The basic principle of investing is simple: buying something today that you think will be worth more in the future. But which investments offer the best returns? That’s the hard part about investing – no one can be certain which assets will be worth more tomorrow. Although predicting the future is impossible, doing your research and following a few basic principles will help you invest well.
Why Should You Invest?
Some days the stock market is up, other days it’s down, but over long periods of time the market is usually on an upward trajectory. During the U.S. housing bubble in the early 2000s, real estate prices kept going up only to crash later, causing millions of homeowners to default on their mortgages and lose their homes. If investments can gain or lose value, and predicting the market is extremely difficult, then why invest at all?
Investing carries risk, but historically, it has been rewarding. A balanced investment plan executed over many years can grow into a comfortable nest egg for retirement. While past performance does not guarantee future returns, the U.S. stock market has been a remarkable engine of wealth creation, growing at an average of about 7% per year after accounting for inflation and dividends. Beyond the monetary rewards from successful investments, there is an equally important reason why you should invest: Not investing actually costs you money.
It’s Important to Beat Inflation
In 1952, a loaf of bread sold for about 12 cents. But the bread wasn’t actually almost free – a dollar simply went a lot further than it does today.
Holding money in cash, whether in an average bank account or under the mattress, is extremely costly in the long run because inflation causes money to slowly lose value each year. That might sound like a bad thing, but economists generally agree that moderate inflation of 2% or less each year encourages spending and it’s a sign of a healthy economy. Major central banks such as the U.S. Federal Reserve, the Bank of England, Bank of Japan, Bank of Canada and the European Central Bank are all pursuing monetary policies that set a target of 2% annual inflation. If cash loses value each year, then putting money in a low-yield checking account costs you money.
What Can You Invest In?
Investing is important, both to grow wealth and beat inflation, but which assets should you invest in? Broadly speaking, the number of investable assets is huge. From baseball cards to bitcoin, from gold to stocks and bonds, from commodities to real estate, there are a multitude of things you can invest in. However, those beginning investors usually focus on stocks (including mutual funds and ETFs) and bonds.
Equities, commonly known as stocks, are most often in the form of shares in corporations. These shares are traded on public stock exchanges like the Nasdaq or the New York Stock Exchange, although private sales can and do happen. Your stake gains in value when the company itself rises in value. You may also receive dividends or other benefits from owning equity in a company. Equities can be easily and quickly bought and sold on online brokerages.
Exchange traded funds (ETFs) and mutual funds resemble equities in the sense they can be easily bought and sold, but instead of being a stake in a single corporation, they are financial products whose price depends on baskets of assets. For example, the Vanguard Global Equity Fund invests in a portfolio of companies around the world while the Powershares QQQ ETF tracks the Nasdaq 100, an index weighted towards tech stocks.
Getting truly diversified exposure to global equities or tech stocks would be extremely difficult for small investors, but mutual funds and ETFs make it easy for them to effectively invest in a basket of assets all at once. From target-date retirement funds that automatically adjust their asset allocations over time to short ETFs that make money as the market falls, the investment possibilities offered by mutual funds and ETFs are nearly limitless.
Most beginning investors should choose index funds that mirror major stock indices. This provides exposure to the broader economy and diversification that reduces risk. Those saving for retirement should also consider a target-date retirement fund.
Fixed-income investments return a steady stream of income to their owner. Bonds are the most common type of fixed-income product. While equities are a stake in an enterprise, bonds are a form of debt. When people buy U.S. government bonds, they effectively are lending money to the government. In exchange, the government will repay the bondholder on a fixed schedule, which explains the term “fixed income.”
Because fixed-income bonds have a guaranteed repayment schedule, they are perceived as safe investments. However, a bond is only as safe as the creditworthiness of the issuer. A bond issued by a failing corporation or a government in crisis may not be repaid. Bonds that pay higher interest usually do so to compensate investors for the greater risk of default.
Alternative investments generally refer to real estate, hedge funds, private equity, cryptocurrencies, commodities and other types of products that go beyond stocks and bonds. Except for real estate, most of these alternative investments typically are held only by high-net-worth individuals, not by beginning investors.
Start a 401(k)
Even if you’re young, the first step of investing should be saving for your retirement with a 401(k) plan. First, 401(k) retirement accounts offer tax advantages compared to standard investment accounts. Second, the funds deposited in a retirement account have the longest period of time to benefit from compound interest. Furthermore, many employers will match your retirement contributions up to a certain percentage of income. Matching is akin to an instant return. Once you have begun investing for retirement, including maxing out any employer contributions, you should consider other ways to invest.
While wealthy investors can benefit from the services of an investment advisor, beginning investors are often faced with making daunting investment decisions on their own. Robo-advisers offer investors targeted recommendations without the cost of a human investment adviser. Robo-advisers are automated investment services that use algorithms to rebalance your portfolio and invest for you.
Betterment, a robo-adviser, has no minimum account balance and uses tax-efficient investment techniques to save you extra money. Wealthfront has a low minimum investment of $500 and charges no management fees for balances under $10,000, making it an affordable and easy way to get started. Schwab Intelligent Portfolio has no account fees or commissions, but requires a minimum investment of $5,000. This doesn’t mean you can completely ditch fees with Schwab – the company still makes money from ETF management fees.
Open a Low-Fee Brokerage Account
Online brokerage accounts are an affordable way to buy and sell investments. Companies like TD Ameritrade have fees as low as $6.95 per trade with no account minimum. Serious investors with an account balance of $10,000 or more can benefit from fees as low as $0.005 per trade at Interactive Brokers.
Understand the True Cost of Your Investments
Investment companies want to help you make money, but they aren’t charities. In return for holding and managing your investment, companies make money with minimum balance fees, trading fees, and expense ratios that take a percentage of the money invested in mutual funds or ETFs. These fees vary by company, but they can add up fast. And they can be the difference between a profitable investment and one that loses money.
In 2016, index equity mutual funds had an average expense ratio of 0.09%. By contrast, actively managed equity mutual funds had an expense ratio of 0.82%. Some actively managed accounts do outperform index funds, but if you are unsure which investment to make, you usually want to choose the one with lower fees.
Diversification is Crucial
Diversification is important because it can help reduce risk. Consider a $100,000 portfolio that contains the stock of a single automaker. If gas prices spike, there is a labor strike or other bad events happen, your entire portfolio could take a big hit. By contrast, a diversified portfolio made up of many different companies and asset classes is much less vulnerable to any single bad event.
Diversification can’t ensure you never lose money – during a financial crisis nearly all stocks are likely to be affected – but it can help protect you from sector-specific risk.
When many people think of investing, they picture men and women on Wall Street making big trades that make and break fortunes in the space of days. Although movies such as “The Wolf of Wall Street” are heavily dramatized, the people portrayed in them do exist – but they are traders, not investors.
Traders are professionals who buy and sell assets with short time horizons: generally under a year and often times much shorter. By contrast, investors generally buy and hold assets. Sophisticated investors also use options, derivatives, and other complicated financial instruments best left to professionals.
By Investing in index funds you can benefit from the knowledge that, in the long run, the U.S. stock market has historically risen. However, short-term trading requires entirely different skills and often uses complex, difficult-to-master strategies. Moreover, trading fees on many platforms mean frequent trading is prohibitively expensive.
Avoid Panic Selling
All assets have good days and bad days. In some markets, bad news leads to quick losses after months or years of slow gains. It can be tempting to immediately sell, but that is usually a bad idea. If you are investing for the long run, you can often let time help you recoup investment losses. Consider the Great Recession. On Oct. 8, 2007, the Standard & Poor’s 500 index reached a record 1,561.80. By March 3, 2009, it had fallen to 683.38, losing more than half its value. Investors who panicked and sold their stocks missed out on the great bull market that lasted from April 2009 to January 2018.
Beginner investors see the market fall and they panic, selling their shares at the bottom of the market. But once the stock market has crashed, selling probably won’t help you. The market won’t go to zero unless society collapses, and in that case, you’ll have more important things to worry about. If your portfolio has already lost half its value, selling is more likely to rob you of future gains than protect you from a total collapse.
Don’t Rely on Social Security
Although investing is a one way of becoming wealthy, it is also an important way of preserving your financial independence and comfort as you age.
Social Security and other government pension funds may not be adequate for most people to have a comfortable retirement. The Social Security Administration estimates that the Social Security trust fund will be exhausted by 2040. In the same year there will be only 2.1 workers paying into Social Security for every retiree. That means many of today’s workers can’t depend on Social Security for their retirement unless the government takes action.
Even if Social Security is saved, there are other good reasons to invest. Because people are living longer, young people will be able to work until well past 65. Living for 40 years on income earned in the previous 40 years may not be feasible. If you want your golden years to, well, be golden, you’ll want to put your money to good use.
Getting Started Is the Most Important Part
Technology and competition mean there has never been an easier or cheaper time to get started investing. Robo-advisers help you create a balanced portfolio at low prices. The vast number of ETFs and mutual funds mean that you can invest in nearly any asset class on earth. The hardest part of investing is getting started. Whether you consider a 401(k), a mutual fund or a robo-adviser, starting today is a responsible choice that should pay literal dividends in the years to come.
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