How Do Investments Work? A Beginner's Guide

Why understanding how investments work is important

Knowing the basics of investing helps you make better financial decisions.

When investors understand how investments work, they are better equipped to:

• Spot opportunities
• Manage risk
• Understand returns
• Build long-term wealth

If you want to invest in global markets, this knowledge is even more important.

Saudi Arabia is an emerging market offering a variety of investment types, including Shariah-compliant assets. Coupled with the country's sovereign wealth fund, the Kingdom offers unique opportunities for investors.

With the importance established, let's define what investments actually are.

What are investments?

An investment is something you buy that has the potential to become more valuable in the future. You can make money from investments through an increase in value, regular income, or both.

There are many ways to invest, but the main options include:

• Shares: Buying a stake in a business.
• Bonds and sukuk: Lending money to governments or companies.
• Real estate: Buying property to earn rental income or benefit from rising property values.
• Funds: Investing in a ready-made mix of investments.

Related article: The Different Types of Investments Explained

How does investing work?

At its most basic, investing is simple.

• You put your money into one or more investments.
• Over time, your investments can earn you money.
• You can choose to reinvest your earnings or take them out, depending on your goals.

Keep in mind that all investing comes with some risk. You might not always make money, and sometimes you could end up with less than you started with.

The different ways investments generate returns

You can earn returns in different ways, depending on what you invest in. Some investments even give you a mix of returns.

Capital appreciation

Capital appreciation, or growth, means that something you own becomes more valuable over time. It's the difference between what you paid and what you sell it for later.

For example, if you invest $10,000 and later sell your investment for $20,000, you've made a $10,000 capital gain.

Shares in companies and real estate investments often make money through price appreciation. Other types of investments can also grow in value this way.

Income generation

Some investments pay you regular income. These include:

• Dividends: A portion of a company's profits paid to shareholders.
• Interest: Money you earn from things like bonds, sukuk, or even a savings account.
• Rent: Money you get each month from renting out homes or business properties.

Investments that pay regular income are popular with people who want a steady cash flow.

Compound growth

If you reinvest your income or gains, your portfolio can grow faster. Instead of taking out your earnings, you use them to buy more investments.

Interest-paying assets, like savings accounts, benefit from compound interest. This means you earn interest on your original amount and also on the interest you've already earned.

Both of these approaches create a snowball effect, helping your money grow faster over time. Try our calculator below to see how compound interest can boost your savings.

Understanding risk

Every investment comes with some risk. Risk means your investment could lose value or earn less than you hoped.

Different types of investments have different levels of risk. Usually, investments with higher potential returns also have higher risk.

Several factors can influence risk, such as:

• Market volatility
• Economic conditions
• Interest rate changes
• Political or regulatory developments

Emerging markets like Saudi Arabia can offer strong growth opportunities, but they also come with more uncertainty than mature markets.

Once you know how much risk you're comfortable with, it can help you make better investment decisions. While you can't get rid of risk completely, there are ways to reduce it and reach your goals.

One of the main ways is to spread your money across different types of investments, which is called diversification. This way, if one investment does poorly, it won't hurt your whole portfolio as much.

Learn more: 6 Investment Strategies to Maximise Growth and Manage Risk

What is return on investment (ROI)?

Return on investment (ROI) is a measure of how profitable an investment is relative to its cost. Simply put, ROI shows how much money you gained or lost compared to what you first invested.

Investors use ROI because it's a simple way to see how well an investment is doing. It helps them:

• Measure the success of an investment.
• Compare different investment options.
• Evaluate the effectiveness of financial decisions.

How to calculate ROI

The return on investment formula is simple and widely used in finance. It's shown as a percentage, using this calculation:

Return on Investment (ROI) = (Net Profit ÷ Cost of Investment) × 100

There are two main parts of the ROI calculation to understand:

• Net profit: The total gain minus the initial investment cost.
• Cost of investment: The amount you first put in.

Here is a simple example.

You decide to invest $10,000 in an asset and later sell it for $15,000.

• Net profit = $5,000
• ROI = (5,000 ÷ 10,000) x 100

So, the return on investment in this example is 50%.

Factors that influence investment returns

How well your investments perform and the rate of returns you get usually depend on several factors, not just one. Many things can affect how your investments grow over time.

Market conditions

Stock markets, such as the Tadawul in Saudi Arabia, are influenced by news, global events, and government policies. These factors can cause prices to rise and fall, and if investors lose confidence, prices can change quickly in the short term.

Time horizon

Investing is a bit like a rollercoaster; it's full of ups and downs. Dips are to be expected, and the length of time an investment is held can play a major role in its potential returns.

Short-term investments usually react more to market changes. Investments held for longer can ride out the ups and downs and benefit from compounding returns.

Economic factors

Economic growth, inflation, and interest rates all affect how investments perform. These factors can cause markets and asset values to rise or fall.

For example, when the economy is strong, companies often earn more, which can push asset prices higher. On the other hand, recessions can slow down investment growth.

Asset allocation

Asset allocation is the process of dividing your money among different types of investments. Getting the right balance can have a big impact on how your portfolio performs.

A balanced portfolio might include:

• Equities for growth
• Bonds for stability
• Real estate investments or alternative assets for diversification

In the end, how you spread out your money affects both the risk and growth potential of your portfolio.

Fees and costs

Investment fees can slowly reduce your returns over time. These fees may include:

• Fund management fees
• Brokerage commissions
• Transaction costs

As an investor, always keep fees in mind.

Key takeaways and conclusion

Learning how investments work gives you a strong foundation when you're starting out.

Some key points to remember:

• Investing involves allocating money into assets that may generate income or increase in value.
• Investors typically earn returns through capital appreciation, income payments, or both.
• Balancing risk and return is crucial to success.
• Return on investment (ROI) measures profitability.
• Several factors influence how your investments perform.

If you're ready to take the next step, talk to a regulated investment adviser for expert advice.

Holborn Assets is a leading global financial service provider and one of the few Western investment companies licensed in Saudi Arabia. We offer tailored financial solutions and specialise in the expat market.

Start building your financial future. Get in touch with us today to see how we can help.