Investing— what is it and how is it done?
This is a blog about money, so let’s get some things straight. When I talk about savings, I am not talking about investments. Savings are incredibly important, but they differ from your investments. The easiest way I can distinguish the two is this:
savings— money that you have in an MMA (money market account) or a standard savings account. These funds make up your emergency fund which should be six to twelve months of expenses (opinions vary on how much, for instance Dave Ramsey says start with $500 then work up to three to six, but a year is my personal standard! If you get laid off or quit to start your own business you won’t get far with three months expenses). This money is easily accessible to you in the event of an emergency or an unexpected expense and you are able to get the money quickly.
investments— investments are things you buy into with the expectation that over time your money will grow. The key phrase here is over time. Time is key because invested money accrues interest. Investments are typically not able to be traded in for quick cash since they’re tied up in the market, and the longer you leave them untouched the greater return you’ll yield.
So if you are putting together your emergency fund: put it in your savings account. Once you’ve got six months to a year of expenses on-hand in case of emergency, then you’re ready to start investing.
There are a lot of ways to invest your money, so let’s walk through a few.
stocks— shares of a company that you purchase individually. The more shares you own the more ownership you have. You purchase stocks in hopes that your investment in the company allows them to further their mission, sell more of their products, etc., and by the end of the trading period (generally a year) the company will be worth more than they were when you bought into it. When that happens, you get a return on your investment (ROI) which means that your shares go up in relation to the company’s value increase. Let’s say you bought one share for $10 and the company was worth $100. If their worth increases to $110 by the end of the year (10% growth, not bad!), then your share also goes up 10% (congrats on your $11!).
bonds— a bond is basically an IOU. When companies or corporations are in debt, you can loan the company money through a bond. Bonds differ from stocks in that the company is required to pay you back in a set amount of time and you are owed interest payments from the company throughout the duration of the bond agreement. If you enter into a five year bond, the last day of your contract is known as your maturity date and your initial invest plus any interest it’s accrued is owed to you on the spot.
alternatives— this is a fancy way of saying “everything else”. You can invest in real estate, oil, gold, art, or any other commodity and it will fall under the alternatives category. The returns on alternatives can be harder to measure, but they can be high. A big difference between stocks/bonds and alternatives is how you acquire them. Stocks and bonds have to be purchased through a trader, but alternatives can be bought on your own. For example: if you choose to invest in real estate, you can buy your own properties without having to use a financial advisor to proctor the deal.
Now that you know what these things are, you have to choose where to put your money and there are a lot of options. When thinking about investments it’s important to keep your portfolio diverse. Don’t invest all of your money into the stock market or all of your money into alternatives. Don’t invest all of your money at all! Invest incrementally in a variety of investments because at any given point in time, one might be underperforming. If you keep a diverse portfolio, your stock shares might be falling but your bonds will be accruing interest, your oil investment might be going up, and the real estate market might be booming. About 70% of my investment dollars go into stocks while 20% goes into bonds and the remaining 10% goes to alternatives (excluding real estate). Keep it diverse and let your money work for you.
When you know what you want you have to decide exactly what kinds of stocks, bonds, and alternatives in which to invest. Stocks can often be the hardest to navigate, and this is where things can get a little tricky (so stay with me!). There are generally two different types of stock shares you can buy: growth or income shares. What’s the difference?
growth— a growth share is a smaller investment that you plan on leaving in the market for an extended period of time. Growth shares, when left alone, typically yield higher returns for the investor. Given that they grow slowly at first, they are also the riskier investment of the two. Growth shares are a really smart investment as you’re starting out. Millennials have years before we’re retiring, sending kids to college, etc., so there is a lot of opportunity for these shares to skyrocket before we need to pull out the funds.
income— this one sounds pretty great because we all love a paycheck, but an income share is not a bi-weekly payout (if only). Income shares are typically offered by large corporations who are well-established within their market. Remember when I said if a company grows by 10%, your share also grows by 10% (hope you’ve still got that $11)? Typically you would take your gains and invest them back into the company or the market in general (please don’t take the $1 and buy a stick of gum), but with an income share the company will pay out what are called dividends. Dividends are payouts that occur when the company is profitable or has a budget surplus. Each shareholder receives a portion of the profits relative to the size of their stake. Income shares can be more expensive to purchase, but they’re considered to be much steadier than a growth share. They yield a consistent profit over time, but it’s unlikely that you’re going to see a large return from them. When you’re an older investor or if you’ve already got money in some high-potential growth shares, then income shares are a great way to diversify your portfolio and ensure that you get a piece of your investment back quickly without having to cash out.
Once you know the difference, you can figure out exactly what kinds of stock you want to buy into. You can purchase stock electronically via NASDAQ or you can work with an advisor who will help you select your shares. Working with an advisor is great for beginner investors but it can be expensive. Any advising firm is going to charge you a service fee for their help, so shop it like you would any other big purchase. I personally use Ellevest which is an amazing platform designed by women for women (sorry men, but every other bank was made for you). If you’re going it alone, get yourself an experienced mentor who’s willing to show you the ropes.
This wouldn’t be a real intro to investing if we didn’t talk about ETFs and mutual funds. These things should be one of your best friends.
ETF— stands for exchange-traded fund. Rather than being an individual asset that’s bought and sold, it’s a fund that holds a bit of everything and you buy a small share.
mutual fund— an investment pool where many investors put in money to invest. Professional financial advisors manage these accounts and will work with you on how to allocate your investment.
ETFs and mutual funds aren’t all that different: they’re both a basket of stocks, bonds, and alternatives and your money buys a chunk of everything that’s in the basket. It’s a great way for beginner investors to diversify without having to shop each piece of the pie separately. Within an ETF or mutual fund your money gets split between investments based on how aggressive or conservative you want to be. A more aggressive approach will involve a large percentage going towards growth stocks, whereas a more conservative approach might put a larger percentage towards income stocks, bonds, and alternatives. Again a diverse portfolio is key and ETFs and mutual funds are designed to make diversifying your investment easy.
I’ve saved the sexiest for last, and that is retirement! Trust me when I say this is the good stuff. There are a lot of ways to invest in your retirement and some of the more common are:
401(k)— in the US, a 401(k) is often offered through your full-time employer. Your employer taxes whatever portion you’ve decided to invest, and then they put the rest into an investment account that (like an ETF or mutual fund) is automatically diversified. Many large companies also offer a match program, meaning that up to a certain percentage of your contribution will be matched by your employer. Under a 401(k), you can be investing in your retirement while someone else also puts money into the account for you (a dream).
IRA— stands for individual retirement account and you can invest in this without going through your job. Your contributions to an IRA are tax-deductible in the year that you make them (meaning if you put $100 into your IRA, your account will show you’ve put in $100), but your withdrawals are not. Basically, if you need to take out money it’s going to be viewed as taxable income when you file your taxes for that year (whether you’re past retirement age or not).
Roth IRA— it’s the same idea as a traditional IRA, but the tax roles are reversed. Your contributions will not be tax-deductible so anything you put in is going to be taxed before it hits your account (so if you put in $100 and the tax rate is 10%, your account will show that you have $90 invested). The trade-off is that withdrawals after you hit the retirement age are not taxed.
The beauty of all retirement funds is that they compound. Whatever you put into them on your first contribution will continue to accrue interest up until the day you cash out your account. If you choose to invest in nothing else, you should still invest in retirement. If your employer offers a match program for 401(k), you should contribute the max percentage that they’ll match or even more if you can. A general rule of thumb is that 20% of your current income should go to future you. Future you deserves it!
We’ve covered a lot and this only scratches the surface. What kind of investments interest you and what should we deep dive into next?
