Dylan Lewis: Hey, there, I'm Dylan Lewis, and in this FAQ, we’re talking about how you can invest your money.
Regardless of which way you go about putting
your money to work, you're going to need a few things: a brokerage account, the right
mindset and money you won't need in the next three to five years. Investing is a great
way to build wealth, but it's important to make sure you're starting on solid footing.
Generally, it's best to only invest after you've set aside some savings in an emergency
fund and paid down any high interest debt. Having three to six months of living expenses
on hand is helpful in case anything unexpected happens. And paying down high interest debt
is a guaranteed return that's hard to beat by anything that you'd invest in.
Taking care of those things first also allows you to take the long-term approach to investing.
There are years where the economy is doing well and the stock market is up and years
where it's down. If you're only investing money you don't need in the short-term, you
can weather that volatility and know that long-term, growth is on your side.
Also, if you're investing money you might need soon, it could put you in a position
where you have to sell investments at a loss because you need to make a mortgage payment
or pay a medical bill, and nobody wants that. That's all to say that temperament is key;
it is the most important thing when it comes to investing. If you're going into things
with the right mindset, you can go ahead and open a brokerage account.
Now choosing where to open a brokerage account will largely depend on what you're interested
in investing in, though it's hard to go wrong with the major discount brokers and major
institutions like Vanguard. If you want a rundown of the major brokers,
check the description for a link of our Broker Center. Opening a brokerage account is typically
a quick and painless process that you can do in a matter of minutes. You can easily
fund your brokerage account via an EFT transfer by mailing a check or wiring money; there
are a couple things to keep in mind though. First, determine what kind of brokerage account
you need. For most people that are starting out, this means choosing between a standard
brokerage account or an individual retirement account. The main consideration here is why
you're investing and how easily you want to be able to access your money. If you want
easy access or are just investing for a rainy day, you'll probably want a standard brokerage account.
On the other hand, if your goal is to build up a retirement nest egg, an IRA
is a great way to go. These accounts come in two varieties, traditional or Roth.
Traditional IRAs are funded with pre-tax money, which lowers your taxable income in the year you
contribute, but the money you take out in retirement will be taxed. Roth IRAs are funded
with after-tax dollars, so there's no immediate tax benefit, but you can withdraw the money
tax-free in retirement. If you're thinking in years, go with the standard
brokerage account. If you're thinking in decades, it might make sense to start an individual
retirement account. The great thing is, you don't have to choose, you can do both as long
as you continue to save money and both account types will allow you to buy stocks, mutual funds,
bonds and ETFs. So, that's what you need to start investing.
Now, on to what you can invest in. When most people think investing, they think
stocks and bonds, it's what they hear all the time in the news. So, we're going to [quickly]
define both of them. A stock is an equity stake in a business. Owning a share of a company
means you're a part-owner and you're entitled to a sliver of the company's profits.
If the business succeeds, you enjoy your stake in the business being worth more.
A bond is really debt, if you buy a bond, you're loaning a sum of money to the issuer
for a predetermined period of time, in exchange, the issuer promises to make regular interest
payments at a predetermined rate until the bond comes due and then repay what you lent
them upon maturity. There are other ways to invest, but stocks
and bonds are generally the most common. Now, you can put your money to work in stocks and
bonds in several different ways. You can buy individual stocks and bonds, mutual funds
that hold stocks and bonds and ETFs that hold stocks and bonds. We're going to explore all
three options and talk about the pros and cons of each.
One of the most popular investing vehicles out there is the mutual fund. Mutual funds
are a collection of stocks, bonds or other securities that investors can buy a share of
and they're wildly popular because rather than having to choose individual stocks or
bonds a single mutual fund can instantly give you a well-diversified set of investments.
You can find mutual funds that invest in stocks, bonds as well as other types of investments
such as commodities. Within each category there are a variety of subtypes, such as,
growth stocks, value stocks international stocks and a variety of risk levels.
If there's something you're interested in investing in, there's probably a mutual fund
for you. Most funds are available to all investors even those who only have modest amounts to invest,
which increases investing access for many. Beyond that basic definition, if nothing else,
the thing you need to know about mutual funds is that they're actively managed mutual
funds and index funds. We generally prefer the latter. Actively managed funds have a
manager who's trying to follow a specific strategy to try and provide superior returns.
Unfortunately, many of them don't succeed. Most research shows that due to short-term mindsets,
active trading and high fees, actively managed funds tend to put up worse returns
than the major stock market indices like the S&P 500.
That's why many investors, like us, prefer to put our money into index funds. An index
fund manager’s job is to simply match the index the fund tracks which takes significantly
less time and effort than the analysis and portfolio management involved with actively
managed funds, because of that, index funds typically have significantly lower costs and
are virtually guaranteed to match the long-term performance of their underlying index.
If you're interested in mutual funds, be sure to keep an eye on the returns over the one-,
three- and five-year period and how they compare to the S&P 500 or the funds relevant benchmark.
You should also look at the fund’s expense ratio. Basically, how much you have to pay
the person managing the fund. If it's high, the fund better be putting up better returns
than the S&P 500 or its relevant benchmark, net of fees.
Mutual funds are great for beginners. They allow you to instantly be diversified and
you'll earn returns that beat most professional investors. For example, the S&P 500 mutual funds
like the Vanguard VFINX, have allowed folks like you and me to instantly own a piece
of the 500 largest publicly traded companies in the U.S., enjoy annualized returns of 10%
per year and pay very little to get started. Another very popular investing option for
folks is the ETF, or exchange-traded fund. ETFs and mutual funds are basically siblings,
mutual funds are offered directly through mutual fund companies and many brokers also
offer access to certain index mutual funds in their brokerage accounts. ETFs trade directly
on stock exchanges, allowing anyone with a brokerage account to buy or sell shares at
any point when the stock market is open for trading.
Like, mutual funds there are thousands of ETFs out there. So, it's important to understand
what you're looking at when you're looking to buy. The important metrics are also very
similar to mutual funds. You want to look at your performance and your fees. Each ETF
publishes an annual expense ratio, which represents the percentage of the total fund assets that
goes towards covering the cost that the ETF incurs every year. Smaller expense ratios
mean more money staying in your pocket. And the biggest and most efficient ETF providers
have expense ratios for their funds that can be less than 0.1%. Some high fee ETFs are
worth paying for, but only because their returns beat their benchmark even when you factor
in those fees. If you're new to investing, ETFs are a great
place to start because they're widely available across brokerages, and unlike some mutual funds,
there generally aren't account minimums associated with buying them.
ETFs and mutual funds allow the average investor to easily and cheaply be invested and diversified,
buying baskets of stocks and bonds at once rather than picking and choosing them one-by-one.
And because of that they are one of the best tools for new investors, but they are not
the only options. Most of us are used to borrowing money in
some capacity, whether it's mortgage on our homes or bumming a few bucks off a friend
when we realize we've left our cash at home. Just as borrowing is a part of life for everyday people,
it's a practice companies and municipalities uphold as well. Even the federal government
does it. How? By issuing bonds. Bonds come in several varieties: corporate,
municipal and government. Though their nuances might differ, they're all generally the same;
debt instruments used to raise money. When an organization issues a bond, it asks for
a certain investment of money, it then promises to pay back that investment plus interest
over a specified period of time. For example, you might buy a ten-year $10,000 bond paying
3% interest. The issuer, in exchange, will promise to pay you interest on that $10,000 every
six months and then return your $10,000 after ten years.
There are two ways to make money by investing in bonds. The first is to hold the bonds until
their maturity date and collect interest payments on them, bond interest is usually paid twice-a-year.
The second way to profit from bonds is to sell them at a price that's higher than what
you pay initially. For example, if you buy $10,000 worth of bonds at face value, meaning
you paid $10,000, then sell them at $11,000 when their market value increases, you can
pocket the $1,000 difference. Stocks and ETFs are traded on public exchanges,
so they're fairly easy to buy and sell. Now, bonds on the other hand, aren't traded publicly
but rather trade over-the-counter, which means that investors must buy them from brokers.
The problem with the system is that because bond transactions don't occur in a centralized
location, investors can have a harder time knowing whether they're getting a fair price.
The Financial Industry Regulatory Authority, or FINRA, regulates the bond market to some
extent by posting transaction prices as that data becomes available, but investors can
sometimes experience a lag in getting that information, this isn't a reason not to buy bonds,
but it's something to be aware of. When it comes to bonds, the things you want
to focus on are the bond rating. Now, this is a score of sorts that measures the financial
strength of the entity issuing the bond. There are three major bond rating agencies:
Standard & Poor's, Moody's and Fitch. And these agencies use a combination of letters, numbers and
symbols to indicate the creditworthiness of bond issuers. Ratings tend to follow the general
grading system, As are great, and everything else that follows is progressively worse.
Generally speaking, the higher a bond’s rating, the safer it is as an investment.
But higher rated bonds also tend to offer lower interest rates than bonds with lower ratings,
and that's because investors are rewarded for taking on additional risk.
Although bonds are generally considered a lower risk investment than stocks, they are by no means
risk-free. All it takes is for a bond issuer to default and you as an investor will be
out some money. Bonds generally offer stability and predictable
income, but they come with some disadvantages. For one thing, bonds require you to lock your
money up for extended periods of time. For example, if you buy a bond with a ten-year term.
You're committing to keeping that money invested for ten years.
And because bonds are a relatively long-term investment, you'll face what's called interest
rate risk when you buy them. As we learned before, each bond pays a certain amount of interest,
but what happens if you buy a ten-year bond paying 3% interest, and then a month
later that same issuer offers bonds at 4%. Suddenly, your bond drops in value, and if
you hold it, you'll lose out on potential earnings by getting stuck at that lower rate.
Additionally, bonds aren't all that conducive as long-term investments, because they won't
grow in the same way, that's because the return on investment that you'll get with a bond
is substantially lower than what you'll get with stocks. Consider this, between 1928 and
2010 stocks averaged an 11.3% return, while bonds averaged just a 5.3% return.
Now, imagine you're able to save $300 a month for retirement over a 30-year period. If you
load up on bonds, an average that 5.3% return during that time, you'll wind up with just
over $250,000 nest egg. But if you go with stocks instead and score an average annual
11.3% return on your investment, you’ll grow your retirement account to over $750,000.
And that's important, because without that growth, you'll have a hard time keeping up
with inflation and maintaining your buying power when you're older.
We talked before about mutual funds and ETFs and how they give you access to hundreds of
companies at once, but what if you want to buy a specific company? That's where buying
individual stocks comes into the picture. You can invest in individual stocks if and
only if you have the time and desire to thoroughly research and evaluate stocks on an ongoing basis.
If this is the case, we want to 100% encourage you to do so. If not, it's totally
okay to stick with ETFs and mutual funds and call it a day. This video is more of a broad
stroke look at investing basics. So, we're not going to go super in-depth on how to pick
individual stocks, but we do have a lot of other content on the channel about that.
Here are the important concepts you need to understand before you get started.
Only invest in businesses you understand, avoid high-risk stocks until you get the hang
of investing and always avoid penny stocks. Start out with established growing businesses
with market-leading positions. For example, Apple and Disney are great beginner stocks.
They have businesses that are easy to understand. Apple sells “i” products and has a software
marketplace. Disney makes movies media and owns theme parks, plus they're growing profitable
companies that aren't going to disappear overnight and they both pay dividends.
I like to think the first couple of stock purchases someone makes as a tuition payment
in understanding how investing works. Like anything, starting out investing is humbling
and there are many mistakes to make along the way, but if you choose stalwart companies
like these, you'll be able to learn how successful businesses operate, how to read financial
statements, like an income statement and a balance sheet, and you'll likely see your
tuition grow as these companies continue to succeed.
If you focus on speculative growth companies or penny stocks, you likely won't see your
tuition payment back. Start out with a base of rock-solid, established businesses in your
portfolio and expand into more growth-oriented businesses as you learn more. For a quick
checklist, look for businesses that you can wrap your head around that also are growing
their revenue, have a moat or an element that protects them from competition, and a management
team that you believe in and can trust. For a more in-depth look at how to pick stocks,
head over to our free starter kit, it covers how to know you're ready to invest, what specific
metrics to follow and it has five great starter stocks. You can get that over at fool.com/start.
And for more information on investing in stocks, bonds mutual funds and ETFs, check out the
episode description, we've got links to our comprehensive guides there.
If there's anything you think I missed or you have an idea for a future video,
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Thanks for watching and until next time, Fool on!