About 9 minutes
 
 
No matter what your specific goals are, investing will likely play a key role in your financial plan. That’s because it 1) helps us build wealth with our savings, and 2) helps our money keep up with inflation over time. Both of theses are incredibly important.
 
But now we need to get down to some specifics. Like, um, how do you actually invest? We’ll cover that and more here and over the next three guides on investing returns, investing risk, and investing portfolios. So let’s get to it!
 

Here’s what we cover in this guide

Setting up an investment account
Understanding asset classes
Mutual funds
Actively managed funds vs indexing
Exchange Traded Funds (ETFs)
 

Setting up your investment account

For most of us, investing starts with opening an investment account.
 
But there are a few different types of accounts out there – 401(k), IRA, brokerage accounts – and choosing the right account (or accounts) will partly depend on your end goal.
 
While the names may sound like an alphabet soup of financial acronyms, your options basically fall into two two broad categories;
 
1) Retirement accounts, which, as you can probably guess, are for retirement savings
 
2) Brokerage accounts, which are for more general investing purposes
 
Here’s a brief overview of each.
 

Retirement Accounts

If you know you won’t be needing the money for a while (i.e. until retirement), then a dedicated retirement account, like a 401(k), IRA, or 403(b) can be a great place to start.
 
For one, they offer tax advantages that more general taxable investment accounts don’t have.
 
With a 401(k), traditional IRA, or 403(b), your taxes are deferred, meaning your contributions come directly from your paycheck without being taxed. Then your money is allowed to grow tax-free until you take it out in retirement. This can potentially add up to serious money over time.
 
You may also get an employer match. This would obviously only apply to plans offered through your employer, like a 401(k) or 403(b), but some employers will match a portion of your contribution, usually up to a certain amount. It’s about as close to free money as you can get.
 
For these reasons, dedicated retirement accounts are often a great starting place for most people.
 

Brokerage Accounts (taxable accounts)

While dedicated retirement accounts can be a great place to invest, there is a catch. Your money is essentially tied up until retirement.
 
So if you’ll be needing the money sooner, you’d be better off with a taxable account, like a brokerage account. These are kind of like bank accounts for investments and don’t have restrictions on when you can take your money out.
 
And if you’ll be needing the money in the next few years, you’re probably better off not investing it at all and keeping it in a savings account.
 
Also keep in mind you can have more than one investment account.
 
So maybe you’ll have some money invested in a retirement account and some invested in a brokerage account to cover multiple goals. If you’re just starting out, a retirement account might be enough. But over time you’ll probably have both kinds, and maybe a few different accounts.
 

More to Explore: There’s a lot more we could say about both types of accounts. So we have additional guides that cover more details on dedicated retirement accounts and brokerage accounts. Feel free to check them out!

Okay, so what do I invest in?

Once you’ve set up your account, it’s time to think about selecting your investments.
 
As we discussed in Setting Goals, building your wealth is about growing your assets. So it’s helpful to divide our investment choices into asset classes. Think of it as a way to broadly categorize assets based on shared characteristics. This will be particularly useful when we get to creating a portfolio and talk about asset allocation.
 
There are different ways you can group assets. But for the most part, we’re going to group them into four primary asset classes;
 
Stocks – owning a share of a business
 
Bonds – making a loan to a business or government
 
Real estate – owning physical property
 
Cash – money in the bank
 
Let’s break each one down into a little more detail.
 

Stocks – owning a share of the business

When businesses need to raise money, they have a few ways to do it. One way is by issuing stock, or equity, to the public. Essentially, investors pay money to own some of the business in the form of shares of the stock.
 
Those shares can then be bought and sold in the market. So if you buy some, you’ll now be a partial owner of the business.
 
When the business does well and grows, you’re likely to benefit. Alright! But, if the business struggles, your investment probably will too. In other words, you participate, or share, in both the upside and in the downside when you invest in stocks.
 

Bonds – making a loan to a business or government

A bond, on the other hand, represents a loan that’s been made to a business or a government. As an investor owning the bond, you are the lender.
 
Every bond has a contract that defines the terms of the bond – information like how much has been borrowed (the principal), what interest rate the bond pays, and when the principal is to be repaid (the maturity date).
 
Since the payments you receive as an investor are determined by a contract, bonds are also referred to as fixed income.
 

Real estate – owning physical property

Real estate refers to physical property, like houses, land, and office buildings.
 
If you own your home, you can think of it partly as a real estate investment, and partly as a living expense. However, if you buy a second home to rent out for the income, it would be considered purely a real estate investment.
 
While owning a rental property is one way to invest in real estate, you can also invest in something called a REIT, or Real Estate Investment Trust, that invests specifically in real estate assets. This is a way to diversify your real estate holdings without having to buy multiple properties.
 

Cash – money in the bank

Your cash is also considered an asset. In the investing world, the term cash doesn’t just mean the paper money in your pocket. Checking accounts, savings accounts, money market accounts, and CDs are all typically considered forms of cash. We cover these in more detail in Banking Basics.
 
Whether your cash is in a savings account earning interest, in a checking account not earning interest, or hidden under your mattress, it’s still a way to store, and possibly grow your wealth. So when you’re figuring out your total assets, don’t forget to include it.
 

Putting the fun in funds

Alright, you’re now an investing expert and ready to buy and sell some stocks just like Warren Buffett, right? Not so fast!
 
While you can buy individual stocks and bonds as investments, this isn’t usually the best approach for the average investor. It can take a lot of time, energy, and brainpower to manage a well-diversified portfolio of investments. A more practical approach for most people is to invest in funds.
 
When you invest in a fund, your money is pooled alongside the money of many other people to collectively purchase investments on behalf of the group. This means you can invest in a single fund (or a few funds) and not have to deal with the hassle of buying and selling individual stocks and bonds yourself.
 
There are two basic types of funds you’ll want to know about;
 
• Mutual Funds

• Exchange Traded Funds, or ETFs
 

Mutual Funds

Believe it or not, the first mutual fund actually dates back to 1770s Amsterdam. But they rose to mainstream prominence in the 20th century as a convenient way for retail investors to participate in financial markets.
 
As we mentioned, mutual funds represent money that’s been pooled across many investors. The managers of the fund then use that pooled money to buy and sell investments, like stocks and bonds.
 
While there are many different kinds of mutual funds, there are two broad categories, actively managed and passively managed.
 

Actively Managed Funds

With some mutual funds, the managers are actively trying to choose good investments and avoid bad ones. Not too surprisingly, this is referred to as active management. There are generally some ground rules the manager must follow, but with active management, the manager has discretion in choosing the investments.
 

Passively Managed Funds

Alternatively, mutual funds can be passively managed, which is typically done by having the fund mimic an investment index or benchmark, like the S&P 500. This removes the manager’s discretion in selecting investments and is referred to as indexing. The basic argument for indexing is a belief that most active investment managers won’t end up beating the market after fees, so it’s better to just invest in the market as a whole, or some index that approximates it.
 

So which is better? Active or passive (indexing)?

This is one of the most hotly debated topics in finance. And the debate mostly boils down to performance and fees.
 
Passively managed index funds tend to charge substantially lower management fees, often around one tenth of one percent of your assets annually. So if you invested $20,000, one tenth of one percent would be $20 a year in fees. Not too bad.
 
Actively managed funds tend to charge higher fees, often closer to one percent of assets, or possibly even more. One percent in fees on that same $20,000 investment would be $200 per year. And while actively managed fees have been coming down due to competitive pressure from low-fee index funds, they still typically charge a lot more.
 
This seemingly small difference in fees can have a big impact on how your investments grow over time. So it’s important to be mindful of what you’re paying.
 

Key Terminology: A widely used metric to compare fees across funds is something called the expense ratio. It’s equal to the annual fee of the fund divided by the total assets under management. So in other words, it tells you what percentage of your investment is going towards paying the managers of the fund each year. For example, if you invest in a fund with an expense ratio of 0.5%, you’ll be paying 0.5% of your money in fees each year.

But isn’t a higher fee worth it if the managers can pick good investments?

In theory yes, it could be. That’s assuming your active manager is able to beat the index by more than the difference in fees. But in practice, this often isn’t the case.
 
Research tends to show that on a whole, active mutual fund managers don’t consistently outperform index funds enough to justify the higher fees.
 
Although some managers may beat the market, it’s difficult to identify them ahead of time. And with enough managers out there, some will simply beat the market just by pure luck.
 

Key Point: While the jury is still somewhat out on the issue of active versus passive management, you’re probably better off with lower-fee, diversified index funds and investing for the long term.

Exchange Traded Funds

In addition to mutual funds, you can also invest in something called an Exchange Traded Fund, or ETF for short.
 
In a lot of ways, an ETF is very similar to a mutual fund – an ETF also represents collective ownership of assets by pooling money across investors, just like with a mutual fund. But ETFs are typically more likely to track an index, and often have lower fees than actively managed mutual funds (although it’s not always the case).
 
There are also some technical differences between ETFs and mutual funds though. For example, you can only buy and sell mutual funds at the end of a trading day, while you can buy and sell ETFs throughout the day like you would a stock, but for the average investor, these differences won’t matter much. Not to mention, you probably don’t want to be actively trading your investments throughout the day regardless of which one you choose.
 

A variety of choices

Mutual funds and exchange traded funds come in a wide variety of styles.
 
A particular fund might invest in a specific asset class or it might invest in multiple asset classes. Some invest only in U.S. assets, some invest abroad, and some invest in both. Some funds focus on large companies only, medium sized companies only, or small companies only, while others invest in a range of sizes. They can even target specific industries, like energy or financials.
 
You name it, there’s probably a fund dedicated to a certain objective.
 
Realistically though, you probably don’t need to make it overly complicated and can create a great portfolio with just a handful of basic funds. We’ll go into a little more detail when we get to our guide on Investing Portfolios.
 

Up next

In the next sections, we’ll get into a few more details, like how exactly your investments earn money for you, what risks you need to watch out for, and how to build and manage your portfolio.
 
 

Key Takeaways

1) Investments can be divided into categories, or asset classes, that share similar characteristics, like return and risk. A common breakdown is stocks, bonds, real estate, and cash.

2) Stocks, or equities, represent ownership in businesses. When you own the stock of a business, you share in the profits and the losses.

3) Bonds represent loans that have been made to businesses or governments. When you own bonds, you are effectively the lender.

4) While you can buy individual stocks and bonds, investing in funds, like mutual funds and exchange traded funds, offers the benefit of diversification.

5) Funds can be passively managed (indexing) or actively managed. Index funds typically charge lower fees.