Beginner's Guide to Investing
If you're thinking about investing, you deserve a pat on the back! Why, exactly? Because investing is one of the best financial decisions anyone can make. In fact, it wouldn't make sense not to invest.
Alas, if you've never invested before, you might have a million and one questions running through your head.
Luckily, we've developed our beginner's guide to investing specifically for that reason. In this article, we'll give you a crash-course on just about everything you'll need to know before and during your investing journey. There's a lot of information – so be sure to take notes when applicable (or screenshots).
What is Investing?
Investing is, first and foremost, a tool for building future wealth.
When we talk about the future, we mean long-term. Investing is definitely not a get rich quick scheme. It takes time to earn interest on the money you invest. This means it's going to take some patience on your part.
Investing is also about working smart rather than working hard. You're already working hard to earn a salary, after all. When you invest a portion of that salary with a smart mindset and approach to investing, you're making sure you get the most out of that hard-earned money.
How Do I Make Money From Investing in Stocks?
As with all investments, you'll earn interest on the money you invest in stocks.
Even though the stock market tends to be volatile – (you could see 30% returns for a while, but then that crashes) – you can expect to see positive returns in any given year. Historically, stocks pay an average of about 10%.
The thing to keep in mind when investing in stocks is that it's a long-term commitment. Not only will this increase your chances of receiving a higher payout at the end of your investment term, but you could also collect cash dividends.
Should You Invest?
Let's take an investment of $1,000 over 30 years, compared to that same amount kept in a checking and savings account.
With an average annual interest rate of just 0.4% for checking accounts, you can only expect to see $120 in returns. Savings accounts, on the other hand, have an average interest rate of 0.9%, yielding $281.89.
But if you invest that $1,000 instead, you can expect to gain more than $6,000 in returns at an average interest rate of 7.14%.
You're better off investing 10% of your money, while keeping the other 90% in a checking account. This is much wiser than keeping 90% of your money in savings and 10% in checking – and it pays out more long-term.
Where Should I Start Investing?
As a beginner, you'll want to find a brokerage that offers investment opportunities with lower account minimums. Typically, you'll find these range from $0 up to $2,500 account minimums.
Alternatively, you could opt for a robo-advisor. These allow you to get started quickly with relatively low management fees and low (or even no) account minimums.
Here's our seven best recommendations for beginners:
|Brokerage||Trade/Management Fee||Account Minimum|
|Wealthsimple||0.40% to 0.50%||$0|
Benefits of Starting Young
The stock market – as an example – tends to have both ups and downs. By starting young, you give yourself decades to ride out the downs, increasing your chances of that historical 10% in returns.
This has two major benefits. Firstly, you can afford major expenses like buying a house sooner, without having to take out as big of a loan.
Secondly, with longer-term investments, you're providing for a more comfortable retirement. According to the Social Security Administration, only 38% of U.S. seniors' income comes from their Social Security benefits. And considering Social Security has been paying out more than it collects, that percentage is likely to drop even further.
Pay Off High-Interest Debt First
It's important to note that this isn't a question of whether to pay your debts or invest. You should always pay at least the minimum on your debts. So really, what you're asking yourself is what to do with any money you have left after doing so.
Considering about 75% of Americans live paycheck to paycheck (with no extra money), this becomes a difficult question.
Ultimately, you want to take a look at your post-tax debt repayments and compare them to your post-tax investment returns.
High-interest debt tends to cost more than what your investments will pay out in the same period, and will negatively affect your DTI. This means you should pay off any high-interest debt you have before you start investing. Otherwise, you'll be losing more money than you're earning.
Have an Emergency Fund in Place
Financial advisors are always talking about that extra 6 months worth of savings – separate from your other expenses/savings. This is your emergency fund.
As the name suggests, this is a safety net to ensure you don't end up having to accrue more debt when an emergency situation comes up. Again, this should be separate from your regular savings.
On the other hand, there is some debate as to whether or not you should keep your emergency fund separate from your investments. Betterment (one of the pioneers in the robo-advisor market) shows that keeping your emergency funds in a savings account means you'll lose money due to inflation. Instead, they recommend investing it in a moderate-risk portfolio, so that you still have easy access in an emergency case.
Wealthfront (the other pioneer of the robo-advisor market, and Betterment's biggest competition) advises the opposite. Kate Wauck, Wealthfront's Communications Director, suggests topping up your savings account to combat inflation, rather than investing it.
Either way, you're going to want to build your emergency fund before you start investing.
If you don't already have a budgeting plan, a good place to start is by using the 50-30-20 model:
- 50% of your post-tax income goes toward essential expenses, such as rent/mortgage, utilities, car payments and insurance, groceries, student loans, etc. Ideally, you don't want to spend more than 30% on accommodation.
- 30% of your post-tax income is used for lifestyle or “luxury” expenses, such as new clothes, eating out, gifts, entertainment, etc.
- 20% of your post-tax income goes toward savings, low-interest debt, and investments.
- 30% of your post-tax income is used for lifestyle or “luxury” expenses, such as new clothes, eating out, gifts, entertainment, etc.
Ideally, you want to invest 10% to 15% of your income. But once again, you need to consider your debt-to-income ratio when deciding on an investment deposit. If 10% to 15% isn't a financially feasible goal right now, start off small. Every little bit counts in the long-term.
Don't Invest Money You Can't Stand to Lose
As an extension of the previous section, it's worth highlighting the fact that you should never invest money you can't stand to lose. In fact, this is probably the most important rule of investing.
This hinges on two major factors: your budget (including your debt-to-income ratio), and risk.
Let's take the 50-30-20 budget as our example. If you need to spend 10% of your post-tax income paying off debts and another 5% topping up your emergency fund or other savings, then you can only afford to invest 5%.
Next, you need to consider the risk factor. This goes hand-in-hand with considering your budget. If you can only afford to invest that 5%, then you can only afford to lose that 5%.
In order to be a smart investor, you need to understand the main points of investing vocabulary. There are a lot of terms involved, and trying to learn them all at once can be rather overwhelming – especially as a beginner.
But there are a few basic words and phrases that you're going to come across often as an investor.
In this section, we'll introduce you to some of the most crucial ones you'll need to know (especially if you want to make the most of our beginner's guide to investing).
What is a Stock?
Simply put, stocks are a type of investment representing an ownership share in a company.
Selling stocks is one of the ways companies raise money in order to build their business. Essentially, they sell a portion of the company to investors, with the end-goal of expanding.
From an investor's point of view, stocks are a way to earn interest on your money, in the form of payouts, as the company grows. Owning stocks makes you a shareholder, as your returns are calculated as a relative percentage of their profits over time.
What is a Bond?
While stock trading is very much a long-term investment, bonds are comparatively short-term. This is why Betterment advises investing your emergency fund in bonds rather than the stock market.
Bonds are essentially a debt owed to you. As an investor, you effectively lend money to a borrower, with the understanding that they'll pay you back (with interest) at the end of a fixed term. You'll also receive fixed periodic payments throughout that term. For this reason, bonds are considered a fixed-income security.
Although investing in stocks is more popular due to their longevity, bonds are actually much larger due to their low- to medium-risk factor.
What is a Portfolio?
An investment portfolio is the financial term for all of your investments.
It works the same way as any other portfolio would. Just like a photographer's portfolio is a collection of their best current work (for example), your investment portfolio is the collection of all your current investments.
No matter what type of assets you invest in (and there are many), they'll be displayed in your portfolio. Think of it as a way to keep track of them throughout your journey.
What Does Diversification Mean?
Diversification is a way to ensure your portfolio is as cost-effective as possible by balancing the risk factors of your various investments.
Simply put, a well-diversified portfolio means – when one or more of your investments are performing negatively, those that are performing positively help you to continue earning money rather than simply breaking even (or even worse, running at a loss).
In order for diversification to work, your portfolio's securities (equities and debts) shouldn't correlate perfectly. Otherwise, your portfolio will perform very poorly when investments such as stocks take a dip.
What is Asset Allocation?
Asset allocation is essentially the same as diversification, in that both are a means of balancing risk and returns.
However, while diversification is the act of investing in different assets, asset allocation is merely the division of your portfolio between different types of assets.
For example, you might decide to invest in 25 different stocks. This is diversification. If those 25 stocks form 60% of your total investments when combined, you have a 60% stock asset allocation.
This means that proper asset allocation doesn't automatically mean you have a properly diversified portfolio. Asset allocation could mean that 60% of your portfolio is invested in one stock, with the remaining 40% split between one bond and one real estate investment.
Both portfolio diversification and asset allocation are important factors to include in smart investment strategies.
What are ETFs?
Exchange-traded funds (ETFs) are a relatively new investment opportunity, and one of the most valuable and important products for individual investors.
ETFs are basically a basket of securities bought and sold on the stock exchange through a brokerage firm. What this means is that an ETF's outstanding shares can change on a daily basis, as new shares are created and existing shares redeemed.
There are a few advantages to ETFs. ETFs can be bought and sold at any time of the day, they have lower fees due to the lack of sales load, are more tax-efficient (particularly when it comes to capital gains tax), and they give investors more freedom with trading transaction variations.
Stock funds offer portfolio diversification and help you save time on researching, buying, and selling individual stocks. This is because a common stock fund invests in the common stock of multiple companies that trade publicly.
However, the time you save by investing in stock funds will ultimately cost you in terms of benefits. These are shares that don't offer any special privileges – for example, no guarantee of dividends or preferred creditor status. Shareholders with common stock are typically at the bottom rung of the priority ladder for the companies invested in.
If the company goes bust, bondholders, preferred creditors, and any other debt holders will be paid in full before common shareholders. This makes stock funds relatively high-risk, as you might lose your investment entirely.
Similar to stock funds, bond funds can be more time-efficient than investing in individual bonds.
Once again, your investment is pooled together with those of other investors, and a professional representative invests that money in a bond fund that he or she deems best. Regardless of whether the mandate is comparatively broad or narrow, this makes it easier to diversify your portfolio with a smaller amount.
However, there's also a disadvantage to bond funds. These are bought and sold rapidly according to market performance, which means they're very rarely held until maturity. Income payments will therefore vary from month to month.
What are Dividends?
Dividends form the staple of all investment portfolios, but are often dismissed as retiree investments only. This is most certainly a mistake.
Simply put, dividends are the share of company profits that shareholders are paid as a “bonus,” usually on a quarterly basis. Your dividends are therefore an integral part of your investment returns.
So why do many people make the mistake of thinking dividend stocks are for retirees only? Companies pay dividends according to different schedules, meaning retirees can opt to receive theirs monthly to supplement their pensions. Younger investors don't necessarily need these monthly installments and would prefer to keep their investments long-term.
Types of Investment Accounts
As a beginner, the variety of investment account types can be rather overwhelming.
Each type has its own benefits. Understanding these differences will help you to better decide on what investment accounts to open. After all, before you start investing, you should have at least a basic idea of what you want to get out of your investments and how they'll fit into your financial plans (short- and long-term alike).
Basic employee pension plans and Social Security benefits are no longer sufficient to ensure a comfortable retirement. As mentioned earlier, Social Security benefits currently only cover 38% of senior citizen income and are expected to cover less in the coming years.
The general rule-of-thumb is to have enough saved up to receive 70% to 80% of your preretirement income as your pension payout. But financial advisors are now saying that for the first 10 years of your retirement, you're still going to need 100% of your preretirement income.
Retirement investment accounts are the most sure-fire way to ensure that you can afford to retire.
Employer-sponsored accounts are the first retirement investment accounts that most people have. These include defined benefit plans, Federal employee Thrift Savings Plans (TSPs), 401(k)s, 403(b)s, and 457(b)s. The latter three are collectively known as defined contribution plans.
While defined benefit plans guarantee a specified monthly pension (and are therefore often referred to simply as one's pension plan), defined contribution plans do not. Instead, they work on a percentage of your preretirement income. Typically, this is a set percentage that you, your employer, or both contribute to your pension on a monthly basis.
In some cases, a defined contribution plan includes an employer matching program. For example, if you commit to setting 6% of your income aside for your 401(k), your company may offer to contribute an additional 3%.
Traditional vs. Roth IRA
Some companies don't offer an employer matching program, and some don't even offer a retirement plan. Plus, there's always the chance you could max out your employer-sponsored retirement account. So it's worth repeating: don't rely solely on these and/or Social Security benefits.
Instead, you should look into an Individual Retirement Account (IRA).
|Traditional IRA||Roth IRA|
|Contribution Limit (2019)||$6,000 ($7,000 for age 50+)||$6,000 ($7,000 for age 50+)|
|Pros||-If deposits are tax-deductible, they'll lower your taxable income||
-Deposits can be withdrawn at any time
-Qualifying withdrawals during your retirement period are tax-free
-Phasing out of tax-deductions
-Retirement withdrawals are taxed the same way as regular income would be
-No immediate tax benefits for deposits
-The higher your income, the higher the chance your ability to contribute will be phased out
|Early withdrawal of deposits and earnings are fully taxed and subject to 10% penalty fees unless an exception is met||
-You can withdraw deposits at any time without being taxed or having to pay extra fees
-Early withdrawal of earnings will be fully taxed and subject to 10% penalty fees unless an exception is met
529 College Savings Plans
529 college savings plans are tax-advantaged plans that encourage setting aside money for future tuition fees. Legally referred to as a “qualified tuition plan,” the 529 gets its name from Section 529 of the Internal Revenue Code.
To briefly explain the difference, prepaid tuition plans allow you to invest in future higher education by buying credits or units at a participating college or university. You save this way by paying current tuition fees, avoiding the added costs incurred by inflation.
Educational savings plans, on the other hand, allow you to open an investment account with the express purpose of using that money to pay for tertiary education expenses. Unlike prepaid tuition plans, educational savings plans can be used at any university, and include room and board.
If you used the money from your 529 for anything other than qualifying educational expenses, you'll be fined 10% of the investment earnings, plus federal taxes. The only exception is if the beneficiary received a full scholarship, in which case the 10% penalty may be waived.
Simply put, a brokerage account is an agreement between yourself as an investor and any licensed brokerage. You deposit funds into your brokerage account, and the firm will facilitate your investment orders on your behalf.
You'll still have control over choosing the opportunities your money is invested in, and the assets will be owned by you – not the brokerage.
The brokerage's role is administrative: you'll pay them an account management fee, as well as any other fees they charge.
Cash or Cash Equivalents
Cash or cash equivalents (CCE) are the most liquid form of assets a company or individual entity possesses. These show on balance sheets as a line entry reporting cash-on-hand and assets that can be immediately converted to cash.
Assets held as cash equivalents, as well as cash reserves, are important to both individuals and companies. These act as a sort of emergency fund that can be used when income is low, but can also be used to make a significant acquisition. The flip side of the coin is that companies with higher CCE holdings are often targeted for takeovers.
Moreover, cash and cash equivalents carry a significant opportunity cost, in that you lose out on the investment opportunity.
Easiest Way to Start Investing Now
A lot of people put off investing because they think thousands of dollars are necessary to start off. But as you've seen throughout our beginner's guide to investing, this simply isn't true.
Earlier, we showed you seven different brokerages that are ideal for beginners; especially if you're starting out with very little money for investing. In this section, we'll be taking a closer look at our top three picks.
Remember to take a look at your debt-to-income ratio and pay off any outstanding high-interest debts before getting started with one of these options.
While the latter is beginner-friendly (as the brokerage helps you to manage your portfolio, hence the name), it requires a deposit of $2,500. Therefore, we'll be focusing on the Self-Directing Trade account.
As mentioned earlier, there's no account opening minimum deposit, making it ideal for beginners with lower investment funds. You'll also have full control over your portfolio's management, with the help of provided analysis tools for in-depth research into the stock market.
Stock and EFT trades cost as little as $4.95 each, and you can diversify with options trading for an extra $0.65 per contract.
Betterment, as mentioned before, pioneered the robo-advisor market with Wealthfront. The two companies have since grown in different directions. While both are on the top of their game, Betterment's Digital Portfolio will be the better option for first-time investors who can't afford Wealthfront's $500 account deposit.
Instead of paying per stock, EFT, or options trade, you'll pay a single management fee. For the Digital Portfolio, this is a 0.25% annual fee based on your account balance.
In return, you'll get personalized advice, automatic rebalancing, and advanced, automated tax-loss harvesting. Tax-loss harvesting reduces your tax deductions by selling securities that have experienced a loss and replacing it with a similar one.
Bloom serves as a management platform. All you need to do is connect your employer-sponsored retirement account and Blooom will put their robo-advisor technology to work analyzing it. They'll then make personalized suggestions on how you can optimize your retirement investment choices.
There are no minimums at all, and you can get a free analysis before committing to Blooom. Without spending any money, you'll already benefit from discovering hidden investment fees, get a report on your portfolio diversity, and get recommendations.
If you do decide to sign up, Blooom only charges $10 a month. In addition to the free analysis benefits, you'll also get help with:
- Minimizing your 401(k) fees
- Regularly adjusting your portfolio to stay in line with your retirement goals
- Expert financial advice
- Any suspicious activity reported to you immediately
Investing for Beginners: Rules
We've gone through a lot of investing advice in this article, but before we conclude, we have a little more knowledge to impart.
At several points, we've tried to emphasize the importance of making smart investment decisions. To help you with that, here are five essential rules for investing beginners. Keep these in mind, and your investments are more likely to perform positively.
1. Invest as Early as Possible and as Much as You Can
To repeat a point we've already made: invest as early as possible and as much as you can.
Remember, the sooner you start to invest, the less you'll have to invest each month to enjoy the same rewards later in life. For example, you could start by investing just $380 every month when you're 25, and by the time you're 65, you'll have a million dollars. That's a total investment of $182,400 spread over 40 years.
By contrast, if you wait until you're 35, you'll have to invest $820 a month. That's $295,200 over 30 years – $112,800 more than you would have spent.
Similarly, the more you invest, the higher your returns. If you add an extra $1,000 to your 401(k) every year for 40 years, you'll earn an extra $200,000!
(These examples are based on a somewhat conservative average return of 7%.)
2. Take Calculated Risks
This means you'll need to take the calculated risk of investment.
Taking a calculated risk starts with investing early. High-risk investments, such as stock trading, tend to yield higher returns long-term. And the earlier you start, the more time you have to recover from losses.
3. Don't Invest Money You'll Need Right Away
Another rule worth repeating: don't invest money you're going to need any time soon.
And you should do all three before you start to invest.
4. Don't Invest in Anything You Don't Understand
This cannot be emphasized enough: never invest in anything you don't understand. Doing so is the very opposite of taking calculated risks, never mind smart investing.
Sure, there's a chance you could miss out on some amazing opportunities. That happened to Wall Street billionaire Warren Buffet when he turned down an opportunity to invest in Amazon and Google.
But you'll also skip unnecessary risks that blow up in your face, like Dogecoin. In case you didn't know, Dogecoin is a joke cryptocurrency that briefly hit a $2 billion market cap before crashing. Investors were fleeced because they threw money into something that looked attractive, but also something they didn't understand.
5. Diversify Your Portfolio
Finally, remember to diversify your portfolio.
This goes hand-in-hand with our advice to take calculated risks. By diversifying your portfolio, you balance your risk-and-returns ratios. When one or more of your investments take a dip and start performing poorly (even running at a loss), stronger investments in your portfolio can and will carry you through.
As with investing itself, you should start diversifying as early as possible. This will maximize the advantage you'll already be enjoying by having longer to recover from negative performance.
Throughout our beginner's guide to investing, we've introduced a few investing terms and rules to help you get started.
But the operative term is “beginner.” This is just the beginning of your journey as an investor. Your most important challenge moving forward is going to be increasing your knowledge and staying informed throughout that journey.
Our final piece of advice comes from Benjamin Franklin: “If you fail to plan, you are planning to fail.”
Remember, there's no one-size-fits-all approach to investing. Set clear goals for yourself and analyze your investments according to those goals. Do that, and you're ensuring your own financial success.
Interested in investing? Not sure how to to get started? Build a better financial future for yourself today with our beginner's guide to investing!