Investing for Beginners
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” — Albert Einstein
At this point in your personal finance journey, you probably don’t need to be sold on the idea of investing. You know it’s the way to build a sound financial future for yourself, and that’s great.
Still, many young people need a push to start investing. According to one study, 52% of people between the ages of 21 and 36 keep their savings in cash, where growth is nonexistent. If the goal is financial independence, this isn’t the way to get there.
But you’re in luck: This post is my beginner’s guide to investing and outlines everything that you need to know to get started. Let’s jump right in.
What is Investing?
Investing is the act of allocating money with the goal of achieving a specific goal at a later date. Generally speaking, there are two types of investments:
1. Growth Investments
Growth investing involves increasing your wealth through capital appreciation. This can be achieved using short-term or long-term strategies. Think of growth investments like going on an offensive to increase your net worth. The two most common types of growth investments are property and securities, which most often come in the form of shares in individual companies.
In most cases, it’s a good idea to do the bulk of your growth investing while you are young and have higher risk tolerance. That way, you’re able to weather the ups and downs of the stock market because, in theory, you’ll also be in your prime earning years.
2. Defensive Investments
The opposite of growth investing is defensive investing, which is a conservative strategy used to reduce the risk of losing your assets. By adopting a defensive investing strategy, it’s possible to protect your funds from sudden unexpected downturns like we are currently experiencing in the midst of the ongoing pandemic.
Ultimately, new investors should strive to build a diversified investment portfolio that contains both defensive- and growth-oriented investments. By building a portfolio with a fair amount of defensive protection built-in, it will be easier to avoid the temptation to sell during volatile times.
Examples of defensive investments include bonds, inverse stocks, and commodities.
FAQ: Are Cash, Gold, and Treasuries Defensive Investments?
Investors sometimes ask whether assets like cash, gold, and treasuries are defensive investment options. Technically, these types of investments are considered defensive because they provide stability against volatile market conditions but produce limited capital growth.
Forming an Investment Strategy
Before you dive in and start investing, you’ll also want to think about how you want to manage and grow your portfolio. You can either manage your investments yourself, purchasing individual stocks as an equity investor, or you could leverage a more structured plan around mutual funds, which are managed by professionals.
Only you can determine the best investment vehicles for your needs. It’s important to remember, though, that managing your own investments can come with a certain amount of risk and a likelihood for diminishing returns.
According to one study, between 1990 and 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. During that same time period, the average equity investor earned just 3.49% annually.
The performance differential was mostly affected by investors’ inability to manage funds effectively on their own. Unless you have all the time in the world to study the markets, learn chart patterns, and know the ins and outs of all the companies you invest in, how can you be certain you’re making the best moves?
Before reaching into your wallet and making any investments, here are some questions to ask yourself:
Do You Have the Temperament to Invest?
Remember that we are talking about investing here — and not day trading. Stock trading can be incredibly risky, and the vast majority of investors will never beat the market — especially DIY investors who are just beginning.
The key to making a lot of money when investing is to think for the long term, invest in indexes, and ignore the ups and downs of the market.
If you’re a trigger-happy type who is liable to jump and start trading based on short-term performance, you may want to consider working with a financial advisor until you can gain some experience and learn how everything works.
What’s Your Tolerance for Risk?
If you’re looking to take a gamble and you have a strong feeling that a certain fund can beat the market index, you may want to invest in an actively managed fund. From time to time, active funds can post significant returns.
However, they can also underperform in many cases. You know your appetite for risk better than anyone else, so only you can figure out the funds that work best for your unique situation.
Do You Want or Need Manual Oversight?
Some people like the idea of paying fund managers to actively oversee their accounts. However, this usually comes with a hefty annual fee — and with no guarantee that the strategy will work.
If you think you might want to take the active route, ask yourself whether you’re doing it out of fear of trusting a benchmarked fund or whether you actually think the team you’re picking can beat the index.
Now that you have a better idea of some of the philosophies behind investing, let’s take a look at some of the options that are available to investors.
Mutual Funds, Index Funds, and ETFs
Mutual funds aggregate money from multiple investors, pooling bonds, stocks, and securities together in one financial instrument.
Mutual funds can be either passively or actively invested. Passive funds track a market-weighted portfolio and do not require any manual intervention. Active accounts, on the other hand, are managed by dedicated financial professionals.
Here are three types of mutual funds to consider.
1. Open-end Fund (OEF)
Open-end funds do not restrict how many shares can be offered. They are bought and sold on a rolling basis.
Shares are bought and sold to investors from within the fund, and the price is determined by the value of each of the fund’s securities. To figure out the price, divide the market value of the fund’s assets by the number of investors’ shares.
2. Closed-end Fund (CEF)
Closed-end funds have a fixed number of shares because they are traded by investors on an exchange. These funds are created through an initial public offering (IPO). Like open-end funds, their value is based on the net asset value (NAV). However, their price is governed by supply and demand.
Open-end funds are the more widely used option by investors, largely because they come with more flexibility for purchasing shares. Unlike closed-end funds, open-end funds don’t need to be purchased through a broker.
3. Unit Investment Trusts (UIT)
UITs are sold as unmanaged (i.e., fixed) securities and are only created for a specific amount of time. UITs are exchange-traded, and sold through brokerage firms. In addition, they are not governed by a board of directors.
There are two types of UITs:
Bond trusts pay monthly income in consistent installments until the first bond matures and payments are distributed to clients. This process continues over time until all bonds are liquidated.
Stock trusts provide dividend income and capital appreciation for a specific period of time.
Index funds are a type of passively managed mutual fund built around market segments. For example, index funds may be built around companies that pay high dividends, by certain industries, or by company size.
Unlike actively managed mutual funds, index funds do not try to beat the market. Rather, they are designed to track the market. Index funds can have varying levels of volatility. Still, they are generally seen as safe and cost-effective long-term investments.
There are two important things to consider when purchasing index funds:
- Watch out for high fees. Consider investing through a company like Vanguard, which offers reasonable fees (some of the lowest you can find!) and strong returns.
- Pay attention to how different funds pay dividends. They can be paid either monthly, quarterly, biannually, or annually. It’s also important to pay attention to a fund’s dividend history. At the same time, you’ll want to research and find out whether certain stocks are likely to slash dividends in the near future.
Exchange-Traded Funds (ETFs)
ETFs are similar to mutual funds, but they are bought and sold on stock exchanges.
ETFs can be either actively or passively managed. Actively managed ETFs typically come with higher fees and tend to perform worse over time (sensing a trend here?).
Most investors tend to choose passive ETFs for their low expense ratios and broker commissions. ETFs are generally less risky, as they are highly diversified and can be built around specific industries.
Overall, ETFs are a solid choice for beginning investors.
The Benefits Of Using Brokerage Accounts
By now, you’re probably wondering how you can actually buy stocks. One of the easiest and most cost-effective ways to do so is to set up a taxable brokerage account through a company like Schwab, Fidelity, or Merrill Lynch.
What is a Brokerage Account?
A brokerage account is a financial account that will let you sell bonds, stocks, funds, and other types of securities. In short, a brokerage firm is a holding company that will secure your money while you distribute it into various funds.
Here are some of the top benefits of using a brokerage account when investing.
A Brokerage Account is Easy to Set Up
Most brokerage accounts can be set up in a matter of minutes. Funding can take about a week or longer, depending on the bank you are working with. Setting up a brokerage account is one of the fastest and easiest ways to start investing in the stock market.
You Can Get Access to Supporting Services
The brokerage market is very competitive, as companies are vying for consumer attention. As such, brokerage accounts typically come with a variety of educational tools and services that will help you make smart investment decisions. This may include advanced research, technical data, monitoring services, and access to financial experts, among other things.
You Have Total Control Over Your Finances
A brokerage account will give you complete managerial access over your money. So, if you want to make your own decisions, you won’t have to worry about dealing with pushy financial advisors who may be acting in their own interest (this is why it’s important to partner with a fiduciary if you go that route!). You will have total control to buy and sell securities as you please.
Of course, this can come back to haunt you. If you decide to start buying random securities, make sure you know what you’re getting into ahead of time. The stock market can be a dangerous place, especially for amateurs. Oftentimes, inexperienced traders make mistakes like buying options without fully understanding the implications. If you bite off more than you can chew, a few wrong decisions can send you spiraling into debt.
Setting Up a Retirement Account
It’s important to see the forest from the trees when it comes to investing. You need to think about your life goals and how they may change in the future.
One piece of advice that I always give to beginner investors is looking after your future self. Just because you are young and freewheeling now doesn’t mean that the party will last forever. In fact, you can take my word for it that the party will be over before you know it, and one day you’ll wake up in the real world. Your needs can change suddenly, and they will. To secure a good life for your family, you need to make sure that you are prepared for retirement.
Take my advice: Set up a retirement account while you are young and put money aside each and every paycheck. Even if you’re pushing 40 with no retirement savings, it’s not too late. In fact, 37% of employees between the ages of 35 and 44 have less than $1,000 saved for retirement. So, if you haven’t started planning for your future just yet, take comfort in the fact you’re not alone. And know that it’s never too late to turn things around!
Another thing to think about is how you want to spend your retirement. Just because you are retired doesn’t mean that you have to stop working forever. Rather, retirement can simply give you the option to live life on your own terms, pursuing projects that you find interesting and personally rewarding. Just imagine retiring at the age of 50, training to climb Mount Everest, and writing a book about your experience. This is certainly not out of the realm of possibility. You just need to plan right.
With this in mind, here are some common types of retirement planning accounts to consider.
A 401(k) plan is a tax-qualified, company-sponsored retirement option that many employees have the option to contribute to. In many instances, employers may offer a 401(k) matching program. If, for example, you put in 6 percent of your salary to your 401(k), your company might contribute an additional 3 percent. Contributions are taken on a pre-tax basis and become tax-deferred. Your untaxed funds grow over time, and you have to pay taxes on them once you retire.
Individual Retirement Account (IRA)
If your employer doesn’t sponsor a 401(k), don’t worry — you still have options. In fact, about one-third of working adults don’t have access to a 401(k) at their job. And many large employers have suspended their 401(k) plans in light of COVID-19.
If this is the case, you should look into setting up an individual retirement account (IRA). There are a few different types of IRAs to choose from, with varying rules and regulations about how the funds are taxed and when you can access them.
A traditional IRA is the most popular type of individual tax-advantaged retirement savings plan. It comes with a maximum annual contribution of $6,000 for 2020, or $7,000 if you are over the age of 50. Traditional IRAs are ideal for workers who anticipate they will be in a lower tax bracket at the time of retirement. You put pre-tax dollars in your account and pay taxes on the funds when you withdraw them during retirement.
One of the downsides of a traditional IRA is that it comes with eligibility restrictions based on your income. If you don’t qualify for a traditional IRA, then a Roth IRA may be a good fit. Roth IRAs are typically more lenient, as they come with tax and penalty-free contribution withdrawals. That’s because Roth IRAs are funded with post-tax dollars, and you don’t have to pay taxes on the gains you make when you withdraw your funds in retirement.
Roth IRAs are great for people who may need access to savings before retirement. Many investors also opt to do a Roth conversion as they get older. In these scenarios, you convert your traditional IRA to a Roth IRA by paying taxes on your funds when the conversion commences. But that’s a story for another day.
Self Employed Pension (SEP) IRA
This type of IRA is set up by someone who runs their own business and might not have access to other retirement options. In a SEP IRA, earnings can grow tax-free until retirement and they are taxed once they are withdrawn.
A SEP IRA has significantly higher tax annual contribution limits. According to the IRS, workers can put either 25 percent of compensation or up to $57,000 in a SEP IRA in 2020, whichever is lesser.
Self-directed IRA (SDIRA)
A self-directed IRA can provide access to certain investments that you cannot access through other types of IRAs. For example, you can invest in real estate through a self-directed IRA.
There are a few important restrictions to be aware of with this type of account. SDIRA custodians are barred from giving financial and investment advice, meaning account holders must conduct their own research. In addition, they are only available through firms that offer SDIRA custody services.
Health Savings Account (HSA): An Overview
At some point in your life, you’re probably going to have a costly medical issue rear its ugly head, forcing you to incur heavy payments. When this happens, it’s important to be prepared.
According to one study, 26% of Americans between the ages of 18 and 64 have had problems paying medical bills. You don’t want to fall into this category — and one of the best ways to avoid this is to set up a health savings account (HSA), if you are in a position to do so.
HSAs are specifically for Americans who have high-deductible health plans. Contributions are 100% tax-deductible, and withdrawals can be used to pay for eligible medical expenses without incurring any tax penalty. In addition, interest and investments earnings are tax-free and tax-deferred when used for eligible expenses.
Even if you aren’t eligible for an HSA account, it’s still a good idea to set money aside in case something should happen. Sooner or later, you’ll need to pay some doctor bills.
Are Robo Advisors a Good Idea?
In recent years, we have seen an explosion in mobile “robo advisors,” which are automated investment accounts that provide financial advice with little-to-no human intervention. Some of the top examples include:
The thing to keep in mind with robo advisors is that there are assets under management fees involved, and many providers have sizable opening deposit requirements.
Also, some critics argue that robo advisors are best suited for entry-level investors. While robo advisors can be a great way to get your feet wet in the world of investing, you may outgrow them at some point.
Personally, I prefer to invest with low-cost brokerage accounts, and in index funds with low expense ratios. If you prioritize convenience over costs, then robo advisors may be for you.
What is Micro-Investing?
The digital era has spawned many new types of investment trends and opportunities. One such example is micro-investing, which involves investing in small increments by buying tiny pieces of shares instead of. This is typically done through micro-investing platforms.
Three examples of micro-investing platforms include:
Acorns rounds up purchases to the nearest dollar, takes the difference, and invests it in an exchange-traded portfolio. Automatic investments can be set up, and cashback opportunities are available when you shop at certain companies.
Stash is another platform that can offer investment tools and guidance, and services such as online banking and affordable investing. Like Robinhood, Stash offers micro-investing services that can help turn small amounts of money into legit portfolios, which add up over time.
So, are these investment apps worth it? Only you can make that call. However, I usually tell people that when it comes to investing, taking the easy way out will get you mediocre results.
You can also wind up spending way more than you intend to in hidden fees and usage costs. If you need something like Robinhood or Stash to get started as an investor, then, by all means, go for it.
But for the long term, you’ll want to devise a serious and bulletproof investment strategy. You’re probably not going to retire and achieve financial independence on a micro-investing platform. That’s just the way it is.
How to Start Investing Without Much Money
Becoming an investor can seem like a far-off goal, especially if you are barely making enough money to get by. As it turns out, though, you don’t need to be rich or even financially well-off to invest. Anyone can do it. And the sooner you get started, the better the results will be over time.
Remember the Einstein quote that I mentioned in the beginning. Compound interest — or interest earned on interest — is a marvelous concept. Small investments can compound quickly and bring in more capital over time, growing your nest egg and helping you reach financial freedom that much faster.
Here are some tips to start investing if you don’t have a lot of money in the bank.
Determine a Budget That Works for You
For budgeting, many financial advisors recommend the 50/30/20 rule, where 50 percent of your income goes to daily expenditures, 30 percent goes to medium-term planning, and 20 percent gets put away for retirement.
Depending on your salary, you may find that setting aside 20 percent for retirement is too much at first. Figure out a budget that works for your lifestyle and stick to a plan. This may require getting creative about finances.
But trust me: It will definitely be worth it over the long run.
Pay off Debt
If you have any debt, pay it off entirely before you start investing. Otherwise, your returns will be negated by the money that you are losing in monthly payments.
Debt is one of the top wealth killers, and you need to eliminate it if you want to build a serious investment plan. If you find yourself dealing with debt, start by repaying the bad debt first — like credit card debt — before paying off your student loans and, if applicable, your mortgage.
Shop Around for Cheap Funds
There are plenty of dirt-cheap index funds for investors who do not want to spend an arm and a leg. In fact, you should avoid expensive index funds because they are passively traded and merely track a market index.
Look into Vanguard for cheap index funds.
Ready to Become an Investor?
As you can see, the world of investing is complex. It’s impossible to conquer it overnight, so don’t even try.
From the outset, investing might seem intimidating. And, to be quite frank, it sort of should be. Finances are complicated, and achieving financial independence won’t come easy for everyone.
At the end of the day, you just need to pick somewhere to start. Even if it’s opening an account on Acorns or Fidelity and buying a few shares, you need to dip your toes into the water before you can start to swim.
Since you’ve made it this far, you are obviously interested in becoming an investor and are already researching your best options. Keep doing that, my friend.
Put together an investment strategy that you’re comfortable with and stick to it. Never invest more money than you’re okay with losing, and try to take your emotions out of the equation altogether. You’re investing for your retirement, after all. Day-to-day market fluctuations—and even massive dips like we’ve seen in 2020—shouldn’t get on your nerves. The stock market has a 100-plus year history of increasing in value over time, so if you’re patient, great things can happen.
Bottom line? Start small, diversify your portfolio, be patient, and make smart decisions. That way, it’s pretty hard to lose. Whatever strategy you choose, I’m rooting for your success.