There are just three ways that an investment can make money: by lending to someone who pays interest; by buying shares and thus becoming part owner of a business; or by buying something like gold or real estate, which can be expected to rise in value.
When you buy shares in a business, your profits and losses can be large depending on how the business does.
Buying shares makes you part owner of a business. Of course, the share is too small for you to have any say in how the business is run, but the financial rewards (on a per-share basis) are the same as any other owner.
When the business pays out part of its profits as dividend, then as part owner you get your share. When the business becomes more valuable (the price of its shares increase), then your wealth increases. Like any business owner, you can decide to sell off all or some of your share or keep them for future gains.
The future gains could be in the form of dividends or a further increase in the value of shares. Conversely, if the value of the share goes down, you could lose money. If the business starts doing very badly, you could lose a large chunk of your investment.
A very different form of making gains is to lend money to someone. Note that unlike with shares, we didn't say 'lend money to a business'. Instead we said 'lend money to someone'. That's because you could be lending not just to a business, but even to a government or some other entity. When we say lending, it includes activities that you may not normally think of as a loan.
Lending just means giving someone money and getting interest income in return. For example, depositing money and getting interest on it is lending. When you make a deposit in a bank (it could be a fixed deposit or a savings account), you are lending money to the bank. When you make a post office deposit or PPF deposit, you are lending to the Government of India.
However, the scope of gains is sharply limited compared to investing in shares. When you lend to a business (by making a bank deposit, for example), your gains are limited to the interest rate that the business has agreed to pay you.
No matter how successful that business may become, you are not going to get more than that. Of course, the risks are limited too. In most kinds of deposits, the risk of losing money or not getting your interest is rather limited. So the rewards are predictable and so are the risks.
In the third kind of investment, the risks and rewards are the easiest to understand. You buy something; if the price goes up that's great and if it goes down then you lose money.
In terms of actually choosing an investment from the three, the complexity is of a different scale. Equity is more complex than the others. There are literally hundreds of companies whose shares you could buy from the stock markets and it's not easy to make right choices. Fortunately, there are ways of making the right choice easily.
Asset rebalancing must be the most useful and yet the most ignored of ideas in the world of investing. However, it's actually quite easy to implement, especially for mutual fund investors, so that it's worthwhile to carefully understand the concept and see whether it can be worked into your portfolio.
Asset rebalancing means investing with a target in mind, in terms of how much of your investments should be in debt and how much in equity. Since the two won't rise in tandem, the 'rebalancing' part involves periodically shifting money from one to the other in order to stay on the target.
It's far better to do this on a rule-based principle. That way, you are not forced to make a subjective judgement of when is the right time to decide that a certain percentage of your investments should be in fixed income and the rest in equity.
For younger investors, the fixed income proportion could be as low as ten per cent, but it shouldn't be zero. For those with a more conservative approach, it could be higher. Retirees could have another approach.
Asset rebalancing means that instead of seeing the equity-vs-fixed question as a black-vs-white binary choice, you should be seeing it as a shade of grey. Once every year or so, you could 'rebalance' your portfolio. What this means is, if the actual balance has veered away from your desired one, you should shift money from one to the other in order to attain that percentage again.
When equity is growing faster than fixed income - which is what you would expect most of the time - you would periodically sell some equity investments and invest the money in fixed income so that the balance would be restored. When equity starts lagging, you periodically sell some of your fixed income and move it into equity.
This implements beautifully, the basic idea of booking profits and investing in the beaten down asset. Inevitably, things revert to a mean, and that means that when equity starts lagging, you have taken out some of your profits into a safe asset. Overall, this kind of rebalancing takes care of keeping at least some part of equity gains safe.
Some readers would have seen the fly in the ointment, or rather, two flies. One is the amount of monitoring or work required; and two, the tax implications. Both are easily taken care of by not doing all this yourself and using a balanced fund instead. Balanced funds do all this automatically without building up any tax liability.
If, however, you are doing your asset rebalancing on your own, make sure to not do it too often. Once every year is usually adequate.