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What is an investment?

Anyone who makes an investment invests capital. The term alone does not define what exactly the capital is invested in. The use of capital is therefore essential for an investment. The term "investment" is derived from the Latin word "investire", which translates as "to clothe" or "to equip". Applied to the world of finance, "invest" refers to the process of providing a company with external capital, for example through direct capital investment or the acquisition of shares or bonds. Typically, such financial investments can be paraphrased as capital investments or just investments.

Traditionally, financial investments are associated with a fund, which is why investors also speak of investment funds. The invested money is called fund assets, which are managed by a fund manager of the respective fund company. However, investments are also the purchase of shares in a company, the investor participates in the company through the purchase of shares and is thus entitled to profits, thus collecting a profit distribution, which is called a dividend. The yield thus achieved is referred to as the dividend yield.

Achieving a yield

In addition to dividends, investors also hope for price increases in their stocks, which in turn depend on the current market environment and the respective company's performance. However, a financial investment can also be the purchase of bonds. Bonds often yield interest, which depends, among other things, on the credit rating of the country or company issuing the bond. The interest payment (coupon) is also based on the maturity of the bond, which is generally considered the more defensive investment compared to stocks. The overall goal of investors is to achieve an attractive return on the capital invested.

Put money to work for you

If you make an investment and collect interest, you can make your money work for you through the so-called compound interest effect. A prerequisite for the compound interest effect is a reinvestment of the income at the same interest rate. The collected interest is not deducted from the investment process but instead reinvested. That means that the capital basis from which the interest is paid keeps increasing.

The longer the term of an investment, the stronger the compound interest effect just described. There is a similar effect with dividends. If they are reinvested, the capital basis for reinvestment also increases significantly over time. Germany's leading index, the DAX, is a dividend index where dividends are automatically reinvested in the index. Over the long term, dividend payments in the DAX account for one-third of the increase in value.

Comparison of investment forms:

  • Investments require a capital investment; investors demand a positive return on their capital investment.
  • The return on a financial investment such as stocks and bonds consists of dividends and interest, respectively.
  • Long-term investments benefit from compound interest when the returns are reinvested.
  • Saving hardly yields any returns in a low-interest environment, while stocks are suitable for long-term investing in such an environment.
  • Trading requires active action and usually leads to numerous transactions

Investing vs. saving and trading

Saving and investing are both ways of putting money aside for the future. However, saving is different from investing: Saving means putting money aside in safe but low-interest accounts. The investment horizon can be short- or long-term. However, in a low-interest rate environment such as the current one, long-term saving offers little chance of returns. Investing, on the other hand, is about building wealth for long-term goals such as a sufficient retirement. The investment horizon is often more than 10 years. The holding period is particularly important when distinguishing between trading and investing. Investment styles sometimes use similar investment securities such as stocks or ETFs. The frequency of transactions also differs. Active trading involves significantly more transactions, which is why a low-priced and qualitatively reliable broker is essential.

Three basic forms of an investment

Investing Shares are suitable for long-term investing
Saving is mostly done through bonds, overnight money or time deposits
Trading The time horizon for trading is short- and medium-term oriented.