I know that people reading this website come from all over the map and have all different backgrounds in regards to personal finance. My goal for this article is to provide some basic nuts and bolts to investing to hopefully lay some ground work for someone who hasn’t invested ever in their life or is just looking to start. I will get much more in depth on this topic down there road, but wanted to start with the basics. So with that, away we go!
1) Should I Begin Investing?
Before we get into investing, this should be the first question. The answer really depends on your current financial situation. If you don’t have any sort of emergency fund to fall back on if something bad were to happen, then you probably shouldn’t start with investing just yet. It’s putting the cart before the horse. Typically, a good recommended amount for your emergency fund is 3-6 months of living expenses. Get that first before you think about investing.
You may say, “yeah, but I have a line of credit I could take out if something bad happens” or “I can just put it on my credit card.” The reality is that when you go into a tough financial situation, you don’t know how long it will last. Having 3-6 months of living expenses will help shield that fall, and if you still were in financial crisis after that 3-6 month period, then you would have to resort to something else. At least in that case, you haven’t accumulated 3-6 months of extra debt that you’re paying interest on in the mean time. For those of you that may like some extra resources on this, reading Dave Ramsey’s book The Total Money Makeover will help lay out an order of recommendations before getting to investing.
2) What is my risk tolerance?
Investing differs from saving because it carries a certain element of risk. In most cases, savings (like in a savings account or CD) takes place in an FDIC (Federal Deposit Insurance Corporation) insured financial institution that clearly spells out the interest rate you will make, and guarantees that you can get that same amount back whenever you want it. With investments, there is a possibility that you could lose money (however there are steps you can take to spread out that risk which we’ll talk about later). That is how I differentiate between saving and investing. Saving doesn’t carry the risk that investments do, but in many cases it also may not have as great of a reward. So your plan for investing should align with your risk tolerance. It may be a good idea to take a quiz, similar to this investment risk tolerance quiz from Rutgers, to see where you line up.
3) What are my investment goals? When do I plan to use this money?
You’ve assessed your risk tolerance and you’re ready to dip a toe in the water, but first it is helpful to come up with a plan. First, decide what the end game is. When are you planning on cashing out and using the money? If you’re looking to invest some money for a vacation you are planning to take six months from now, what happens if your investment lost money over that time? Would you want to scale back your vacation? Probably not, so it’s probably best not to invest your money for that. If you are looking for something farther out in the future, and you understand (and are ok with) the risk of losing money, then you can afford to invest it instead of putting it in a savings account.
I regularly invest in a 401k plan. However there have been times that perhaps I’ve saved up a little bit of money and we don’t have a specific plan for it, or possibly you came in to some money (perhaps from an inheritance or a large gift from someone) and you want to build that wealth for the future. Those circumstances would be a great time to invest. If you don’t have a current use for it, it’s ok to take on a little bit more risk with it, and you don’t need it in the short term, it may be a good time to invest the money.
4) What should I invest in?
There are many different investment vehicles. 3 main vehicles are stocks, bonds, and mutual funds. I know there is more out there, but we’ll start with that. In purchasing stocks, you are essentially becoming part-owner of a company (granted in most cases, a very very small part-owner) As a Minnesota Vikings fan, I should say to my friends just east of me in Wisconsin that while buying stock and becoming part owner of the Green Bay Packers may be cool, it doesn’t build any personal wealth as you won’t be able to sell your shares to fund your retirement. But, buying stock on a stock exchange allows you to become part-owner so to speak and hopefully grow your seed money over time. There are many great stocks to invest in out there. Finding ones that you like does take some time and research.
The second type of investment vehicle is bonds. Think of it like giving that person an IOU. A particular company, city, or even professional sports teams trying to fund a stadium building project will issue bonds to the public. You are giving them money now, and they will repay you later. It is more risky than a savings account because it’s possible that this person may not be able to pay you back (just like you may have lent money to someone who promised to pay you back but never did). However, although it is more risky, it also oftentimes pays a higher reward or interest rate than a savings account. Bonds are rated different letters, which dictate how risky an investment is.
The third type of investment vehicle is mutual funds. Mutual funds are essentially a collection of assets that someone can buy shares of, and the person in charge of the mutual fund will take that money and invest it based on the goals of that particular fund. In this case you would not own a particular stock, but you would own multiple stocks, and a mutual fund could also contain bonds and other investments. Stocks and mutual funds are similar in the fact that they could gain and also lose money. However, if you owned stock in a company and that company went under, you could lose most, if not all of your investment. For you to lose most, if not all, of your investment in a mutual fund, EVERY SINGLE COMPANY would have to go under – which is something that would be highly unlikely to happen (and lets be honest, if that did happen you probably have much worse economic problems out there than your mutual fund performance). So in that regard, mutual funds are deemed as being safer than owning a single stock as the risk is spread out over the whole fund as opposed to an individual company.
5) Who Can I Use To Invest My Money?
If you aren’t well versed on investments, it is very wise to talk with someone who is licensed who can help you navigate what you should do. They would help you get everything set up and walk you through the process. However, if you’re comfortable, there are a lot of companies out there where you can sign up and pay only a few dollars per trade for you to invest your money on your own. A few companies out there that do this are Scottrade ($7/trade), E*Trade ($9.99/trade), Sharebuilder ($4/trade), or Charles Schwab ($8.95/trade)
One of the most important rules to learn in investing is to diversify. As I’ve mentioned, investing comes with risk. While it may be enticing to pick one horse and ride it all the way to the end, it’s not wise investing. Spread out your risk. I was reading an article on personal finance a month or two ago (imagine that) and a person was commenting on an article and bragging how in 2-3 years they went from having no money saved up to having something like $60,000 in Wal-Mart stock. Now it’s great that he was able to save up so much in a short period of time, and I’m not saying that owning Wal-Mart stock is a bad thing by any means, but to own your entire nest egg in one company isn’t the most wise thing to do. This particular person got ripped to shreds by other people commenting on it saying how he should spread things out. That’s the message here – spread things out.
I promise that I will cover A LOT more about investing in the future, but I hope that this beginners guide got you familiar with some things and hopefully you picked up on something you may not have know before. Before I close, I would like to recommend a book that can give some additional information. It is Investing for Dummies. I’m a big fan of many books in the “For Dummies” category because they provide a ton of information all in one book. They keep things simple and it’s a pretty easy read if you’re interested in that particular subject. There are a lot of great books on investing which I’ll talk about at a later date, but wanted to throw that one out there to get you started. Happy reading!