What is investing and why is it important in the long term?

Simply put, investing means putting your money to work by investing it, hoping it will become more valuable. Instead of putting all your savings in a bank account at a low interest rate, you can buy a share (piece of ownership) in a company or provide a loan to a government or company (bond), for example. You do this because you expect your investment to grow in the future – the share may increase in value or pay dividends, and the bond pays interest. Investing is therefore a way to build wealth for later, such as for the purchase of a house, for your pension or to achieve financial goals.

It is especially important in the long term because time is a powerful ally when investing. Due to compound interest, money you invest grows exponentially as the years pass. A small amount that you invest now can grow into a substantial amount over the decades, precisely because any profits are repeatedly reinvested and generate new profits again. In addition, inflation plays a major role: prices of products rise over time, which reduces the purchasing power of idle savings.

In the Netherlands, savings rates have often been lower than inflation in recent years, which means that the real value of money in a savings account can decrease. Investing can help counteract this, as it has historically provided a higher average return than saving. For example, the broad stock market (such as the S&P 500 index in the US) has achieved an average return of around 6–7% per year over the long term, significantly more than the interest on a savings account. Although investments can fluctuate (or even fall) in the short term, the chance of a positive result increases the longer you give the investment time.

How does investing work and what are the benefits?

When you invest, you buy assets – things with value, such as shares, bonds, real estate or funds – with the aim of gaining financial benefit from them. So you invest your money in something that you expect to increase in value or generate income in the future. How does this work in practice? Suppose you buy shares in a company. The company can use that money to grow or make a profit, and as a co-owner, you benefit: the share price can rise, so you can sell at a profit later, and some companies periodically distribute profits in the form of dividends. Or take a bond: you lend money to, for example, the Dutch State or a company, and receive a fixed interest (coupon) for this. In both cases, your money potentially yields more money.

The advantages of investing lie mainly in achieving a higher return than with saving in the long term. Historically, healthy companies increase in value as the economy grows, and as a result, stock markets grow with it. You "put your money to work" – while you study, work or sleep, the market can grow your investment. A well-known advantage is beating inflation: because you make a return, your capital retains its purchasing power or even grows, despite everything becoming slightly more expensive every year. In addition, you benefit from diversification and economic growth: for example, if you have a basket of dozens of different shares (e.g. via a fund or ETF), most economic blows in one place will often be compensated by growth elsewhere. Investing also makes it possible to share in company profits worldwide – something you would otherwise not have access to as an individual saver. Finally, starting to invest early, even with small amounts, can yield great benefits thanks to the long investment horizon. Someone who invests a monthly amount at a young age can build up considerable capital over the years purely through the effect of reinvestment and time.

Of course, there are also risks associated with investing – prices can go up and down. The money you invest can increase in value, but also decrease. You mainly see this in the short term: the stock market has good and bad days (and occasionally some longer periods). However, an important advantage of a long-term approach is that temporary declines often recover in the long term, especially if you invest broadly. By remaining calm and not panicking and selling at every dip, you increase the chance of a good final result. In summary, investing works as follows: you invest money in various sources, let time do its work, and reap the benefits of economic growth and compound returns in the long term.

What are stocks and bonds, and how do they work?

Shares and bonds are the two best-known forms of investment. For beginners, it is important to understand exactly what these entail, because they form the building blocks of many investment portfolios.

• Shares: A share is proof of partial ownership in a company. Think of it as a company being a cake or pizza that is divided into pieces; each piece is a share. Once you buy a share, you become a co-owner of the company for that piece. If the company is doing well – for example, because it is making a profit or growing – you will benefit. The value of your share may increase, so you can sell it for more later. In addition, the company may decide to distribute part of the profit to shareholders in the form of dividends (a kind of “bonus” in cash or extra shares). For example, if you own a share of Shell or ASML and the company achieves good results, you will usually see the share price rise and you may receive a dividend. But be aware: if the company does less well, the price may fall and you, as a shareholder, run that risk. Shares offer the highest return on average in the long term, but also have greater fluctuations in value in the short term.
• Bonds: You can see a bond as the opposite of a share: instead of becoming a co-owner, you become a lender. It is in fact a loan that you give to a government or company. When you buy a bond, you lend a certain amount for an agreed period, in exchange for regular interest payments. At the end of the term, you (in theory) get your borrowed amount back. Because you usually get your deposit back and receive interest in the meantime, a bond is considered a more defensive investment than a share. The risk is lower: unless the party to whom you have lent goes bankrupt (which is very unlikely with, for example, the Dutch government), you will get your money back plus interest. The downside is that the expected return is also lower than with shares. Bonds are therefore often used to bring stability to a portfolio. As an example: the Dutch State regularly issues government bonds; if you buy such a bond, you will receive, for example, ~2% interest annually, and at the end of the term you will get your original investment back.

How do these work together in practice? Many investors opt for a mix of stocks and bonds in their investments. Stocks for long-term growth, and bonds for stability and a steady income stream. When stock prices fall, bonds often (but not always) retain their value better, and vice versa. By diversifying across both categories, you can find a balance between risk and return that suits you.

Other investment options: gold, real estate, funds, ETFs and pension investments

Besides stocks and bonds, there are many other ways to invest. Diversification across multiple investment categories can further reduce risks. Here are some popular options:

• Gold and other precious metals: Gold has been seen as a 'safe haven' for assets for centuries. People invest in gold (or silver, platinum) because it retains its value in times of economic uncertainty or high inflation. You can buy physical gold (for example, gold bars or coins) or invest in a gold fund that tracks the price of gold. Gold does not give interest or dividend, but the price can rise if demand increases or if people seek protection against inflation. In the Netherlands, you can buy gold through specialized dealers or online brokers that offer gold ETFs. The same applies to silver and other commodities: they are tangible assets that can be useful as insurance in your portfolio, but they do not produce income themselves.
• Real estate: Investing in real estate means investing in “stones”, i.e. houses, apartments, offices or retail properties. Real estate can be attractive because it offers two sources of income: rental income (if you rent out the property) and potential appreciation of the real estate itself. Many people think of buying a second home to rent out when it comes to real estate investment. That is possible, but requires a lot of capital and comes with practical concerns (maintenance, finding tenants, etc.). An easier way is through real estate funds or REITs (Real Estate Investment Trusts) – these are investment funds that invest in a portfolio of real estate projects. You are then effectively buying shares in such a fund, and sharing in the rental income and value development thereof. This way you can invest in real estate with smaller amounts, without having to manage a property yourself. In the Netherlands, for example, there are listed real estate funds in which you can participate through your investment account.
• Investment funds: An investment fund is a collective pool of money from many investors that is managed by a fund manager. The fund invests that money according to a specific strategy. This can be anything: some funds invest worldwide in shares, others only in bonds, or in specific sectors (technology, sustainable energy, you name it). If you buy a participation (share) in a fund, you own a piece of the entire mix of investments that the fund has. The big advantage is diversification: with one purchase you indirectly invest in tens or even hundreds of different securities. In addition, the fund manager takes the work off your hands: he/she decides which shares or bonds are bought and sold. You do pay costs for this (the management costs of the fund). An active investment fund tries to beat the market by making smart choices; we will come back to this later when discussing active vs. passive investing.
• ETFs (Exchange Traded Funds): An ETF is similar to an investment fund, but has an important difference: ETFs usually passively track a specific index and are traded on the stock exchange like a share. For example, consider an ETF that tracks the AEX index (the 25 largest listed companies in the Netherlands) or one that tracks the S&P 500 (500 large American companies). Instead of a fund manager actively choosing, an ETF simply copies the composition of an index. This also gives you broad diversification, but often at lower costs than active funds. ETFs are popular among novice investors because they are simple, transparent and inexpensive. You can invest in an entire market in one go via an ETF. In the Netherlands, you can buy ETFs from almost any broker or bank; for example, an MSCI World ETF with which you invest in thousands of shares worldwide in a diversified manner. ETFs therefore offer an easy way of passive investing (more about this in the next section).
• Pension investing (annuity): In the Netherlands, it is possible to invest specifically for your pension with tax benefits. This can be done via a pension account or annuity account with a bank, asset manager (Vive for example) or a broker. The idea is that you deposit money into a special account that is intended for your pension; you will receive income tax back (within certain limits) on that deposited amount or you do not have to pay it. That money is then invested, often in a mix of shares and bonds that suits your age and risk profile. Your assets then grow through investments, gross (without paying tax on returns every year), and on your retirement date you take it out in the form of an annuity payment, which you then pay tax on. The advantage is therefore tax deferral/benefit and the investment return. Many Dutch people invest in this way for an extra pension in addition to their employer's pension. By the way, realize that you are probably already investing for your pension through your employer: pension funds invest your deposited premiums in large investment portfolios to allow them to grow for later. Pension investing under your own management (via an annuity, for example) is additional and especially interesting if you have a pension shortfall, want extra money for later or if you do not accrue an employer's pension as a self-employed person. It is a relatively safe and smart way to invest long-term, because you don't need the money until your retirement age anyway and you benefit from tax benefits.

Active versus passive investing

An important topic for novice investors is the difference between active and passive investing. This concerns the question of whether you are trying to be smarter than the market, or move with the market.

• Active investing: This involves trying to achieve better results than the average market through research, analysis and timing. An active investor (or fund manager) chooses specific stocks or other investments that he/she thinks will perform better than others. An active investor also often tries to enter and exit the market at favorable times (market timing), for example, selling just before an expected fall or buying before an expected rise. The idea is therefore: to pick out the winners and avoid the losers, in order to achieve a higher return than “just holding everything”. Active investing sounds attractive – who doesn’t want to beat the market? – but in practice it turns out to be very difficult. You have to constantly monitor the economy and companies, make analyses and sometimes dare to intervene. Moreover, you make more transactions, which entails transaction costs, and active funds charge higher management fees. Many studies have shown that only a small proportion of professional investors manage to consistently outperform the broad market after costs. In other words, most stock pickers and expensive fund managers achieve less return in the long term than simply the market average, precisely because of these costs and timing risks. Active investing can be fun and educational as a hobby (and some people beat the market for short periods), but it brings extra risks and uncertainty.
• Passive investing: This means that you do not try to beat the market, but to follow it. For example, you buy an index fund or ETF that represents an entire index, and you hold it for a long time. Instead of looking for the new Apple or the next Amazon, you actually buy a piece of all the big companies at the same time. Passive investing is also called “index investing” or “diversification”. The big advantage is that it is simpler and usually cheaper: you don't have to follow the news daily or do balance sheet analyses, and the costs of index funds/ETFs are low. By spreading widely, you also reduce the risk that one wrong choice will cause your entire assets to plummet – after all, you only have a small stake in each company. Although passive investing does not select the top winners in the market, it also does not completely avoid the big misses; you get the average of everything. But surprisingly, that average is often very good in the long term. In fact, because actively managed investments lag behind due to costs and errors, passive funds on average appear to deliver better returns than active funds over the long term. So with passive investing you may not beat the market every year, but you get the market results – and historically the trend of markets is upward. For most people (especially beginners), passive investing is a sensible strategy: it takes less time, it is calmer (you don't have to get in and out all the time) and the return is often very competitive. A saying in the investment world is: “Time in the market beats timing the market” – in other words, simply staying in the market (letting time work) usually beats trying to time it. Passive investing embodies that principle.

Finally: start simple and be patient

Investing doesn't have to be rocket science. This explanation has shown the basic principles: buy pieces of the economy, spread your risk, give it time and don't be fooled by daily fluctuations. Whether you are a student starting with a small amount per month, or a working adult who sets aside part of their salary – the most important thing is to start and learn through experience. If necessary, start with a small amount that you can afford to lose, so that you become familiar with how it works. You will notice that as you understand the terms and movements, investing can be quite interesting and even fun, especially when you see how your money can grow for you.

Always keep in mind that investing is a long-term process. There will be good years and less good ones, but by persevering, diversifying your investments (preferably many passive index investments for peace of mind) and not trying to time every move, you will steadily build a financial safety net. This is how you work step by step on your future wealth. Good luck with your first steps in the investment world – hopefully you now have a better grasp of the basic concepts, and remember: every great oak was once an acorn that was planted!