There are more than a handful of reasons for people like you to start investing.
Maybe you’re nervous about your future. With Social Security basically exhausted, you might be looking for ways to support yourself after retirement. A diverse investment portfolio is a simple strategy to establish financial security.
Maybe you’ve struggled to generate a healthy savings cushion. (In this economy, who hasn’t?)
On a more positive note, maybe you just came into a nice chunk of money and you’re ready for it to grow.
Or maybe your paychecks just aren’t cutting it. Maybe you have a hole of debt, and you’re trying to crawl out.
The average American debt has increased significantly in the past few years, and it’s not just credit cards. Americans are taking on more student loan, auto, and mortgage debt as well.
“Student loan debt outstanding has climbed from $1.21 trillion to $1.3 trillion; auto loans outstanding have grown from $866.44 billion to $943.76 billion; and mortgage debt outstanding increased $35 billion between the second and third quarter to $8.13 trillion.”
No matter what your motivation, investing may very well be the answer.
And with that, we get to the first step to investing: Know Yourself.
Know what you want to do. Before moving your money into any kind of market, it is essential to have a clear objective — a clear goal in mind. Are you investing to generate wealth, increase your income, or add value to existing wealth?
Know what you own. Basically, know how much money you are able (and willing) to spare. This is the same as deciding on an amount of money that you are willing to lose. You should only start investing if you have a comfortable cushion of money to use. Never live beyond your means.
“A good rule of thumb is to always have six months’ salary in savings.”
— Charles Rotblut, Vice President of the American Association of Individual Investors
Know your timeline. Are you looking to invest for the long term? Then you might be able to afford to take more risks. If you have a shorter time horizon, risk should be toned down. This also parallels your age.
Know what kind of person you are. Are you willing to perform diligent research, or would you prefer to have a broker do the research for you? How strong is your stomach? Will you be able to handle the stress that comes with risk? Forbes calls this “intestinal fortitude.”
Everyone should be concerned with risk to a certain degree. However, there are certain strategies that everyone can employ to reduce that risk overall.
A Quick Note: No matter what kind of investor you may be, an easy way to reduce risk is to diversify your portfolio.
As an early investor in your 20s or 30s, a majority of wealth should be in equity (stocks). At least, it can be, if you are okay with the risk. As you age into your 40s and 50s, you’re probably developing what millennials might call “adult stuff.” You probably own a home. You might have children or other important responsibilities. At this point in your life, it’s usually time to add some stability to your wealth. Diversification percentages shift away from stocks. Instead, the majority of your investments should be in the form of fixed income (bonds).
A good (though arguably antiquated) rule of thumb is the “Rule of 100.”
Simply subtract your age from 100, and you’ll have a ballpark number for the percentage of your assets you should consider investing in stocks. For a 30-year-old, that means investing 70% of your assets in stocks (100-30). The remaining 30% should be in bonds. As you age, that ratio starts to shift in the other direction.
At 55, the 100 rule would suggest that you invest 45% of your assets in stocks and 55% in bonds.
At 70, you might shift to 30% stocks and 70% bonds.
That leads us to the next step: Know Your Options. To keep things simple, we’ll stick to the basics.
Bonds & Funds
If you think of yourself as a risk-averse person, or if you cannot afford to ride the short-term volatility of the market, then bonds or mutual funds are the way to go. They’re more reliable and therefore most appropriate for long-term investors who have something to lose — maybe your son or daughter’s college fund, your retirement income, your home.
As for how bonds actually work, think about what you, as an individual, would need to do to purchase a home. Unless you have the cash in hand, you will have to acquire some debt. That means going to the bank and taking out a mortgage loan. The terms of the loan require you to pay back the principle plus interest, so the bank makes a profit.
Bonds operate in a similar fashion. When large companies or governments need significant sums of money to fund projects or expand services, they might issue bonds to the public. When you purchase that bond, you are actually loaning money to the issuing entity. Your profits come from the interest that accrues on the face value of the bond, which you can cash in after the maturity date. That date is predetermined, so it’s almost guaranteed that you will receive a known amount of profit (from the interest) once the bond matures. For that reason, bonds are referred to as “fixed-income” securities.
Mutual funds are pretty simple, which is why the majority of Americans choose to go this route. More than half of Americans invest some portion of their assets in mutual funds. It’s better than keeping money in a savings account but less risky than stocks. Even more, mutual funds require relatively little work on your part — there are managers to monitor your investments, and they are the ones responsible for developing a diverse portfolio. Larger mutual funds usually own hundreds of various stocks across multiple industries, so they are an affordable strategy for investors to gain exposure to the larger market.
Unfortunately, mutual funds may also come with a hefty set of fees, and the returns are not always worth it. Diversification may also lead to dilution, which reduces the effectiveness of your returns. High returns from a few firms can easily be negated by low returns from other firms. Thus, your overall return is fairly weak.
Also keep in mind that bonds and funds might be the poster children of secure investments, but nothing is guaranteed. We’ll get to this later.
“Stocks aren’t only for the rich; even if you start small, investing in stocks can help you build wealth over the long term. The key is to have an investment plan in place that aligns your investments with your risk tolerance and goals.”
— Claes Bell, a CFA and Bankrate.com analyst
Stocks are easily the most popular avenue for investors, particularly those investors who are more actively involved with their own wealth. Historically, the stock market has been the most reliable and accessible way to generate wealth in the long term.
When someone mentions a stock exchange, images like this one probably come to mind:
Frantic Wolf of Wall Street-style brokers, hustling around on the trading floor, screaming and signaling to each other to “BUY, BUY, BUY” or “SELL, SELL, SELL!” If you’re interested in older and larger companies like General Electric (GE), Citigroup (C), or Ford (F), then the environment above is where those transactions will take place: The New York Stock Exchange. There are almost 3,000 companies that trade on the NYSE, which translates into about 1.46 billion shares each day.
Unlike the NYSE, the NASDAQ is completely virtual. Thanks to the tech boom of the early '90s, what used to be considered the home of “second-tier” stocks is now the exchange for some of the largest companies in existence. You’ll find Microsoft (MSFT), Apple (AAPL), Alphabet (GOOG), and Facebook (FB) here.
When you get down to the bones of it, an exchange is really just a place where buyers and sellers decide share prices. But what kind of factors influence that decision?
Unfortunately, there’s no foolproof formula for this one.
At the most basic level, the market forces of supply and demand are responsible for fluctuations in stock prices. However, today’s market is a little more complex than that. Some brokers place more confidence in price/earnings ratios, others on market capitalizations. A company’s earnings are obviously essential to its survival, and those earnings are reported each quarter. Market capitalization determines how large a company is by multiplying the number of outstanding shares by the price per share.
The general margins break down as such:
- Mega cap: $200 billion+
- Big cap: $10 billion+
- Mid cap: $2 billion+
- Small cap $300 million+
- Microcap: $50 million+
- Nano cap: less than $50 million
Each type of cap has its own pros and cons. For example, smaller firms may be threatened by larger competition but also have the most room for growth. (Even AAPL had to start somewhere, right?)
We’ve already covered why it’s necessary to know yourself and prepare your finances for investing. Of equal if not greater importance is knowing your investments.
Even the smallest amount of research could be the difference between a wise investment and throwing your money into the wind on pure speculation.
What does this company do? Who is the competition? What were the earnings last quarter?
If this sounds elementary to you, that’s a good thing. Unfortunately, there are some investors out there who buy and trade based on “insider tips” they hear around the water cooler. This is a terrible idea.
Once you purchase shares of a company, you become a partial owner. Like anything else, you should know what you’re buying before you buy it.
Pull the Trigger
You’ve established your goals, and you’ve done your research. You’ve determined how much risk you are willing to stomach. Now what?
If you’ve decided to take the more secure road of bonds or funds, then just request to open an account.
Stocks require a little more work and research. This is one of those times where reading the fine print is incredibly important. Online brokerages are usually low-cost but still offer educational tools for beginner investors. Get information about trading commissions and management fees.
“Fail to pay attention to fees, and you can easily end up paying 10 times as much, or well over 1% of assets annually.” — Forbes
The next step is to keep researching, be actively involved in your investments, and do not become complacent. If done right, investing can be your golden opportunity. Take the right precautions, and get the right information.
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