The Beginner’s Guide To Investing

Investing your money can be a powerful way to build wealth and achieve your financial goals over time. It is far more effective at growing your money than savings accounts, which often fail to keep up with inflation. The S&P 500, the most popular of the three major stock indices, has returned an average of 10.2% annually over the last 20 years.

Investing can feel daunting, but these basic guidelines will give you the information needed to avoid common mistakes get started in putting your money to work.

GETTING STARTED

Common investments include stocks, bonds, mutual funds, and ETFs. Investors can mix and match among these categories to build a portfolio that matches their risk appetite and goals. But before you start investing, there are some important questions that you need to answer.

Create A Budget

The first step in investing is determining how much money you can invest. To do this, you need to create a budget. The goal is to cover your essential expenditures before funding your investments. Before devoting any money to investments, you should pay off high-interest debts. Paying off a 25% interest rate credit card is like getting a 25% return on your money.

You should also establish an emergency fund that is quickly accessible before putting money towards investments. A sudden forced liquidation of your investments could cause unnecessary losses.

Decide How Much Money To Invest

How much you should invest depends on your financial situation, investment goals, and when you need to reach them. Some sources recommend that investors devote 10% or even 20% of their income to their investments. High inflation has made this difficult for many Americans.

What is more important is being consistent with your investing. Whether $50 a month or $5,000, treating contributions as a fixed monthly expense will establish a habit of regularly funding your investments.

Only invest with money you can afford to lose, even if it means temporarily cutting back on your scheduled contributions. Don’t draw from your emergency fund or your child’s future tuition just to fund your investments.

Plan on leaving your money in the stock market for at least five years to even out volatility. The S&P 500 goes up in the long run but falls on average three times every ten years.

Setting Goals

Setting vague goals and timelines are mistakes that many beginning investors make. Determine concrete investment goals, such as “generating at least $X in monthly passive income before I retire in 30 years” or “make enough money to pay for our child’s college education in 10 years.”

The feasibility of your goals will be constrained by the amount of money you can invest and how close your anticipated deadline is. Another major factor in the accomplishment of your goals is your risk appetite.

Risk Tolerance

All investments carry a chance for losses. Some are more risky than others but carry the possibility of higher returns. Determining your comfort level on the risk vs reward scale is an important part of your investment planning.

Your risk tolerance can be informed by the timeline you’ve established for your investment goals. Meeting an aggressive timeline can either require you to take on more risk than you initially envisioned or require a reassessment of your goals.

Investing Styles

Your investment portfolio can be as aggressive or as passive as you desire. Aggressive investors will tend toward growth stocks or specific market sectors that are outperforming, with the understanding that greater returns come with a higher risk of losses. Aggressive investing requires closer attention to market movements in order to maximize returns and minimize losses.

Passive investors can buy index funds or more bonds than aggressive investors. The lower risk of losses means that returns will lag when compared to high-risk investments. Passive investments are a good choice for investors who don’t have the time or inclination to constantly monitor the market.

Diversification

No matter what sort of investor you are, it makes sense to diversify your investments. Diversification means choosing assets that behave differently to different financial conditions. This way, losses in one type of asset are offset by gains in another. For example, bonds provide low but steady returns, helping balance out downturns in the stock market. Broad-based index funds are commonly used as a foundation for equity investments.

Diversification is another area where risk tolerance plays a part. One baseline for determining how you should diversify your portfolio is the “110 Rule.” Subtracting your age from 110 indicates the percentage of your investments that should be in stocks. This metric is more of a guideline than a rule. The percentage of equities in your portfolio can be tweaked by choosing the type of stock investments you buy. A broad index ETF like an S&P 500 index fund will be safer than buying risky, high-growth stocks.

STOCKS

Stocks are a claim to a share of a company's assets, making stockholders partial owners of the company. A stock’s share price is determined by buyers and sellers on the stock exchange. A company’s performance. A well-run company should see its share price increase, while one in trouble can see its share price fall.

Investors buy stocks because they believe they will increase in value over time, or that they can profit from short-term price movements, or, in the case of dividend stocks because they provide regular income.

If a company fails, the value of its stock falls to zero. Any residual value is given to bondholders first. Once creditors are all paid, any remaining value is portioned out to shareholders. Many times, the company’s liabilities are such that shareholders are not compensated at all.

Growth Stocks

Growth stocks are shares of companies expected to increase in value faster than the market average. They often trade at a high price-to-earnings ratio in anticipation of large capital gains.

Investors in growth stocks expect to gain from increases in the stock price driven by the company’s increasing earnings and revenue. Growth stocks are usually found in new or rapidly expanding market sectors like technology.

Value Stocks

Value stocks are shares of companies in established sectors, such as utilities and consumer staples. As established and mature companies, they are seen as lower risk than growth stocks. Value stocks trade at lower price-to-earnings ratios than their intrinsic value would indicate. Investors buy value stocks in anticipation that their price will increase once the market realizes their true value.

Dividend Stocks

Dividend stocks are shares of companies that regularly return profits to shareholders in the form of quarterly dividends. Investors usually choose dividend stocks for the steady income they provide. Paying regular dividends is one way an established company can signal its strength and stability.

MUTUAL FUNDS

Mutual funds are professionally managed investment portfolios that pool investors’ money to actively buy and sell a stated range of assets to provide returns. Investors like mutual funds because they benefit from a portfolio that would be difficult or impossible to build on their own.

Investors buy shares of mutual funds from the fund itself. The share price of a mutual fund is connected to its Net Asset Value (NAV), which is updated once at the end of the business day. This is also the only time investors can buy or sell shares in a fund.

Some major types of mutual funds are:

• Equity mutual funds;
• Bond mutual funds;
• Diversified mutual funds;
• Index mutual funds, which have lower expenses than actively managed funds; and
• Money market mutual funds.

Money market mutual funds are very popular as a high-yield vehicle for parking funds. When you hear reporters talk about investors “moving to the sidelines” or “parking their cash” they are selling assets and transferring the money to money market mutual funds.

Mutual funds have several expenses that directly owning stocks do not incur. Management fees cover the fund managers' compensation as well as staffing and operating costs. There are several shareholder fees as well. These include sales loads, account fees, and purchase fees.

What is a Mutual Fund Load?

A mutual fund load is an annual charge of a fixed percentage of the fund’s assets. There are also front-end loads that are charged when you buy mutual fund shares and back-end loads that are charged when you sell shares.

ETFS

Exchange-Traded Funds (ETFs) are similar to mutual funds but with several key differences. ETF shares trade on the stock market instead of being bought and sold directly through the fund. They are traded throughout the day instead of only at the market close. The price of ETF shares fluctuates throughout the day like stocks, instead of the price being set like a mutual fund.

ETFs cover the same market sectors as mutual funds. Index ETFs are some of the most popular investment vehicles. The first ETF was the SPDR S&P 500 index trust (SPY.) It remains the world’s largest ETF. Since they are passive funds, the expenses for index ETFs are far lower than those of actively managed funds.

BONDS

Bonds are fixed-income investments issued by companies and governments to raise money. Bonds have fixed interest rates and fixed dates of maturity. Bondholders earn regular interest payments and receive their principal back from the bond issuer at maturity.

The face value of a bond (par) is the amount paid out at maturity. The yield (effective interest rate) on a bond can be changed in the secondary market by trading it at a price above or below par.

Treasury Bonds

US Treasury bonds are considered to be the safest investment available since they are backed by the US government. They are issued in three major classes, ranked by duration:

• BILLS: Treasury bills are sold in durations of 4, 8, 13, 17, 26, and 52 weeks. These short-duration bonds don’t provide interest payments. Instead, they are redeemed at face value upon maturity.
• NOTES: Treasury notes are sold in durations of 2, 3, 5, 7, and 10 years. Treasury notes pay interest every six months. The difference in the yields between the 2-year and 10-year Treasury notes is used as an indicator of the health of the economy. The yield on the 10-year Treasury note is considered the “benchmark” interest rate. It is used as a basis for many financial instruments, most notably for mortgage rates.
• BONDS: Treasury bonds, often called “long bonds,” are sold in durations of 20 years and 30 years. The 20-year bond replaced the 15-year bond in 1981.

Treasuries are sold at government auctions where demand (or lack of demand) sets the initial yield. Treasury yields rise when the economy is good or inflation is rising and fall during economic downturns and on lower inerest rates.

Corporate Bonds

Corporate bonds are bonds issued by public and private companies to raise capital. Since no company is more secure than the US government, corporate bonds trade at a premium compared to Treasuries. The difference in yield is a function of the health of the company.

Corporate bonds are graded for risk of default by three credit rating agencies: Moody’s, S&P, and Fitch. The safest corporate bonds are graded AAA (Aaa by Moody’s) and the riskiest bonds are graded CC (Ca by Moody’s). Companies who lose their “investment grade” rating find that they must pay much higher yields to attract buyers.

Investment Grade Ratings

Speculative Grade Ratings

INVESTMENT GRADE

Investment grade bonds are rated from AAA (Aaa) to BBB- (Baa3.) Companies will do nearly everything possible to avoid their bonds falling to junk status. Many investment funds require their bond holding to be at least BBB-.

When a company’s bond falls below investment grade, all these fund managers have to dump their holdings of that bond. This causes the value of the bonds to plummet, and yields to spike.

HIGH-YIELD (JUNK) BONDS

“Junk” bonds are now named “High-Yield” or “Speculative” bonds due to the stigma attached to the former. These bonds offer high yields to compensate buyers for the increased risk that the company will default.

MARGIN TRADING

Margin trading is the risky practice of borrowing money from your broker in order to buy more stock than you ordinarily could, with the expectation that you can sell it at a profit in the near future. Called leverage, this allows you to make more profit than you normally would.

The reverse is also true. If the stock price goes down, you still have to repay your broker the entire amount you borrowed, plus interest. If the stock price falls to a certain level, even temporarily, your broker will demand that you put more money into your account to cover the shortfall (called a margin call.)

If you don’t meet the margin call, the broker will liquidate your position to recover the money it lent you, including the money in your margin account. You still have to reimburse the broker for any remaining balance. Because trading on margin is so risky, your broker will require you to have a certain amount of money in your account.

Even experienced margin traders are subject to the market moving against them and racking up large losses. This is why beginning investors are strongly discouraged from margin trading.

WRAP UP

This article gives you an overview of investing, but it takes more knowledge than this to be a successful investor. Fine-tune your investing with these three investing strategies that work, and continue your financial education with Verified Investing’s free Apprentice Trading Library.