This is everything you need to know to understand investing basics.
When you think of investing, you might think of Wall Street, charts and graphs, and a litany of investing terms. As a newbie investor, all of that might seem overwhelming and keep you from investing. Let’s start with helping you understand investing basics so you can successfully invest for independence or invest for retirement.
What is Investing?
Investing is the act of committing money to an endeavor with the expectation of earning additional income or profit. There are a number of ways you can invest such as with stocks, bonds, mutual funds, real estate, or your own business. And depending on your risk tolerance one may be a better fit for you.
There is a simple way to define investing. It’s buying anything that you expect will increase in value and be sold for a profit. You could also think of it as a deposit in an account that earns interest. There are two types of asset classes: liquid assets or fixed assets.
Liquid assets mean that you can either access cash in an asset quite easily or convert the asset to cash by selling it off. This is also referred to as liquidity. If you have a savings account at your bank, then you already have a liquid asset investment. The money stored at the bank is easily accessible and may earn interest, albeit small until you withdraw it.
Other types of liquid asset investments include the following:
- mutual funds
- most types of bonds
- shares of other securities such as money market funds and real estate investment trusts (REITs)
The degree of liquidity can vary with these assets, but you can sell most of them if needed.
These assets tend to be more tangible than liquid assets, and they aren’t as easy to withdraw from or sell for cash. Usually, investors buy into hard assets in hopes of holding onto them for a longer period of time.
The following are usually considered as fixed asset investments:
- Real estate
- Precious metals
- Commodity investments
- private business assets such as equipment and vehicles
Usually, most beginners start investing in liquid assets such as stocks through brokerage firms. In contrast, hard assets often require more knowledge and cash upfront and can come with a bit more risk and complexities for beginners.
Investing in the Stock Market
The stock market is the term used to talk about a place where stocks and bonds are bought and sold. When most people think of investing the first thing that often comes to mind is the stock market. In a stock market shares of public companies are issued and traded either through exchanges or over-the-counter markets.
Stocks are a type of security or equity that gives stockholders a share of ownership in a company. When a company needs to raise money for business operations or growth they have two choices: 1) borrow money or 2) raise it from investors by selling them a piece of the company by issuing shares of stock. When you own a share of stock you are a part owner in the company.
A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation.
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.
An index fund invests in a specific list of securities that see to track the returns of a market index. For example, the S&P 500 Index and the Russell 2000 Index are just two examples of market indexes that index funds may seek to track. In short, index funds are a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index.
Most ETFs are index funds. Exchange-traded funds are baskets of assets traded like securities. They can be bought and sold on an open exchange, just like regular stocks, as opposed to mutual funds, which are only priced at the end of the day.
Starting Your Investment Portfolio
Your portfolio is basically the total amount of investments you have in one or more investment account. To get started with a portfolio, answer the following three questions:
- What kind of investment account do you want to open?
- Where do you plan to open that account?
- How much risk can you handle?
Each type of investment account, whether it’s a 401k plan, IRA, standard brokerage account, college savings 529 plan, or health savings account (HSA) will have its advantages and disadvantages. Where you open your investment account matters because different brokerages will require different investment minimums, charge different fees, and allow for different investments in the account. You also need to know how much risk you can handle because stocks, bonds, mutual funds, ETFs, and other securities have different risks associated with market movements.
What Investment Accounts Are Available?
Probably the two most common types of investment accounts are retirement accounts in the form of either IRAs or variations of the 401k and traditional brokerage accounts. But there are a few others that can be used for specified purposes.
A 401k is offered by an employer, although if you are self-employed, you can also set up a plan. With 401ks, the employer sets policies on employees’ eligibility and chooses the plan administrator. Plan administrators provide investment options and offer simple investment guidance. As a benefit, many employers may even make matching contributions to them.
Have a 401k plan? Check your investment allocation and projected returns to optimize your 401k.
Most employers offer traditional 401k plans where the money grows tax-deferred. A growing number of employers also offer a tax-free plan called a Roth 401(k). The IRS sets the contribution limits in 2020, you can contribute up to $19,500 annually to a 401k, and those 50 or older can contribute up to $26,000. You cannot withdraw from a 401k until you reach age 59 1/2. However, under certain limited circumstances, you can borrow money from it.
Individual Retirement Account (IRA)
An Individual Retirement Account often referred to as an IRA is similar to a 401k in tax advantages and follows much of the same rules such as being kept until you reach age 59 1/2. You can open it as either a tax-deferred traditional IRA or a post-tax Roth IRA. And you’ll often have more investment choices compared to a 401k. There is an annual contribution limit of $6,000 per year (as of 2020) for those under age 50 and $7,000 for those over. Also, you usually cannot borrow from an IRA. And if you choose to withdraw can face penalties and fees.
Learn more about Traditional and Roth IRAs.
A brokerage firm offers two account options: a standard or a margin account. There are traditional brokerages for high net-worth investors and online brokerage accounts for many others.
With a standard account, you can open, fund, and make your investments to buy/sell stocks or funds. A margin account gives you a few additional options such as borrowing from other accounts to make moves such as shorting stocks (a more complex investing strategy).
Usually, margin accounts will have much stricter requirements and aren’t ideal for beginning investors. You can invest, sell investments, and withdraw funds from a brokerage account at any time, but you will be subject to any and all taxes on capital gains you incur in this account each year.
Shop for an online brokerage account in the marketplace.
529 College Savings and HSAs
A 529 plan is like a Roth IRA, though it’s subject to different state regulations instead of federal regulations. Basically, you invest for a specified period, usually for a child’s college education, and the funds you withdraw can be used for tuition, college materials, and other allowed purposes.
A health savings account (HSA) can be used for emergency healthcare-related costs and is usually offered through a Healthcare focused financial institution.
Different Investment Brokerages
Aside from the 401k which your employer sets up with their own firm, it’s up to you to decide who to invest with. Traditional investment firms such as banks and brokerage firms like JP Morgan usually require higher minimums to start investing and may come with higher fees and administrative costs.
There are also online brokerages like M1 Finance which still have startup minimums, but also usually have fewer fees and give you more flexibility with your investments. Find the right online brokerage for you in our list of the 5 best online brokerages for beginners.
Another type of online investment platform is Robo-advisor that is ideal for newbie investors. Robo-advisors offer recommendations through algorithmic and modern portfolio theory. Read our list of the 5 best Robo-advisors to help you reach financial goals.
Congrats, you just learned investing basics. Now, there are many more aspects of investing in the stock market with complex trades. You might of heard of options, futures, and derivatives. But these advanced levels may not even be necessary to achieve your financial goals.