How to Start Investing
One of the best ways to prepare for retirement is investing. Yet, almost half of Americans don’t have any investments. I’ve been learning about the stock market and actively investing for the past 10 years. So let me share with you what I’ve learned so far.
All you really need to start investing is internet access and some cash. There are tons of online brokers you can open accounts with and some of them don’t even have account minimums. Once you open your account, you can immediately start purchasing investments. I opened my first investment account while I was still in high school (and I accidentally opened my first IRA). The main barrier for most to start investing is actually understanding what to invest in.
Investing Basics
When you’re investing, there are 2 basic types of assets you can purchase: stocks and bonds.
Stock investing is what most people think of when they hear investing. But what exactly is a stock? At it’s core, a stock represents partial ownership in a company. Companies will sell stocks in order to raise money for other business operations.
Once the company receives funds from the sale of their stock, the company doesn’t directly benefit from it anymore. But they still have an incentive to grow the value of their stock. A higher stock price is advantageous since companies can continue to sell stock and add more to the market to raise more funds. Also, the performance of their stock price is often correlated with the performance of the business. If the stock is performing well, creditors will be more willing to provide financing to the company at lower interest rates.
Your partial ownership as a shareholder allows you to participate in shareholder conference calls and cast votes on various aspects of the business. However, unless you have a large investment in shares, your vote won’t count for much since there will be others who have larger investments and more votes.
Owning a company’s stock is a statement that you believe the company will do better tomorrow than it does today. By being a part owner in the company, you get to reap the benefits of the business’s success. If the company does well, they may start paying a dividend or increase it if they already have one. A dividend is a payout of the profits the business makes to its shareholders. Dividends are typically paid on a regular schedule such as quarterly or semi-annually. Dividends are expressed as a ratio of the annual dividend payment to the stock price, which is referred to as the yield. For example, if a company pays $0.25 per share on a quarterly basis and the share price is $100, their dividend yield would be 1%. If you owned $1000 of this company’s stock, by the end of the year you would have received $10 simply for being a shareholder.
Another way to benefit from the company’s success is an increase in the value of their stock. Company share prices are dependent on their financial performance. If a company does well and you purchased their stock for $100, their share price may increase to, say, $120. You could then sell your stock and make a 20% profit.
The second type of asset is bonds. Bonds are another way for companies or governments to raise money. Bonds are loans sold to investors with a specific coupon and maturity date. The coupon is the interest rate that you receive on your loan to the company. Before financial transactions were electronic, bonds were often physical certificates that had tabs for interest payments. These tabs, referred to as coupons, were taken to the bank or company and exchanged for the interest owed. Even though bonds no longer have the physical coupons, the term coupon is still used to refer to the interest rate a bond provides. The maturity date is the date when you will get the amount loaned back.
For example, say you have a 5 year $1000 bond with a 3% coupon. To purchase this bond, you would pay $1000 today. Every year for the next 5 years, you would get paid $30 and at the end of the 5 years you would get your $1000 back. So by purchasing the bond, you would make $150 over 5 years.
After bonds are initially issued by companies/governments, they can be sold and purchased just like stocks. The difference is that the purchase price is dependent on the bond issuer’s credit rating, the coupon, and the maturity date.
Investing Costs and Risks
It’s not all rainbows and sunshine when it comes to investing. As the saying goes, “it takes money to make money.” Though you can likely find an online broker who will allow you to open an account with no minimum, they are still likely to charge you trade fees, which can range from $4-$10. You’ll have to pay these trade fees each time you buy or sell an investment which can quickly eat into your returns. Robinhood is a mobile-only app that allows you to trade commission-free, but they don’t offer as many research tools as other online brokers, which can be helpful when first starting out.
Investing also has risks. There is the chance that the stock you purchased languishes in price and the company never pays out a dividend. Or worse still, the company goes bankrupt and your stock/bond is then worthless, causing you to lose your entire investment.
Generally speaking, bonds are considered lower risk investments than stocks. If a company goes bankrupt, bonds will be paid off if possible as part of the bankruptcy proceedings whereas stocks won’t be worth anything. With bonds, you know exactly what you’re getting. Stocks have more volatile pricing since it’s more dependent on the performance and public perception of the company. It’s not uncommon for individual stocks to rally up 5% in a single day and then lose 10% the next day. This volatility can be difficult for some to bear.
The best way to mitigate the risk of losing your investment is to diversify your holdings across stocks, bonds, different companies, and different sectors. That way, if one of your investments performs poorly, it only has a small effect on your overall portfolio. You could do this by purchasing lots of different stocks and bonds. But choosing individual stocks and bonds is difficult even for professionals. So unless you’re really willing to do a lot homework to learn about markets and financial reports, you’re better off staying clear of purchasing individual assets. Luckily there’s an easier way. Let’s take a look at other options besides individual stocks and bonds.
Mutual Funds
Mutual funds are portfolios managed by professional money managers. You can buy and sell shares for mutual funds the same way that you can for stocks. The mutual funds use cash from sold shares to purchase other investments. The types of investments the mutual fund purchases are specified in the prospectus. Mutual funds bundle investments based on all different types of criteria. Examples include funds that concentrate on the best energy stocks or funds attempting to find undervalued bonds. There are even mutual funds geared towards specific retirement dates. Each of these funds is actively managed by a portfolio manager in an attempt to provide adequate returns using the clients’ cash. By purchasing a share in mutual funds, you’ll be instantly diversifying your holdings since the mutual fund will already be made up of several different investments.
There are a few downsides of mutual funds that you should understand before purchasing. Many mutual funds have minimum investment requirements, which can be a barrier for many people. There can also be additional transaction fees each time you purchase or sell shares on top of the trade fees you pay your broker.
Finally, every mutual fund has what’s called the expense ratio. This ratio is the annual cost that you will pay to have your investments managed by the money manager as a percentage of your invested value. You won’t see it deducted as a transaction. That’s because the expense ratio is deducted daily directly from your returns. For example, say you invested $10,000 in a fund that has a 1% expense ratio. Your investment may end the year up 6% to $10,600. But that 6% return is after the expense ratio. If you instead created the exact same portfolio on your own, you would have made an extra 1% return so your investment would be worth $10,700. 1% may not seem like a lot but it adds up over time and the expense ratio is taken regardless of the performance of the mutual fund.
ETFs
ETFs or Exchange Traded Funds are another type of investment you can make that is less risky than individual stocks or bonds. ETFs are similar to mutual funds in that they are portfolios that you buy into. The difference is that ETFs follow a specific index of the market. Market indices are hypothetical portfolios that represent different segments of the market. For example, the Standard & Poor’s (S&P) 500 index is a common index used for the broad stock market. It consists of 500 stocks handpicked by employees at S&P Dow Jones Indices, the company that maintains the index. ETFs then actually create the portfolios based on these indices, which have shares that can be bought and sold.
Like mutual funds, ETFs have fees associated with them but the fees are often much lower. This is because market indices don’t often change, so portfolio managers have an easier time managing ETFs based on them. ETF expense ratios can range from 0.05% to 0.75% while expense ratios for mutual funds can be as high as 1.5%. Lower fees mean higher returns for you!
Creating Your Portfolio
Now that you understand some of the basics of investing, you can start looking at what exactly you want to invest in. For the majority of people, I suggest using ETFs to invest in a mix of stocks and bonds. The exact makeup of your portfolio will depend on your objectives. Are you primarily looking to generate income? What kind of timeline are you looking at? Questions like these play into the type of portfolio you should put together.
There are a few general strategies that can be used for every portfolio. The first is that you should diversify your investments. Investing into ETFs and mutual funds is an easy way to diversify across different companies and markets. If you plan on picking your own stocks and bonds, you’ll want to diversify across different companies. You should also diversify between stocks and bonds since each will act differently in various market conditions. Many investment professionals advise allocating no more than 75% of your portfolio to a single type of asset. Diversifying mitigates the risk of a single mistake hurting your portfolio.
You should also be using some form of dollar cost averaging. Dollar cost averaging in its purest form is purchasing the same dollar amount in an investment on a regular schedule regardless of the performance. Instead of trying to time your investment purchases, you always buy the same dollar amount. This means during the down times, you’ll purchase more shares/bonds whereas when the investment is going up, you’ll purchase fewer. This helps you systematically follow the idea of buying more when the price is low and buying less when the price is high. While dollar cost averaging can be difficult for the average person, you can put into practice the act of investing on a regular schedule regardless of the market.
With those strategies in mind, you’ll want to ask yourself what your risk tolerance is. Risk tolerance is how well you tolerate variability in your investments. If you’re okay with watching your investments lose value, knowing that you may gain that value back the next day, then you have a higher risk tolerance. On the other hand, if you don’t want to see your initial principle lose any value at all, then you have a low risk tolerance. Generally speaking, higher risk investments provide a greater possibility for higher returns.
As I mentioned above, stocks are generally riskier than bonds. In 2008, the S&P 500 lost 35% of it’s value! The Vanguard Total Bond Index (BND) ended the year 2008 about where it started and actually returned 4% when including dividends. But even though stocks have more volatile pricing, they have historically outperformed bonds. The S&P 500 has returned an average of 9.8% since 1928. Compare this to BND which only returned 3.9% over the past 10 years.
In addition to your risk tolerance, you’ll want to consider your time frame. If your time frame for investing is 10 years or longer, you can plan on weathering some ups and downs from the market knowing that you won’t need your investments for awhile. So a portfolio tilted more towards stocks may be appropriate. On the other hand, if you’re saving for a down payment a few years down the line, you may want to trade the possibility of higher returns for more stable value in the form of bonds.
Starting out with investing can be intimidating at first. But putting in the effort now to understand financial markets can (literally) pay dividends in the future.
