I recently had a conversation with a co-worker about investing. She makes good money and generally knows how to manage her money in terms of spending and saving.
But she’s not investing.
Table of Contents
- Basic Terminology
- Our Investing Game Plan
- Helpful Tools and Resources
I asked her why, and she said it’s just too difficult to understand.
Coming from an investment background, it made no sense to me. That’s because I know just how simple investing can actually be.
But then I put myself in her shoes. She has no background or education in finance or investments whatsoever. So I could start to see how investing might seem like this big, scary animal.
Well I’m here to tell you that it’s not.
Investing can be very easy to understand. You can dive as shallow or deep as you want in the investment knowledge pool. There are tools and resources to help you make decisions and to make your financial life easier.
In this article I’ll cover some of the basic terminology you should know. From there, I’ll show you a framework for an investment game plan to get you started.
By the time you’re done with this article, you should be able to:
- Understand key investment terms
- Choose a target asset allocation
- Open an investment account
- Pick investments appropriate for your goals
- Know how and when to monitor your investment choices
Let’s get started with some basic terminology:
First things first. Let’s cover some of the basic terminology you’ll need to know when you’re just starting out as an investor.
Asset allocation is the breakdown of how your overall investment portfolio works. We use the term ‘asset’ to refer to investment types.
So for example, as a new, young investor, your target asset allocation might be 90 percent stocks and 10 percent bonds. We’ll discuss why this might actually be a good asset allocation in the game plan section below.
This means 90 percent of your invested dollars are tied up in stocks. Stock investments come in many forms, including ETFs, mutual funds, or index funds (discussed below). Ten percent of your total invested dollars are in bonds. As you get closer to retirement, though, this balance might change.
People tend to obsess over asset allocation. For a new investor, my recommendation is to get a good understanding of the following:
- Your investment horizon: How long you have before you really need the money – i.e. retirement age;
- Your risk tolerance: How much risk you’re willing to take on; and
- How much you can safely invest: Remember, we’re not talking about investing to make a quick buck; we’re talking about investing for the long-term, so this should be a dollar amount you’re comfortable losing in the short term due to market ups and downs.
Once you fully understand all of those factors, choose an asset allocation that makes sense for YOU, and stick with it for a while before adjusting things.
A mutual fund is essentially a large bucket of money that a fund manager receives from investors to purchase a whole slew of different stocks and bonds.
A key thing to note here is that mutual funds are actively managed by a professional. This means an actual person is picking and choosing your investments.
One of the great things about mutual funds is that they take the decision-making process out of your hands as a new investor and place it in the (usually) capable hands of an investment professional (though, naturally, there’s a cost to this).
An index fund is like a mutual fund, only it’s not actively-managed. In fact, they’re mostly managed by a computer. An index fund matches the composition (and thereby performance) of an index, such as the S&P 500 (which tracks the performance of 500 large company stocks based in the United States).
ETFs are nearly identical to an index fund, only you’ll find more options, and they trade like a stock. For example, you can buy one share of an ETF that invests in only gold or silver. Like index-funds, these are not actively-managed and their costs are low.
Stocks are shares of ownership in a company. There are many complexities to stocks. On the most basic level, however, you can be a part of the growth and profit (or loss) of a company like Facebook. You can either buy individual shares of the company through what’s referred to as the secondary market (when you buy shares through your broker), or you can obtain them through an option like a mutual fund.
Bonds are loans that are made to companies and governments and are part of a larger loan. The borrower agrees to pay the loan back in full on a specified date, and will make interest payments until then. These bonds are usually resold on the secondary market, where investors like you can buy them in the form of a mutual fund or ETF (or just individually).
Bonds are very unlikely to lose money unless the borrower defaults. We recommend staying away from risky bonds and investing in simple, U.S. Government bonds.
The expense ratio is what a fund charges its investors for managing the fund. This will be higher for actively-managed funds, such as mutual funds, and lower for things like index funds and ETFs which are not actively-managed.
The expense ratio is in the form of a percentage, and includes things such as management fees, operating costs, administrative fees, and other fees related to operating the fund.
Make sure you have a good understanding of exactly what you’re being charged, as some funds will charge a higher fee for no real reason at all.
Asset classes are groups of investments that have similar characteristics, are subject to the same types of regulations and laws, and typically have common trends in the marketplace.
To better understand, I’ll give you an example.
The major asset classes you’ll run into as a new investor are stocks and bonds. There are also cash equivalents, such as money market funds, but you’ll mostly focus on stocks and bonds.
Stocks, in general, behave in a similar way. Historically, we’ve seen large ups and downs, and stocks are impacted by many factors. These include the economy, specific company news, and many other factors. They’re considered a more high-risk, high-reward option.
Bonds on the other hand have been historically considered a safer investment. While you won’t earn as much of a return, you also don’t risk losing as much.
Now please keep in mind, those are both very broad generalities, and you shouldn’t take them as specific investment advice. The point is simply to call out the two different asset classes and how they’ve historically behaved.
These are accounts that are traditionally offered through your employer. The most common types of accounts are a 401(k), 403(b), and TSP, which I’ll break down below.
- 401(k) – A 401(k) plan is a retirement account offered by your employer that allows you to invest with pre-tax money. That means dollars are taken out of your paycheck and placed into an investment account before they’re taxed. You only pay taxes when the money is withdrawn. Most 401(k) plans offer a wide variety of investment options.
- 403(b) – A 403(b) plan is nearly identical to a 401(k), but it’s only offered to employees of educational institutions and some non-profit organizations. Like a 401(k), a 403(b) usually has a good mix of investment options and is tax-deferred until you withdraw the funds.
- TSP – A Thrift Savings Plan (TSP) is a retirement account for federal employees to give them a similar option to people working in the private sector who have access to a 401(k) plan.
Individual retirement accounts (IRAs) are accounts you can set up on your own, outside of your employer. The most common types are Roth IRAs and Traditional IRAs. The money you contribute to these accounts are after-tax, but they’re taxed differently.
With a Roth IRA, you contribute after-tax dollars, but the money grows tax-free. When you withdraw the funds, you don’t pay income tax on the money.
With a Traditional IRA, you contribute after-tax dollars, but get a tax deduction each year for your contributions. You pay income tax when the funds are withdrawn at retirement age.
There are income limits and contribution limits for both types of account. RothIRA.com does a really nice comparison of the two.
Now that you have a better understanding of some of the jargon you’ll hear when getting into investing, let’s take a look at our investment game plan, which all starts with creating an investment plan.
The first, and most important, thing you’ll need to do as a new investor is determine your desired asset allocation (remember, we discussed that above) of stocks and bonds. The overall breakdown of where your money goes is an important decision, but digging into the details of how each asset class is divided is critical.
There are many ways to invest in stocks, but let me show you a few of the biggest decisions you should be making off the bat by comparing some of the different types of funds you’ll see:
There are funds that invest only in U.S.-based stocks and funds that invest only in international stocks. There are thousands of options within each category for you to pick a fund that matches what you’re looking for, but one thing to consider (and this is a personal investment philosophy of mine) is that a lot of U.S.-based companies do business and invest in international markets.
So it might make sense, as an example, to invest in a large-cap U.S. stock fund and an international fund that focuses on smaller, growing companies (or even emerging markets as I’ll discuss below).
The “cap” size of a fund tells you how large (or small) the companies that fund invests in. To better understand, look at market capitalization. Market capitalization is the share price multiplied by the number of total shares outstanding. So for instance, if Company X has a share price of $20 and they have 200,000,000 shares outstanding, their market capitalization would be $4,000,000,000 (20 x 200,000,000).
This allows a company (and fund) to be categorized by their corresponding market capitalization. Here are the three main types you’ll see, along with their corresponding market capitalization:
- Small Cap: $250 million to $2 billion in market capitalization
- Mid Cap: $2 billion to $10 billion in market capitalization
- Large Cap: $10 billion to $100 billion in market capitalization
So if you want to invest in companies like Company X, which has a market capitalization of $4 billion, you’d focus on a Mid Cap fund.
The reason this is important is you should always have a blend of these types of companies. Each has its place in an investment portfolio.
Large Cap funds will focus on the biggest companies in the world. These may be safer bets, but your returns may not be as large. Small Cap funds will focus on small, growing companies. They tend to be riskier, but can net higher returns in some cases. Mid Cap falls somewhere in between.
Emerging markets also have a special place in an investment portfolio. Everything we’ve discussed to this point has been focused on companies that operate in a developed country.
Emerging market funds focus on companies that are in developing or emerging countries. These countries are not under-developed, but aren’t fully developed either. They tend to be moving away from industries like agriculture and focusing more on corporate businesses and improving their residents’ quality of life.
They’re volatile and less mature, but tend to offer a quick rate of growth and higher returns than more developed countries’ stocks. This comes, however, with higher risks. Be sure to add some emerging market funds into your portfolio to help balance out the risk and reward.
Bond have historically given lower returns but offer lower risk and are a key part to any investment portfolio. While there are many different types of bond funds out there, you don’t have to get too fancy with it. We recommend investing in just a single U.S. government bond fund, and keeping it at around 10 percent of your total portfolio allocation if you’re still fairly far away from retirement.
Aside from stocks and bonds, you might run into (or just have an interest in) some other types of asset classes. The most common one you’ll see, and the one I’ll focus on here, is REITs — Real Estate Investment Trusts.
REIT funds are a great way to get your hand into the real estate market without shelling out all the money for an actual property, or taking on as much of the risk of being a landlord.
REIT funds invest in companies that invest in (confused yet?) income-producing real estate. So it’s a broadly diversified blend of companies that deal in all types of real estate.
It’s not completely necessary, but I’d strongly urge you to consider putting some money into REITs, as it adds a further level of balance and exposure to your overall portfolio.
To help you with your desired asset allocation, we’ve put together five resources that will offer you some guidance:
- Was Your Portfolio Designed by Rube Goldberg?
- The Perfect Asset Allocation Plan
- How to Create an Asset Allocation Plan
- The David Swensen Unconventional Success Portfolio
- 5 Resources to Help You Allocate Your Retirement Assets
Now that you’ve begun to develop your asset allocation plan, it’s time to start thinking about where you’ll invest your money.
If you’re employed, your company probably offers a 401(k), 403(b), or TSP. For the sake of argument, we’ll say it’s a 401(k).
For 2017, you can contribute up to $18,000 into your 401(k). Any type of employer match you receive will not count toward this limit. There are many benefits to maxing out a 401(k), namely the amount you’re setting aside and the fact you’re reducing your taxable income.
So the first step we recommend is maxing out a 401(k).
From there, we recommend opening an IRA. There’s a debate on which is better, Roth or Traditional, but this comes down to your personal preference. Personally I have both but I prefer the Traditional IRA because I assume I’ll be making less money when I retire.
If you’re under the age of 50, you can contribute up to $5,500 in an IRA (over 50 goes to $6,500) per year.
After maxing out your 401(k), we suggest maxing out a Roth or Traditional IRA.
Once the two of these accounts are maxed out, and if you still have money left to invest, we suggest opening and using a taxable investment account. This is just a basic brokerage account where you can buy and sell stocks, bonds, and funds. The only major difference is that you’ll be taxed on your investment gains (with a retirement account you’re not).
For both IRA and taxable investment accounts, we recommend using Vanguard. Their interface, account features, and customer service are excellent. You can, however, open these types of accounts at any brokerage or mutual fund company. Do your research, and open an account where it suits you best.
Okay, you’re almost there. You now have a good understanding of investment terms, you’ve determined your asset allocation, and you’ve opened an account somewhere (or you just plan to use your 401(k)). Now it’s time to pick those investments.
I recommend keeping a broad mix of investments, but do what suits your investment plan the best. Your options will be rather limited with a 401(k), but the main things you want to look for are:
- The expense ratio – Is there a similar option that’s cheaper?
- The type of fund – For example, you can get a Large Cap Growth (companies that are growing) or a Large Cap Value (cheaper stocks that are more stable), yet still fall into a Large Cap fund. Pick what’s best for you.
- The historical performance – I don’t put a lot of weight on historical performance because there’s no scientific evidence to prove that historical stock performance is any true indicator of future performance (something they’ll teach you in Personal Finance 101). But it does help some people sleep at night. If all other things are equal, I’ll choose the fund with a better historical performance because it gives me some sense of personal comfort with my choice.
My advice would be to not spend too much time dwelling on which specific fund you’re going to invest in. Focus more on the asset allocation you decided earlier, and try to stick to that.
If you go with individual funds, you’ll want to rebalance at least every year. Most 401(k) plans offer to do this for you, but if they don’t, go in manually each year and reset your asset allocation (unless you change your strategy).
One final recommendation here is just to KIS — Keep It Simple.
You can avoid some headaches by choosing what’s called a Target Date Fund. These aren’t quite as cheap as, say, a Large Cap fund, but it’ll save you some decision fatigue.
A Target Date Fund allows you to choose a fund that closely matches when you intend to retire. So, for example, if you’re 27 and plan to retire at 65, you might choose a 2055 Target Date Fund.
The fund will invest in assets that are appropriate for this investment time horizon. For instance, if you plan to retire in five years, your portfolio will place a heavier weight on bonds, which tend to be safer. But if you’re 30 or 40 years out, the fund will put a heavy weight on stocks, which are more volatile but offer a better return, since you won’t need the money for a long time.
For a brand new investor looking to just get started, I would recommend a target date fund. It’s just easier and it will give you time to get used to investing. You can always change your investment options later on.
The last step in our game plan is to monitor your investments. Even if you choose a target date fund, you should never just “set it and forget it.” I recommend checking in on your investments at least once a month, and rebalancing your entire portfolio at least once a year, but no more than quarterly.
It’s easy to choose a mutual fund or index fund and stop thinking about it, but that’s a big mistake for many new investors. Keep an eye on your money while it’s going to work for you.
Just like the working world, we hire employees that don’t always work out. Same thing with investments — sometimes we buy ones that don’t work out.
There is a free tool that makes managing your investments easy (and fun). It’s called Personal Capital’s free financial dashboard.
Personal Capital enables you to connect all of your 401(k), 403(b), IRAs, and other investment accounts in one place. Once connected, you can see the performance of all of your investments and evaluate your asset allocation.
With Personal Capital’s Retirement Fee Analyzer you can see just how much your 401k and other investments are costing you. I was shocked to learn that the fees in my 401(k) could cost me over $200,000!
Personal Capital also offers a free Retirement Planner. This tool will show you if you are on track to retire on your terms.
Robo-Advisors have become incredibly popular in recent years. Basically, it’s a computer algorithm that does all of your investing and rebalancing for you. All you need to do is set a target asset allocation of stocks and bonds (or sometimes they’ll recommend one for you) and deposit money. The Robo-Advisor does the rest. It is more expensive than doing it on your own, but many people prefer using these new brokers because it will automatically adjust their portfolio for them.
I personally switched to a Robo-Advisor a little over a year ago, and my entire educational background is in advanced investments and equity analysis (so I’m comfortable choosing individual stocks). I just find the time-savings and hands-off approach well worth the cost. For more information on Robo-Advisors, check out these resources:
- 7 Simple Reasons Why You Should Use a Robo-Advisor
- Are Robo-Advisors Worth It? 5 Reasons NOT to Use One
- 5 Reasons Robo Advisors are Worth the Cost
- Robo Advisors–The Pros and Cons
- How to Prepare for a Bear Market – An Interview with Paul Merriman
- How to Learn from the Stock Market Crash of 1929
- What Are ETFs (and Are They a Strong Investment Option)?
- Large Cap vs. Small Cap Mutual Funds – How to Increase Your Returns
- How to Get Help Managing Your 401k (for $10 a Month)
- Wealthfront Review: How it Compares to Other Robo Advisors
- WiseBanyan Review – Is This Free Robo-Advisor For Real?
- Charles Schwab Intelligent Portfolios Review: A Free Robo-Advisor?
- Betterment vs. Wealthfront: Which Is the Best Robo-Advisor in 2017?
- Future Advisor Review — A Tool to Automate Your Investments
- How Can Patch of Land Change the Way You Invest?
- Is Realty Mogul the Easiest Way to Invest in Commercial Real Estate?
- 8 Best U.S. Housing Markets for Real Estate Investing