Deep Dives
Investing 101

New to investing or just want to brush up on the basics? You’re in the right place!

Investing 101
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July 5, 2022

New to investing or just want to brush up on the basics? You’re in the right place! This is your starter guide on investing. Not to throw it all the way back to elementary school, but we’ll go through the five W’s (and 1 H) of investing to get you on your way.

What is investing?

We’re taking it back to the basics. Investing means to:

“expend money with the expectation of achieving a profit or material result by putting it into financial plans, shares, or property, or by using it to develop a commercial venture.”

Literally, that’s the dictionary definition. Basically, it means that you give money to an organization (company, government, or other entity) and hope to receive more money in return.

Who can invest?

Ok, the truth is anyone can invest, but it’s important to have your ducks in a row. First, do you have any higher-interest (e.g. credit card/personal loan) debt? If so, you should focus on paying that down since it’s not likely your investments would outperform the interest you’re paying. Second, is your emergency fund in place? Job loss, unexpected medical, car or home expenses… life can throw many a curveball. Make sure you’ve got a cash cushion for the proverbial rainy day before starting to invest.

Why should I invest?

Inflation averages around 1-2% a year. This means your money, if just left as cash under your mattress, will decline in value by that much each year. While there is a lot of volatility in markets, we use the past performance as a guide. Historically, the returns have been about 1% per year for cash, around 3% a year for bonds, and about 7% per year for stocks. We can invest in stocks to keep up with inflation and hopefully make additional yield on our investments. We recommend an allocation that combines each of these 3 asset classes to keep pace with inflation, but also minimizes volatility in your portfolio.

Savings chart

 

Where can I invest?

There are many different ways you can invest, and it’s important to remember that all investment types come with risk. We’ll go through the most common types of investments.

Different Types of Investments
 

Stocks: stock is a security that represents a fraction of ownership in a company. This is probably what you think of first when you think of investing. Stocks are usually traded on exchanges, and a unit of stock is called a “share.”

Bonds: a bond is a loan made by an investor (you) to a borrower. The most common types of bonds are corporate and government bonds. A bond represents an “IOU” from the borrower to the investor. Bonds usually pay an interest amount and the principal is returned at the end of the bond period.

Mutual Funds: a mutual fund is an investment that pools together investors’ money to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are managed by professional managers.

Exchange-Traded Funds (ETFs): a collection of securities (ex. stocks) that are traded on exchanges. They often track an underlying index, like the S&P 500. ETFs can be comprised of many types of investments, including stocks, commodities, bonds, or a mixture of investments. ETFs are similar to mutual funds, but there are some differences. ETFs trade throughout the trading day, whereas mutual fund trades placed during a trading day will be executed at the close of trading hours. ETFs are sold as whole shares, but with mutual funds, you can purchase units according to a specific dollar amount. ETFs also tend to have lower expense ratios and can be slightly more tax efficient than mutual funds. ETFs trade transaction cost-free on most platforms.

Real Estate: investing in real estate is the purchase, ownership/management of property for a profit. Examples of real estate investing include rental properties and house flipping.

Real Estate Investment Trusts (REITs): a pool of investors who own, operate, or finance income-generating real estate. Most REITs are publicly traded and invest in most property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.

Commodities: buying and selling of physical goods such as metals, agriculture, oil, and livestock. One way to invest in commodities is through futures contracts. Investors can use commodities to diversify their portfolio because the prices of commodities tend to move in opposition to stock.

Options: a type of derivative, meaning their value is based on an underlying asset. Options give buyers the right to buy or sell an underlying asset at an agreed-upon price and date.

When should I invest?

Because investing comes with risk, the “when” to invest involves utilizing these asset classes while keeping in mind your timeframe for needing the funds.

Short Term Investments (0 to 3 years): For example, let’s say you are trying to buy a $300,000 home in the next 12 months and have $60,000 saved for a down payment. Where should that money sit for the next 12 months? Since you need the money in the short term, we recommend keeping it in cash, or a high yield savings account. We would not recommend investing it, as there is significant risk that you could lose money over a 1-year time horizon.

Intermediate Term Investments (3 to 10 years): Let’s say your home purchase timeframe is about 5 years, and you have $20,000 of the $60,000 down payment saved. Your time frame allows you to think a little differently about where that $20,000 can be put. We might recommend an investment allocation of 60% bonds and 40% stocks. The larger allocation to bonds helps dampen the volatility of the investment, while the stock portion helps boost expected returns.

Long Term Investments (10+ years): If your home purchase is in the distant future, you might want to invest more aggressively. For example, a portfolio that is approximately 10% bonds and 90% stocks (even 100% stocks) may be appropriate. Though there will be more volatility, you don’t need the money in the near term so you are able to withstand that volatility. Also, because of the higher allocation to stocks, you can expect a higher return over this time horizon.

How do I invest?

You can elect to self-manage your own portfolio to save investment fees, or select a portfolio manager that fits your investment objectives.

To self manage, determine what you want to invest in, then decide which custodian (brokerage firm) you’ll use to place your trades and hold your brokerage account. When deciding where to open your brokerage account, it’s important to note that trading some securities may incur transaction costs each time you trade. If you stay within the fund family, typically the transaction fees to buy and sell their own funds will be waived. For example, if you plan to buy Vanguard securities, you should open a Vanguard brokerage account because Vanguard will allow you to buy and sell Vanguard proprietary funds transaction cost-free. This is true with most custodians.

For simplicity and cost efficiency, we do not recommend buying individual stocks or bonds directly. Instead, we recommend using ETFs (exchange-traded funds) or mutual funds, which are pooled investment vehicles. This not only keeps fees low, but also provides diversification as well. For example, buying a single share of the Vanguard Total Stock Index (VTI) for $200 will give you partial ownership in 3,500 stocks in the US. Your $200 investment wouldn’t go far if you were trying to buy individual shares of various companies. Buying an ETF like VTI provides greater diversification than investing in individual companies.

Each ETF or mutual fund has an associated expense ratio. This fee goes to the fund manager and compensates them for buying and selling securities for you inside the fund. These can range from .01% to over 2%. This fee comes out of your investment returns, and your returns are credited to your account net of the fee. Select funds or ETFs whose performance justifies their expense ratio.

Sometimes, however, it makes sense to hire a portfolio manager. Common reasons include high net worth, the desire for complex investment analysis, to take advantage of tax-efficient trading, or simply wanting someone else to take care of your portfolio so you don’t have to worry about it.

When selecting an investment manager, consider their investment style and make sure it is consistent with your goals. For example, some managers will select broadly diversified index funds (passive investing) and others will select individual companies to try to beat a target index (active investing). The indexed approach tends to be much less expensive. Active managers may sometimes justify their fees through performance, however it is difficult for active managers to consistently outperform index returns in many markets over time. If you choose to use an investment manager, you will pay management fees in addition to any expenses and fees associated with the funds as described above. Management fees may be charged as a flat rate or a percentage of assets managed assets (i.e. .25%-1.5% per year).

Once you understand these basic concepts of investing, you’ll be equipped to ask the right questions and get your money working for you. Professionals use complex investment strategies of all kinds, but these building blocks will help you get started investing today.

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David Barta, CFA, CFP®