Investing 101
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Invest your money.
You've probably heard that before. But what is the buzz all about? And how do you even get started?
Welcome to Investing 101.
In this post I will cover
- What is investing?
- Investing key terms
- Types of accounts
- How to begin investing
- Five rules to follow
Investing is about making your money work hard for you. Let's dive in.
Investing Overview
What is investing?
So what is investing all about?
You may have heard of investing in the stock market. But let's step back for a moment and define it in a broader sense.
Investing is the act of spending money, time or effort today with the expectation of benefit in the future.
So it’s about today and it’s about the future.
It applies to a number of things.
Investing in your health means spending time and effort now, with the expectation of sustained future health. You eat kale and salmon today and anticipate a longer life because of it.
Investing in yourself means putting in money, time and effort now to improve yourself in the long term. Typically this means education. Getting a college degree is a huge investment. You sacrifice a lot in the short term but expect it to pay off over time.
Companies invest in their employees when they train them. They spend a lot of money up front with little initial return. In the future, however, they expect the employees to use their newly acquired skills and earn more money for the business.
Finally, there's investing in the traditional personal finance sense. It means putting your money into something today, expecting a future, monetary return. That "something" could be stock in a single business, a bond, a mutual fund, real estate, or anything of the sort.
Usually when I talk about investing, it's this last one. It's about putting your money somewhere so it can grow and work for you.
That’s what investing is all about.
Is Investing Gambling?
Okay, now that we’ve defined investing, let’s answer this question.
Maybe you've heard it before, or maybe you're thinking it. Investing sounds like... gambling?
Don’t worry, it's not. And here’s why.
First, gambling is time-bound. If you play the slot machine, you know the outcome right away. If you bet on a baseball game, then once it's over, you have your payout.
But investing is timeless. In most cases, you can keep a stock as long as you like. You buy it at a certain price, and your payout is only decided when you sell it.
Second, investing involves an expectation of future return. It's more than a possibility, it's an expectation. You can control the risk you take, and the expected return is typically positive.
Gambling is all chance. The expected return on your bet is negative, and there's nothing you can really do to reduce risk. (Sure, arbitrage bets do exist but they're very difficult to find and execute). It’s a losing game.
So gambling is not investing, and investing is not gambling. Both of them involve risk, but not at the same levels. And in the long term you stand to gain way more from investing.
Why should you invest?
You should invest to turn a little money into a lot of money over time.
When following certain guidelines (that I’ll get to in a bit), you can grow your net worth with minimal risk.
With the power of compounding interest, your money grows substantially. You can see this using the Time Value of Money Calculator. Assuming a conservative 6 percent return on the stock market, $10,000 becomes $20,000 in 20 years.
That’s quite a bit of growth. It’s something you can’t get just by saving.
A savings account is good for short-term goals and emergency funds. But the return on a high-yield account is only 1 to 3 percent. You can do much better over time in the stock market.
Money in a savings account tends to lose value over time, since inflation outpaces the interest rate. But money in investments typically gains value over time, since the rate of return is much higher.
So for long-term goals, you should invest. It can be a relatively safe way to grow your money.
"If you don't find a way to make money while you sleep, you will work until you die." - Warren Buffet
Investing is how you make money while you sleep.
Overall, you should invest to prepare for the future. You should invest to meet your long-term financial goals. You should invest so that you can make your money work for you.
Is investing complicated?
Are you still with me? I know this has been a lot already. And many people think investing is just plain complicated.
But it’s not, I promise. It's really only as complicated as you want it to be.
It can be as easy as buying a fund and not touching it for 30 years. Or you can be more involved, buying and selling on a regular basis. That is up to you, and you can earn great money with either approach.
Investing Key Terms
Here are some key terms related to investing. You’ve probably heard of some of them before.
Warren Buffet said he doesn’t invest in anything he doesn’t understand.
You don’t have to know the ins and outs of everything. But knowing these key terms will give you a good foundational knowledge of what you can invest in.
Interest Rate (Rate of Return)
The interest rate is the percentage return you get from investing. It is usually expressed as an annual rate.
For example, your stock may be worth $110 today. Exactly one years ago, it was worth $100. Your rate of return for that year was 10 percent.
The idea of compounding interest means that you earn interest on interest. Say that you invest $100 with an annual interest rate of 10 percent. You don’t just earn $10 each year. After five years, your investment will be worth:
100 x (1 + 0.10)^5 = 161 dollars.
Stock
A stock represents ownership in a company. A piece of stock is called a share.
You can buy stock in any publicly traded company. Disney, Apple, Amazon, and Walmart are examples. When you buy a share of Disney, you own part of Disney.
There are typically two ways you make money with a stock. First, you may receive dividends. That’s when the company decides to pay you a small amount - usually quarterly - based on their earnings.
Second, the stock value may appreciate. That means in the future, you can sell it for more than what you paid.
Bond
A bond is a loan to a government or corporation. You don't get any ownership with a bond - you are just loaning your money.
The issuer of the bond will pay you back the face value at a specified date (maturity date), plus interest payments (at a "coupon rate") over a fixed interval.
For example, you may buy a $1,000 bond with a 4% coupon rate and 10-year maturity date. Each year for 10 years, you will receive $40 in interest payments. After the 10th year, you will be paid the $1,000 back.
Bonds are generally safer than stocks but have lower returns. In your 20s, you might have 10% of your investments in bonds and 90% in stocks. The closer you get to retirement, the higher percentage of bonds you probably want.
CD
A CD, or certificate of deposit, is a timed deposit offered by banks. In exchange for a fixed interest rate, you deposit your money and can't touch it for a predefined period of time.
A CD is federally insured so there is almost no risk. But because they are so safe, the interest rates are lower than a stock or bond.
A CD is really more like a savings account, except the return will be slightly better, and you can't touch your money for the predefined term length.
Mutual fund
Mutual funds are a way of pooling your money with other investors to buy stocks, bonds, or other assets. You own a portion of the fund itself, rather than individual securities.
Mutual funds typically have a portfolio manager, who does all the hard work to make sure the fund performs optimally.
Because the fund is managed, there are some fees involved. The main one is the expense ratio, which averages around 1 percent. But the closer to zero, the better.
The fund usually includes hundreds of securities, so it’s diversified in itself. And you don’t really have to do any work - you can just buy it and hold it for the long-term.
For those reasons, mutual funds are a great, easy way to start investing. And they tend to do pretty well.
ETF
An exchange-traded fund (ETF) is similar to a mutual fund. It’s another way to pool your money with other investors. And like mutual funds, ETFs are a great way to diversify your portfolio.
ETFs are more passively managed than mutual funds, resulting in lower fees on average.
ETFs typically track a specific market index, and can be traded like stocks. They usually have lower investment minimums than mutual funds.
They’re another great, easy way to start investing your money.
Risk
Risk is the idea that nothing is certain with investing. You could always lose your money.
Strictly speaking, risk is defined as the chance that the actual return differs from the expected return.
But just because there is risk doesn’t mean you shouldn’t invest. There’s some risk in literally everything you do in your life.
Ben Franklin said the only things that are certain are death and taxes.
So investing is about managing risk.
Typically, with bigger risk comes bigger returns.
You could invest in a startup that will probably fail. But if it becomes the next Amazon, then you’re a multimillionaire.
Or you could invest in a U.S. treasury bond. There’s very little risk of losing your money, but you won’t gain too much.
In part, it comes down to how much risk you can tolerate. If you’re younger, you can probably afford a little more risk. You have more time to make up for any losses. But if you’re in or near retirement, you may tolerate less risk.
Portfolio
A portfolio is a collection of all the financial assets you have - stocks, bonds, mutual funds, etc. It can also include things like real estate and other investments.
Diversification
Diversification is a way of reducing overall risk. It means putting your money into a lot of different assets, so that, on average, your portfolio performs well.
It won’t do as well as your top-performing asset, or as poorly as your worst-performing asset. It will be somewhere in the middle.
Really, diversification is just a way of spreading your eggs across multiple baskets. It’s a good idea, unless you’re okay with losing all your money.
Brokerage
A brokerage is a firm that acts as a broker.
A broker, in the most basic sense, is someone who buys and sells things for you. An investment broker acts as a middleman between you and the other guy when dealing with stocks, bonds, or other asset types.
All you really need to know is that a brokerage is a place where you can invest money. The major brokerages are online. Charles Schwab, Vanguard, Fidelity, and AllyInvest are some examples.
Types of Investment Accounts
Retirement accounts
Retirement accounts like a 401(k) and an IRA are tax-advantaged accounts that help you save for retirement.
A 401(k) is an employer-sponsored plan, while an IRA (Individual Retirement Account) is something that you set up yourself.
With a Roth IRA, you pay taxes today, but you don't have to pay when you withdraw money in retirement.
With a traditional IRA, you have to pay taxes in retirement, but you can typically deduct your contributions from today’s tax bill.
Education Account
An education account is meant for saving for college. The most popular type of education account is 529 savings plan, which offers tax-free growth and withdrawals for qualified education expenses.
If you are looking for a 529 plan, you can open an account directly from your state, or you can go through many of the major brokerages.
Standard Brokerage Account
This is a regular investment account. If your goal is to invest money for use before you turn 59 ½, then this is probably what you want.
Your money is fully taxable in this account - it doesn’t have the benefits that retirement accounts do. But there are no rules on withdrawals like there are for an IRA.
Which One to Choose?
Okay, so you have all these options… which one do you choose?
Generally, I recommend investing in a retirement account first. That way you can reap the tax benefits.
Here's a good order of operations:
- Before you begin investing, make sure all your high-interest debt is paid off. The returns on investing won't outpace the interest rate on your credit cards.
- Contribute enough to get your employer's 401(k) match, if applicable. Don't pass on free money.
- Contribute more to your retirement accounts: 401(k) and Roth IRA. Contribute to a 529 plan if that's a priority for you.
- If you max out your retirement accounts and want to save even more, then invest in a standard brokerage account.
This is a good general guideline. Basically, it's usually best to put your money in the tax-advantaged accounts first.
How to Start Investing
Okay, now that you know what investing is all about, here are the steps to help you get started.
Determine what your goal is
What do you want to get out of investing? What is your ultimate goal?
Knowing this will guide your overall approach.
Here are some examples of possible goals.
- To simply get in the habit of investing. Maybe you don't have a lot of money, but you want to get started somehow.
- To save for retirement or financial independence.
- To save for college education.
- To take wild risks and maybe get lucky.
- To simply have more money in the long term.
Determine what kind of investor you are
Active Investor
You are an active, or hands-on, investor if you prefer to be in control of your investments. You like to trade stocks and funds yourself and be actively involved in managing your money.
You don’t want a robot to manage your money because you have knowledge that you want to take advantage of.
Passive Investor
You are passive, or hands-off, if you don't want to worry about choosing and trading the individual assets yourself.
You just want to contribute your money and forget about it. You don’t need to stress yourself out over constant decision making.
Maybe you don’t have time or just don’t like trading. You can still earn great returns with this approach - often better than those who actively manage.
If this is you, then could use a robo-advisor. Or you could just pick a couple of mutual funds or ETFs and then let them sit.
Get Started Investing
Acorns
If you’re a passive investor who just wants to get in the habit of investing, then Acorns is a great place to start.
Acorns is an app that lets you invest your spare change. You can round up purchases and invest the amount in an ETF.
Acorns helps you identify your risk tolerance, and then chooses a portfolio for you accordingly.
The basic plan costs $1 per month. This isn’t a lot. But it is if you only invest a couple dollars each month. So keep that in mind.
A robo-advisor takes care of all the portfolio rebalancing for you. So you hardly have to do anything. It’s a great place for beginners to start investing now.
Brokerage Account
If you’re looking to invest on a larger scale - say, thousands of dollars - then you probably want a brokerage account. You will have way more investment options with a brokerage than you will with an app like Acorns.
A brokerage is a place where you can make and manage your investments. There are many reputable firms you can choose from. Charles Schwab, Fidelity, and Vanguard are good options to look at.
Funding Your Account
With Acorns, your account links to your credit and debit cards. So your investments are funded every time you make a purchase. You hardly have to do any work.
If you open a brokerage account, you need to fund it to begin investing. Many accounts don't have a minimum. You can deposit money and purchase stocks, mutual funds, or whatever you desire.
Five Rules of Investing
Here are five general rules to follow as an investor.
Invest for the long term
Don't expect an immediate return. The stock market is volatile, meaning it goes up and down in the short term. Over the long run, on average, the market as a whole does go up.
So you want to play the long game.
If you need the money in three years, investing in the stock market isn't a great idea. The market could go down, and you won't have the dough. Consider a CD instead, where you're virtually guaranteed a predefined amount.
Keep emotion out of it
Humans are emotional beings, and it often affects how they invest.
They see their stocks go down in value. And afraid of losing more money, they sell them at a loss.
Don't fall into this trap. Hold on to your investments for the long term. The market will go back up.
Invest on a Schedule
If you invest for the long term, don't worry about market volatility. A good approach is to invest on a regular schedule.
Doing this monthly makes sense. Regardless of what the market looks like, just invest the same amount each month.
This both reduces risk and gets you in a constant habit of investing your money. And it helps keep emotion out of it.
Diversify your assets
As I’ve said above, diversification reduces your risk. It spreads your money across different things so that on average, you will do well.
Diversification protects you from any single disaster that could wipe away all your money.
Keep your costs low
The lower your costs, the better your money does.
Always pay attention to fees when choosing your investments. Account management fees, transaction fees, and expense ratios are a few things to ask about.
Thankfully, there are plenty of great low-cost options out there. It’s important to seek them out.
Wrapping Up
Are you still with me?
That was a lot of information, I know.
Hopefully, you now have a good understanding of what it means to invest, and why it’s important.
It’s about making your money work for you. And saving for long-term goals.
Are you ready to do so?