Many people feel intimidated when it comes to investing. 401(k)s, stocks, bonds, mutual funds, and ETFs sound pretty complicated, but understanding the basics is a great first step to investing in your financial future.
Why do we need to invest at all?
I have an uncle ‘Bob’ who refuses to invest, preferring to leave all his extra money in a savings account at a bank. He seems to sleep pretty well every night not having to worry about the ups and downs of the stock market. This, quite frankly, is just not the way to save.
The problem is that without investing, your money actually goes down over time. Yes, especially if it’s in cash. As our products and goods go up over time the value of our dollar decreases. This concept is called inflation. Think about how much farther $1 went 60 years ago. For one dollar you could buy 2 bottles of Coca Cola®! Let’s say, however, we put that money in the bank and earn interest which helps prevent the deterioration of inflation. We are still missing out on the possible upside of investing in high-earning asset classes like stocks or funds.
The loss of inflation is real. Every year the value of your money decreases by about 1-2%, affecting the price of everything - groceries, rent, Big Macs, etc. In a bank account, your money is growing at a rate of 0.01% a year (criminally low interest rates, if you ask us). Combining these two forces, your money is losing value at around 0.99%-1.99% a year. If you have tons of money to start with and aren’t spending very much each year, perhaps you don't need to earn more than negative 2%. But for the rest of us, we need our money to grow.
What are my investment options?
“Cash-stuffed-under-the-bed” does not count as investing. Your money isn’t even earning interest (like it would in a bank account). Broadly speaking, and for the purpose of basic investing principles, we can invest in three asset classes: cash, stocks, and bonds. Historically, if we invested in cash, we could earn ~3%* (this is based on where federal interest rates are at any given time), in bonds ~5%, and in stocks ~10%** annually. While at first glance it’s easy to jump to stocks because of the upside return, it is important to note that this is an average. In reality, in any given year, you will not actually see this return. Instead you will likely see -10% or 19% return. This is what we call volatility. With higher returns typically comes greater risk (alas, there is no free lunch). These are nominal returns (before taking inflation into account). Considering lower inflation in the future, perhaps we can expect real returns (after inflation) closer to 1% for cash, 3% for bonds, and 8% for stocks. As we can see, if we want to beat 1-2% inflation, having part of our investments in stocks will be pretty important. It is not uncommon to use all 3 asset classes for different goals and for diversification benefits.
Let’s start with the “riskiest” of the three assets classes. When you purchase a share of a company you are actually acquiring a small portion of that company. In many cases you will be granted voting rights based on the percentage of the company you own. Any company that you can purchase stock in is publicly traded and therefore is required to disclose their financials to the general public. That is one way you may learn whether it is a good investment or not (it’s not best practice to get all of your stock tips from your friend who really “gets” finance).
As a stockholder you are participating in the growth or decline of a business. If a company reports a good quarter of earnings it is likely the stock value will go up. The reverse holds true as well. Stocks, however, are considered a “forward-looking” indicator which means that if a stock moves up it is likely because we expect something positive within that company. Many times you can see drastic moves in stock prices because reality is not aligned with expectations.
How do I get diversification?
As with any company there is a large amount of diversity within the stock market. You can purchase stocks based in the US, internationally or in the emerging markets. There are also large companies, mid-size, and small. All of these pose a different investing challenge but as a general rule, you should try to participate in all areas to maintain diversification.
If you don’t have hundreds of thousands of dollars to invest, buying individual stocks will likely prevent you from diversifying across these assets. Why is this so important? If you have all of your money in 3 stocks and one (or even worse 2) of them go out of business (think Kodak, Circuit City or Blockbuster) say goodbye to your savings. To solve this problem, investment funds were created.
Funds come in many different forms but the general principle is that you can invest in hundreds or thousands of companies with the purchase of one single fund. Mutual funds and Exchange Traded Funds (ETFs) are these pooled investment vehicles. If you have $300 to invest, you could buy a single share of Microsoft, or you could buy a single share of SPY, VOO (index ETFs) or VFIAX (index mutual fund) and instantly own a portion of each of the 500 largest companies in the US. Mutual funds and ETFs are much better to get diversified exposure.
Bonds are not just something your grandparents gave you as a college present. Bonds can take many different forms but ultimately have a more moderate return than stock because the risk is much smaller.
A bond is a debt obligation from an institution to you. Think of a mortgage. The lender gives you a loan for $600,000 in exchange for monthly payments which include interest. Bonds work in a similar fashion except you are the lender. You can lend money to cities, institutions, or even the federal government. A great example would be a bond used to raise money to build a bridge. The city of San Francisco needs to raise 3 billion dollars to repair a bridge. To do that they will take money from us in exchange for regular interest payments and then a full return of the money after the term period (anywhere from 3 - 30 years).
The reason this investment is more stable and secure is that you know how much the interest payments will be. The general risk in these investments is that the city of San Francisco defaults and can’t pay you back. There are a few other risks but those only occur if you don't plan to hold the bond until its full term (also known as the maturity date).
Cash, as we discussed earlier, is your safest investment. It’s important, however, to ensure you have any assets that are part of your investment strategy in a high-yield account. You can do this through a high-yield savings account or through a Certificate of Deposit (CD). Learn more about the important of high-yield savings accounts here.
How do I determine what mix I should have for my asset allocations?
This can be tricky and it can be helpful to enlist the help of an Origin Planner. In general, we are looking for an understanding of
- How comfortable you are with day to day volatility
- How long until you need the assets
- The type of account you are investing in (i.e. retirement or taxable account)
Once you understand those, you can determine your asset allocation. Let’s see a few examples
The great news about investing with a specific allocation is that there are funds created specifically for that! There are many balanced funds (balanced just means that they contain both stocks and bonds) that are low-cost and are prebuilt at the stock/bond split that is appropriate for you. For example, if your taxable investment account is at Vanguard, you could invest in the Lifestrategy Growth fund (VASGX) which is prebuilt to be an 80% stock/20% bond fund. In your retirement plans, you also have a great option if you don’t want to hassle with reallocating your 401k by selecting a “Target Date” Fund. Learn more about target date funds and reallocating your 401k here.
Anything else I should know?
This is meant to be a high-level overview of the core ideas in investing. We hope that you have learned a few things, and are ready to create a full financial plan. If you are interested in learning more, please contact your Origin Planner.
*Aswath Damodaran, New York University, 2019 http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
**Vanguard Model Portfolios https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations