Investing Basics You Need to Understand
Investing can be intimidating, especially if you have never learned the basics and how to invest. You may know the best way to reach financial security is to invest rather than save, but you need clarification about how to do it outside your company retirement plan.
Investing is a massive topic with many small details to pay attention to. That can be overwhelming and keep you from investing your money. But unfortunately, the longer you wait, the less time your money has to grow.
Although investing feels enormous and complicated, understanding the investing basics and its purpose, your risk tolerance and some terminology can make the process easier.
The basic difference between investing and saving
Although saving and investing both involve setting money aside for future use, they are fundamentally different.
Saving for the future means collecting and setting money aside for a short-term goal, usually for something you’ll need in one to five years, or an emergency fund for unexpected expenses. Keeping this money accessible and safe, rather than growing it as much as possible, is your primary goal so that it’s available when you need it.
On the other hand, the basic goal of investing is to make your money grow. You are purposefully setting aside funds for long-term goals like retirement, your child’s college education or a down payment on a house.
The longer you let your money sit in an investment, the better the chance you’ll see a positive return and be in a position to let your money work for you. But investing isn’t all sunshine and puppies.
Investing in the stock market carries more risk than just putting money into an FDIC-insured traditional or high-yield savings account. There is no guarantee that you’ll see a return on your initial investment, called your principal. You must be willing to understand and tolerate the risk and stay with the market through its ups and downs.
Use the stock market to help your money grow
If you aren’t comfortable with risk or grew up in a family that didn’t believe in investing, you might think that stockpiling your money in a savings account or cash hidden at home is enough to help you prepare for the future.
But when you do that, you are losing money to rising prices over time or, in economic terms, inflation.
Generally, the best way to keep up with inflation is by investing in the stock market since you can buy shares of companies (in the case of stocks) or a portfolio of stocks (in the case of mutual funds, index funds and exchange-traded funds, or ETFs) that will likely continue to grow over the long term.
By investing, you’re giving your money a chance to work against inflation. You’re putting money into assets that historically grow faster than inflation rises. This can help you either keep up with or even potentially outpace the future price increases we’ll likely see.
Understand your risk tolerance
To help your money grow as much as possible, you need to leave it invested for as long as possible. That can be hard to do, especially with the recent market jumps and tumbles.
One way to avoid panicking is to understand your risk tolerance. Risk tolerance depends on multiple factors, including when you’ll need your money and your emotional response to loss.
If you’re in your 30s and investing for retirement, you likely have 25-35 years to weather market ups and downs. Losing a little bit now won’t hurt as much as if you were five years away from retirement.
Understanding where you are in your investing journey can help you avoid making emotional decisions. If you have a long time horizon, you may be concerned by a low market but decide to stay invested in stocks. That way, you’re poised to make gains when the market goes back up.
If you’re closer to retirement, you might be more concerned about a down market and look for ways to protect your money.
Transferring some of your investments into more stable assets like bonds can help you weather market fluctuations and generate reliable income in retirement. A certified financial planner can help you understand what’s best for your specific situation and when it’s time to move toward a more conservative strategy.
Understanding the basics of your investing options
In general, you’re likely to see the best return on your money by investing in stocks or in products like mutual funds, index funds and ETFs that contain pieces of stocks and other assets.
Before deciding where to invest, it’s essential to understand the basics of what each term means.
‘Buying stocks’ gets thrown around a lot in the investing world. At its core, it just means buying pieces of ownership in a company, which are called shares. Buying individual stocks can take a lot of time. You must research the company, its competition and how the sector it’s in (like energy, technology, health care, etc.) is likely to perform.
If you buy individual stocks, experts recommend devoting no more than 10% of your portfolio’s overall value to individual stocks. Doing this can help you better manage risk and avoid putting all your eggs in one basket.
Investing in mutual funds can help mitigate the risk of buying an individual stock that doesn’t do well. Mutual funds are a single investment bucket that holds parts of other investments like stocks, bonds or other assets.
The stocks included in a single mutual fund often have something in common, like companies that all belong to the S&P 500 index or a specific sector like technology or health care. Mutual funds have some risk. But they are generally less risky than buying an individual stock since you’re holding pieces of multiple companies instead of just one.
Mutual funds are usually actively managed. That means there’s a fund manager who decides which and how much of an investment to include in the mutual fund. Because of this, mutual funds generally have higher fees than other investment options.
Index funds are a particular type of mutual fund. Their primary objective is to mirror what a specific market index is doing.
You may have heard of famous benchmark indexes like the S&P 500, the Dow Jones or the Nasdaq. An index fund includes all of the stocks listed in the benchmark index. When you invest in an index fund, you own a tiny piece of every company in that index.
Index funds are considered passive investing. They generally charge lower fees, since a computer algorithm, instead of a fund manager, monitors and adjusts the index as needed. They also tend to be lower risk than stocks since they are inherently diversified because of the multiple types of companies usually included in one index.
Exchange-traded funds (ETFs)
ETFs are another low-cost investment option similar to mutual and index funds. ETFs hold multiple types of stocks, bonds or other options the way a mutual fund does, and they track a particular index, sector or asset.
A primary difference from mutual funds is that you can purchase and sell them on a stock exchange like regular stock shares.
ETFs can be bought and sold daily, whereas you can only trade a mutual fund once a day. ETFs can be either passively or actively managed. They are a good way to diversify a portfolio as long as you’re aware of and comfortable with the fees involved with the particular ETF you’ve chosen.
Now that I understand the basics, how do I start investing?
You don’t need much to open a brokerage account and start investing. Some brokerage firms offer a $0 or $1 minimum investment. Others require hundreds or even thousands of dollars to start. Read up on brokerage firms to find one that matches your investing style and the amount you have to invest.
If you’re new to investing or want more of a set-it-and-forget portfolio, start with low-fee index funds. While all investments carry some risk, using a mutual or index fund can help you manage volatility through diversification. Plus, it requires less monitoring than individual stocks.
If you have some experience and already have investments in a company 401(k) and low-cost index and mutual funds, you can try picking individual stocks. Be sure to research each company thoroughly and pay attention to the fees charged for each transaction.
Do you have questions or does investing still intimidate you after reading up on the options available? Consider speaking with a certified financial planner to help you choose the right investments for your risk tolerance and goals.
Bottom line of investing basics
Understanding the investing basics, the options available and the risks of not investing for the future can help ease your worries about getting started. Although it can be intimidating, starting to invest on your own outside of a company retirement plan can help you take ownership of your future. And it can give you peace of mind that you’re doing everything you can to make a better retirement.
Photo by Arsenii Palivoda/Shutterstock
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