Where do you start when you want to invest?
You’ve probably heard that you should invest, right? Maybe you heard it from a friend, coworker, or a rich uncle. Most of us know we should be investing, but may be intimidated or, if you’re like me, clueless about the difference between stocks and bonds. And what is a mutual fund anyway?
With a savings account earning less than 1% interest, your money may not even be keeping up with inflation. Inflation basically means that prices rise and the purchasing power of our money falls. Basically, $100 today cannot buy you what $100 bought your parents or grandparents decades ago. Inflation is natural and healthy (in small doses) for an economy, however, if the interest earned by your savings does not match the inflation rate, your nest egg loses its value over time.
Investing can provide you with a greater return on investment (ROI) to beat the inflation rate, but of course it may come with a greater risk — a much greater risk in some cases. But where do you begin if you want to invest? The first place to begin when it comes to investments is knowing the basic definitions. This is where I start with my students.
Note: If you have a 401(k), Individual Retirement Account (IRA), or other retirement account, you are already investing. It’s always a good idea to call your retirement fund manager to have someone walk you through your investments. It’s better late than never. I’ll be honest, I had a 403(b) for years before I actually sat down with a representative to go over where my money is.
Very Important Note: Be sure to have money saved in an emergency fund BEFORE putting significant sums into investments. For most investments, you cannot easily withdraw your money (or it may come with fees). Be sure to have an emergency savings account that is liquid (or accessible).
The first definition to know is SECURITY. A security is any sort of financial asset that can be traded (bought and sold, sometimes through markets such as the New York Stock Exchange).
Below I’ve outlines several common examples of securities you may choose to buy as investments. There are so many options for investing, but here is a basic introduction to some of the most popular investments:
A bond is essentially a loan. Bonds are used by companies and governments to raise money. You can think of a bond like an IOU — an investor buys a bond and that money is used to grow the business or fund the government. As a “fixed” security, a bond has set terms and interest that will pay out to the bond holder.
A corporate bond is issued by a company to generate money. Bonds are considered a safer investment if the company has a solid credit rating since the terms of the bond are fixed.
The US Treasury Department raises money for government operations by offering several types of securities (sometimes referred to as T-notes or T-bonds) with different years of maturity (the time when the debt is repaid to the holder of the bond). These bonds and other treasury securities are considered safe investments since they are backed by the federal government.
You can compare US Treasury investment options here
A stock is a security that signifies ownership (or equity) in a particular entity. For example, I own one share of Apple stock, so therefore I own a teeny tiny part of Apple. Buying a stock entitles the owner to a portion of the profits of a company. These profits are sometimes paid out in dividends, which are like little “thank you” quarterly or yearly payouts for shareholders (I remember how excited I was to get a 73 cent dividend for my one share of Apple stock. Woo hoo!). Not all companies pay dividends.
Shares can be bought and sold through stock brokerages, which usually charge fees. Keep these fees in mind when you trade. Personally, I’ve had success using the Robinhood App to trade shares. I find it user friendly and I haven’t incurred the larger fees of bigger brokerages.
Many banks are now getting in on the stock trading options — I can trade through Chase or Ally where I have checking/savings accounts. Be sure to understand the terms and conditions of your trades — Are there minimum balances? Do you pay a fee each time you buy or sell?
The prices of shares are volatile and can fluctuate wildly within one trading day. These prices are mostly dictated by demand — if many investors want to buy shares of a company because it is performing well, the prices tends to rise (sometimes dramatically). If a company is struggling, the prices tends to drop (again, sometimes dramatically).
The conventional “advice” is to buy low and sell high. When you sell your stock, this is when you see the profit (or loss) and pay taxes on any income from the sale of stock. However, the market is unpredictable and impossible to time with 100% accuracy.
There’s an episode of Friends where Monica is desperate for money so she invests in a company that is traded with the stock symbol MEG, her initials. Soon, Monica starts investing in different companies on a whim. Spoiler alert – she ends up losing all her money. If you’re like Monica and don’t have the knowledge or time to study the market, the next options might be better for you.
MUTUAL FUNDS, INDEX FUNDS, AND ETFs
I group these three types of investments together because they can be referred to as “baskets of securities.” While a bond and a stock are each one individual security, mutual funds, index funds, and exchange-traded funds (ETFs) can contain multiple bonds or stocks (or both).
A MUTUAL FUND is a “basket of securities” that is professionally managed. A fund manager takes a large pool of money from multiple investors and spreads that money out among different securities. This way the mutual fund is already diversified.
Some investors prefer mutual funds to stocks because the risk is lower since your money is spread out. If one company fails, your shares may become worthless and you can lose your entire investment. On the other hand, if one small part of a mutual fund fails, it will not drastically affect the overall value of the mutual fund (at least not as much as if you owned the individual stock). As a result, mutual funds are not as “high-risk, high-reward” as stocks, but may have significant management fees. Be sure you know the management fees associated with a potential mutual fund investment.
One way investors who like diversified funds try to get around high management fees is through the purchase of INDEX FUNDS. Index funds also pool together investors’ money, but they are “passively” managed as a sort of “set it and forget it” option. Since index funds are matched to a specific group of stocks (like the S&P 500), they do not need active managers like mutual funds. In fact, these index funds can outperform mutual funds and are favored by many who want to retire early.
The thing that sets ETFs apart from mutual funds and index funds is that they are traded like a stock. All three options are “baskets of securities,” but ETFs do not require the same purchase requirements. In fact, I purchase ETFs through my Robinhood App just as I would any stock.
Investing can be intimidating. It helps to know the basic definitions so you understand where your money is going and you can assess your risk. After amassing a significant emergency fund, investing in different types of securities is a fantastic way to build wealth. If you are not sure exactly where your money is going, do not hesitate to ask someone (I’ve had to approach fund managers several times over the past year and I’m so glad I did). Knowledge is truly power (and money!) in this case.