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August 3, 2021

Analogies to better understand investing

 Investing can be scary for those who are new to it, including getting your head around the many concepts used when discussing financial markets. 


But don’t worry — getting across the basics is much easier than it may first appear. Here are some super simple analogies that can help you get across some key investing terms.



 


Don’t put all your eggs in one basket 


When you physically put all the eggs you have in one basket, you are then at risk of dropping the basket, losing everything. Alternatively, you should put some eggs in one basket and some in another. Meaning, diversify your investment. Do not just invest in one asset. Imagine you put all your hard-earned money in Bitcoin, then the next day the price crash… 


  


Snowball effect 


Compound interest is another concept that can be a bit challenging to understand. It’s usually explained as interest that’s calculated on the initial principal amount, including all of the accumulated interest of previous periods of a deposit or loan. 


If you don’t want to get confused by what it means, it might help to think about compound interest as being like a snowball rolling down a ski field — it builds and builds as it rolls. 


Here’s how it works. Imagine you have $100 with an annual interest of 10% compound interest. Your interest at the end of Year 1 will be $10 but the overall value is $110. The next year the interest will be $11 and you have $121 in your bank account. We can keep going: 


End of Year 3: $121 + $12 = $133; $12 yearly interest earned

End of Year 4: $133 + $13 = $146; $13 yearly interest earned

End of Year 5: $146 + $15 = $161; $15 yearly interest earned 

As you can see, with compound interest the total amount quickly gathers momentum, just like a snowball rolling down a hill. 


 


Growing a plant 


From the snow to the garden, when it comes to the concept of  Money cost averaging, it can be helpful to think about it like growing a plant. 


An investment strategy, Money cost averaging involves making regular investments over time, for example, $100 every month, regardless of market conditions. This strategy can be smart because the short-term moves of the market, which can be volatile, are less important using this strategy given it’s based on a regular investment plan. 


Like the regular care you need to give a plant to make it grow, consistent MOney cost averaging can be an effective way to make your investment reach its full potential. 


  


Collecting seashells 


Want to understand why some news can impact the stock market? It’s all about perception. And, although it may not seem like it at first glance, it’s a bit like collecting seashells at the beach. 


At the beach, there are shells of many different colours and there’s no reason that one type of shell should be more valued by beachgoers than other types. But what if everyone starts collecting purple shells, and no one considers the other colours? 


In that case, the value of the purple shells is likely to go up, despite nothing intrinsically having changed about the shells themselves — it’s all about how they’re perceived. 


So, when it comes to the stock market, remember that moves in prices are often about market anticipation and perception, rather than changes in the underlying companies themselves.