This is part of series of posts I am writing to help educate friends and family on personal finance topics. As Michelle and I plan our own financial future, we realize that much of what we know was pieced together through trial-and-error and pure luck. I write to share what I know so that others can share the wealth. If you see something amiss, please let me know ASAP so that I can fix it. Also, feel free to share additional resources.
We all want to make our money work for us rather than the other way around. One way to do that is by investing. The principle is simple: you buy something at a low price, and sell it at a higher price. The difference is the profit you get to keep. The downside, however, is selling at a lower price, resulting in a loss. These are the risks (losses) and rewards (profits) that come from investing.
There are different types of investments. House flipping or maintaining rental properties are investments in real estate. Loaning a friend or family member money for a business is a form of investment in that business. More commonly, most of us are aware of the stock market. What is it exactly?
The stock market is a way for companies (of varying sizes) to offer shares of the company for sale. The buyer gets a piece, or share, of the company. The company gets cash to grow its operations. Later, as the company grows, the buyer can sell the shares of the company for a profit. However, if the company does not do well or goes bankrupt, the seller may end up with a loss. That’s the stock market in basic form. We won’t delve into IPOs, buybacks, and other transactions right now.
In addition to shares, a company can also issue bonds. If you’ve heard of bonds for cities or school districts, the idea is similar. You loan the company money. The company agrees to pay back the funds at a specified interest rate over some period of time. Like other loans, the interest rate depends on the creditworthiness of the company. The better the creditworthiness, the lower the interest rate. Bonds are generally considered a safer investment than shares because of the defined payment terms and the fact that bond holders are repaid first in the event the company goes bankrupt. Shareholders, on the other hand, usually end up with nothing when a company goes bankrupt.
How do you decide which one is for you? Stocks or bonds? That depends on your risk tolerance and time horizon for when you need the proceeds. If you are saving for a mortgage down payment in the next couple years, you should play it safe and go with bonds or park the money in a savings account or CD where you can earn a 1-2% return. If you’re saving for an event many years down the line, such as retirement, or just trying to increase your net worth, stocks offer a potentially higher reward at the cost of extra risk. Historically, the stock market has returned 10% returns on average. You invest $100 at the beginning of the year. You have $110 at the end of the year. That’s not guaranteed. I owned a lot of shares of Delta Airlines when they went bankrupt in 2005. I was not happy to lose that money! Keep this in mind. If you invest, you need to be mentally and emotionally prepared to lose all of your invested funds. If you cannot handle that, stick with CDs and savings bonds. You simply are not ready for the stock market.
Assuming you’re ready to invest, how do you pick a company to invest in? You can own a piece of Apple, or Walmart, or your favorite car company. So many options! Pump the brakes. You’re not ready to invest in a single company quite yet. Doing that correctly requires a greater understanding of corporate financials than I plan to share here. Also, I don’t yet have the knowledge to pick a good stock. I prefer investing in exchange-traded funds (ETFs) and mutual funds. The idea behind these funds is that you invest a group of companies, entire industry, or the whole market. If you want to invest in the entire US market, you can buy a fund for that. Really think healthcare is going to be profitable? Buy a fund full of healthcare companies. These funds offer a broad exposure to the market that helps offset the risk of a single company failing.
When evaluating ETFs and mutual funds, make sure you are aware of the fees. Most charge a small management fee, or expense ratio. This fee is taken from the invested assets every year. Over time these fees can add up, and can eat into your potential profits. Unless the fund has a history of high returns, I try to stay under 0.3% for fees.
You know about stocks, bonds, and mutual funds. You know about the risks. I haven’t scared you off? Great! Let’s do some investing. For that you need a brokerage account. I do my investing at Vanguard because their fees have generally been lower than other firms’. My 401(k) accounts are at Fidelity because that’s where my companies housed the accounts. Either is fine. I have found Fidelity’s user experience to be a lot more pleasant than Vanguard’s. Set aside 30-60 minutes to look at both and open a personal investing account. Look at the funds they offer and the fees.
When you’re ready, transfer some money from your bank account to your investment account and make a trade. Many funds let you buy partial shares. If a share costs $1000, but you only have $100, buy the 0.1 shares. What’s important is that you start investing sooner rather than later. The longer you can keep money in the market, the greater your potential for gains.
I am only sharing my own investments to provide some insight into how I pick funds. I am intentionally including the individual companies whose shares I own because I haven’t purchased individual shares for many years. Please do not take this as gospel, or a path to immense wealth. We could all end up losing money next year for all I know!
I’ve only covered the basics of investing. Note that there are tax implications when you do sell your investments. Generally, you want to remain invested for at least one full year to qualify for long-term capital gains taxation, which is a much lower rate than your income tax rate. There are far more complex investments, but we don’t need to go into that quite yet. If you have questions, please post them below or message me directly.
Here are some additional resources to learn more about investing: