About 9 minutes
So you’ve decided it’s time to start investing. Way to go! You’re about to take a big, important, exciting step in your financial life, which is great. But now we need to get down to the specifics. Like, um, how do you actually invest?
Well, for most people, this begins with setting up an investment account.
401(k)s, IRAs, Brokerage Accounts, oh my!
There are a few different types of accounts and choosing the right one (or ones) will partly depend on what you’re saving for.
And while the names may sound like an alphabet soup of financial acronyms, your options fall under two broad categories;
1) Retirement accounts, which, as you can probably guess, are for retirement savings
2) Non-retirement, or taxable accounts, which are for more general investing purposes
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) or IRA 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) or traditional IRA, 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 give your savings a huge boost, and who doesn’t like savings? (and boosts?!)
Additionally, 401(k)s, which are sponsored by your employer, often have the added bonus of a match, meaning your employer will contribute money in addition to what you contribute. It’s about as close to free money as you can get. Also pretty great.
But sadly there is a catch to retirement accounts. Your money is essentially tied up until retirement and you’ll face a stiff penalty for taking it out early.
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.
It’s also important to keep in mind that you might/will have more than one investment account, especially as your savings grow. So maybe you’ll have some money invested in a retirement account and some invested in a brokerage account to cover multiple goals.
Okay, so what do I invest in?
Once you’ve set up your account, it’s time to think about choosing your investments.
As we discussed in Setting Goals, building your wealth is about growing your assets, so it’s helpful to divide your investment choices into asset classes. Think of it as a way to categorize assets by common characteristics.
There are different ways you can group them, but for most investors, the main asset classes to focus on are;
• real estate
Stocks, owning a share of the business
What exactly do businesses do anyway? Basically they sell stuff or provide services, and sometimes they need to raise money to do so. One way they do this is by issuing stock, also called equity, to the public.
And that’s where you, the public, come in.
As an investor, you can buy some of this stock, in the form of shares, and become a partial owner of the business.
When the business does well and grows, you benefit. Alright! But…when the business struggles, your investment might go down. Bummer. In other words, you participate, or share, in both the upside and in the downside.
Bonds, investment bonds
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). So since the payments are determined by a contract, bonds are also referred to as fixed income.
Real estate refers to physical property, like houses, land, and office buildings. When you own your home, you can think of it partly as a real estate investment, and partly as a living expense. If you own a second home that you rent out for income only, 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 (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.
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
While the first mutual fund actually dates back to 1770s Amsterdam, mutual funds rose to mainstream prominence in the 20th century as a convenient way for retail investors to participate in financial markets.
Along with other types of funds, 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.
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.
So which is better? Active or passive?
This is one of the most hotly debated topics in finance, and it’s primarily about fees.
Passively managed funds tend to charge 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 make a huge difference in how your investments grow over time, so it’s important to be mindful of what you’re paying.
Quick Note: The annual management fee of a fund divided by the total assets under management in the fund is referred to as the expense ratio. It’s the percentage of your investment that goes towards paying the managers of the fund each year.
But isn’t the higher fee worth it if the managers can pick good investments?
In theory yes, it could be, if 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.
And although some research does suggest the best managers may be able to consistently 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.
So here’s the punchline: While the jury is still somewhat out on the issue of active vs passive management, you’re probably better off sticking 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. (Incidentally, 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.
We’ll cover these some more in the section on Investing Portfolios, but the range of options is too extensive for us to go over exhaustively. Realistically though, you probably don’t need to get this fancy and can create a great portfolio with just a handful of basic funds.
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.
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.