means giving someone else the use of your money in exchange for interest. When you buy a bond or put money in a term deposit, you are lending to a government, a bank, or a corporation. They pay you interest for the use of your money, and (usually) return the principal at the end. Your return is more predictable, but it is also typically lower.
Most investments fit into one of these categories, or a combination of both. Shares are ownership. Bonds are lending. Property can be both (you own an asset that may appreciate, and you may receive rental income). Understanding which type you hold helps clarify what you are exposed to.
Where Returns Come From#
Investment returns come from two sources: growth and income.
Growth (also called capital gains) happens when the value of your investment increases over time. If you buy a share for $50 and sell it later for $70, the $20 difference is growth. This is not guaranteed. Prices can fall as well as rise.
Income is money paid to you while you hold the investment. Dividends from shares, interest from bonds, rent from property. Income provides a return even if the price of the asset does not change.
Different investments offer different mixes of growth and income. Some assets (like growth-oriented shares) reinvest profits rather than paying them out, aiming for higher capital appreciation. Others (like bonds or income-focused shares) prioritise regular payments. Neither approach is inherently better. They serve different purposes.
The Risk-Return Trade-Off#
Here is a pattern that holds across most of investing: assets with higher expected returns tend to come with higher uncertainty.
This is not a flaw in the system. It is the system. If an investment offered high returns with no risk, everyone would buy it, the price would rise, and the returns would fall until the relationship balanced out.
Historically, shares have delivered higher long-term returns than bonds, and bonds have delivered higher returns than cash.¹ But shares have also been more volatile. There have been years where share markets fell 30% or more. There have been periods lasting years where returns were negative. The higher expected return is compensation for accepting that uncertainty.
This trade-off is not precise. It does not mean that every risky investment will pay off, or that safe investments are always inferior. It means that, on average, over long periods, bearing uncertainty has been rewarded. Whether it will be rewarded in any specific case is unknowable in advance.
What Diversification Does (And Does Not Do)#
Diversification means spreading investments across different assets, sectors, or regions rather than concentrating in one place.
The logic is straightforward. If one company fails, owning shares in many companies means the failure affects only a portion of your portfolio. If one country's market struggles, exposure to other countries provides a counterbalance. Diversification reduces the impact of any single bad outcome.
What diversification does not do is eliminate risk entirely. Diversified portfolios still fall in value during broad market declines. Owning shares in 500 companies does not protect you if all 500 decline together, as they often do during recessions or crises.
Diversification reduces concentration risk (the risk of being wiped out by one bad bet) but not market risk (the risk that markets as a whole decline). Both types of risk exist. Diversification addresses one of them.
Why Returns Are Uncertain#
If returns were certain, investing would be simple. Everyone would know what to expect, prices would adjust accordingly, and there would be no edge to gain.
Returns are uncertain because the future is uncertain. Companies can fail, economies can contract, technologies can shift, and sentiment can change. No model perfectly predicts what will happen. This uncertainty is what creates the opportunity for returns above the risk-free rate.
Accepting this uncertainty is not reckless. It is realistic. The question is not whether uncertainty exists, but how much of it you can tolerate given your time horizon, your financial situation, and your temperament.
A Simple Mental Model#
Here is a way to hold all of this together:
- Investing is putting money to work in exchange for expected future returns.
- Returns come from growth and income, depending on the asset.
- Higher expected returns come with higher uncertainty. This is the trade-off.
- Diversification reduces concentration risk but does not eliminate market risk.
- Uncertainty is permanent. It is the reason returns exist.
This does not tell you what to buy or when. But it provides a framework for understanding what you are doing when you invest, and why the outcomes are not guaranteed.
Summary#
Investing means putting money to work through ownership (shares, property) or lending (bonds, deposits), with the expectation of future returns. Returns come from growth (price increases) and income (dividends, interest, rent). Higher expected returns are generally associated with higher uncertainty, a relationship known as the risk-return trade-off. Diversification reduces the damage from any single bad outcome but does not protect against broad market declines. Uncertainty is not a problem to be solved. It is the reason investing offers returns at all.
Sources#
- Dimson, E., Marsh, P., & Staunton, M. (2020). Credit Suisse Global Investment Returns Yearbook 2020. Credit Suisse Research Institute. (Long-term historical returns across asset classes)