Beginners’ guide to investing

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Investing can be intimidating, but it doesn't have to be. The key is to get a few basic concepts down first and then set clear goals for your money. Then it's a matter of determining which tools will be best for the job at hand — do you want to be risk-averse, passive investor? Are you focusing on retirement and college savings at the same time?

To the end, we've gathered all the basics in one place so anyone can quickly get a sense of the mechanics of the market and what it means to their future.

Start at the Beginning

You're young. Perhaps in your 20s or 30s. You've stashed some money into your company's 401(k) plan – but only because your parents somewhat guilted you into saving for retirement soon after you landed your first job. The company match is a no-brainer, they said, if somebody gives you free money, take it.

But now things have changed. Maybe you see the life changes just up ahead, you've changed jobs and have 401(k) decisions to make, or you're starting to bank some extra cash (good for you!). Now your interest in investing is piqued. Is the stock market the right place for you? That's a question a lot of millennials are asking. According to a Harris poll commissioned by Stash, four in five millennials are not investing in the stock market. While student debt is the reason for 13 percent of those polled, 34 percent said they simply don't know how.

Today, that last reason will change. You'll be in the know. As a young person, you have a higher risk tolerance and, thus, greater opportunities for a higher return. This series of articles will give you a solid introduction into what the stock and bond markets are, how to start investing and the top terms you need to know.

Three Main Asset Classes

First things first. You need to know the three main asset classes or types of investments where you will park your money. They are:

Equities (stocks)
Fixed income (bonds)
Cash equivalents (certificates of deposit (CD), money markets and cash)
Each of these asset classes is an important component of your investment portfolio. When you buy a company's stock, you are investing in that company. (Truth be told, you are actually buying the stock from someone who is selling it, not directly from the company because that is done during the initial public offering). But you are still investing in the strength and success of that company.

Being an Investor

Stocks are the most volatile investment. The reason is that the price of a stock can rise or fall depending on a variety of risk factors. One way to mitigate some of that risk is to place a stop-loss order with your individual stock purchase. If you purchase a stock at a price of $20 per share and you are comfortable with taking some loss if the stock goes down, you can place a stop-loss order at $18 per share. If at any point, the stock hits that point, your shares will be sold automatically. If the stock price rises to $25 per share you can raise the stop-loss order to $22 and you then will gain at least $2 per share on your initial investment. Many people mitigate stock risks by investing in mutual funds or exchange traded funds, which collect pools of money from investors and then invests it in multiple stocks and bonds, thereby spreading the risk.

Being a Lender

When you purchase bonds, you are loaning money to a corporate or public entity (cities, water districts, park districts, tollway authorities, etc.). Let's say your city needs to raise money to build a new police station. The city will typically issue bonds that you can purchase in $100 increments. Twice a year you will be paid a coupon, which is interest on your loan. Also, if you keep the bonds through the duration of the issue, say 10, 20 or 30 years, then you will also receive all of your principal back in addition to the twice annual interest payments over that period. The interest varies depending on various factors, the most notable being the debt-worthiness of the issuing entity. The higher the risk of default of payment to bondholders, the higher the interest. The lower the risk, the lower the interest. You can lose money in bonds. If the issuer defaults, you may not get your principal returned. If you sell your bond before maturation, your initial investment may have less value because of inflation.

Being Liquid

Having some cash alternatives in your portfolio provides liquidity. Certificates of deposit, money markets or cash don't earn you much or any interest, but they do allow you to take the cash in an emergency rather than selling your stocks or bonds. You may want to keep between 3 and 5 percent in cash alternatives in your portfolio.

Now that you know the basics of stocks, bonds and cash alternatives, you're set to put your money to work for you long-term.

Basic Terms For Beginning Investors

As you begin your journey into the investment world, it helps to be armed with definitions of terms that you will hear frequently. Here are the main ones you should keep in your back pocket. Learn a more robust definition or find other investment terms at Investopedia. Don't worry, you won't be quizzed on them.

401(k) Plan — A qualified, employer-sponsored retirement savings plan in which earnings on contributions are tax-deferred, meaning you don't pay taxes on earnings until you start drawing the income from the plan, which you can begin doing at age 59 ½ without paying a 10 percent penalty.

529 Savings Plan — A way to save for college expenses. Money can be invested in the stock or bond markets and all earnings are exempt from federal income tax (and state income taxes in some states).

Asset Class — A group of securities with similar characteristics. The three main asset classes are equities (stocks), fixed income (bonds) and cash equivalents (CDs, money markets). Other asset classes include real estate and commodities.

Capital Gain — The increase in the value of the investment at the time it is sold. If you buy a stock at $100 a share and you sell it at $120 a share then your capital gain is $20 per share. A short-term capital gain is on securities owned for less than a year. The gain is taxed at your ordinary income tax rate. A long-term capital gain is on a security owned for more than a year. The gain is taxed at 15 percent for most tax brackets.

Cash Equivalents — Securities that are short-term, high credit quality and are liquid. An example is a CD.

Coupon — The annual interest rate paid on a bond.

Diversification — A technique that mixes a wide variety of investments in a portfolio. It can include stocks across various industries and a mix of bonds (corporate and municipal). Diversification helps mitigate risk by spreading investments across a broad range. Eggs are not in a single basket.

Dividend — A distribution of a company's earnings to shareholders. The dividend is determined by the company's board of directors.

Dow Jones Industrial Average — The price-weighted value of 30 stocks on the New York Stock Exchange and NASDAQ.

Equities — Formal name for stocks.

Exchange Traded Fund — This investment vehicle combines the diversification of a mutual fund and the flexibility of a stock. It's like a sister to the mutual fund.

Financial Advisor — A person who provides financial advice and guidance to customers for compensation.

Fixed Income — Formal name for bonds.

Index Fund — This is a mutual fund with a portfolio of investments designed to mirror a particular index, such as the S&P 500, Russell 2000, etc.

Large Cap — A company with a market capitalization greater than $10 billion.

Market Capitalization — The number of company shares outstanding multiplied by the current share price. Investors prefer this number to determine size of company rather than using sales or revenues.

Mid Cap — A company with a market capitalization between $2 billion and $10 billion.

Mutual Fund — A portfolio of stocks and bonds in a single fund. Mutual funds are very common in 401(k) retirement plans. A sister to the exchange traded fund.

NASDAQ — A stock exchange where more than 3,000 stocks are traded.

Robo Advisor — An online wealth management service that provides portfolio management advice without the use of humans.

Roth IRA — An individual retirement account using after-tax contributions. Withdrawals are tax-exempt.

S&P 500 — The Standard & Poor's 500 is an index that measures the value of stocks of the top 500 companies based on market capitalization listed on the New York Stock Exchange and NASDAQ.

Sectors — An area of the economy where companies share related types of products and services.

Small Cap — A company with market capitalization between $300 million and $2 billion.

Stockbroker — A Registered Representative who executes buy and sell orders for investors.

Target-Date Funds — Mutual funds with a mix of securities that automatically resets itself based on the time frame of an investor. Many 401(k) plans offer these funds as it's an easy way to park your money and not worry about it. For example, if you plan on retiring in 30 years, there are 30-year Target-Date Funds. The portfolio may begin with a mix of 80 percent stocks and 20 percent bonds, and over time, will reduce the percent of stocks and increase the percent of bonds so that in 30 years it might be a mix of 50-50.

Traditional IRA — An individual retirement account using pretax dollars. Withdrawals are taxed at ordinary income.

Yield — The income return on an investment, such as interest and dividends.

Do I Need a Financial Advisor to Build a Portfolio?

The easy answer is “no” but it might be where you want to start. There are two kinds of financial advisors: fee-based and commission-based. The latter earns a commission on products that you invest in. The former may charge an hourly rate, a flat retainer or a percentage of the assets under management (AUM), which is the value of your total investments.

Here are the steps that a beginning investor can take when dipping your toe in the investment waters.

  1. Identify someone you trust.
  2. Interview 3-5 financial advisors in your community after getting referrals from people you respect and doing some online research about various investment firms and the bank where you have your checking and savings accounts.
  3. Some questions you should ask: How long have you been a financial advisor? How big is your book of business? (This is important as you will know how hungry (they have a slim book of business) or comfortable your advisor is (they have a fat book of business)).
  4. How long have you been with this firm/bank? What is your approach to working with first-time investors? Are you fee-based or commission-based? What is the range of fees I can expect to pay on an annual and quarterly basis? What happens to me/us if you go to another firm/bank?
  5. Do a financial inventory. Gather up all of your insurance and financial documents, such as 401(k), 403 (b), 529, savings bonds, certificates of deposit, bank statements, etc. Take them to the advisor(s) you feel comfortable with after your interviews. Remember, if you are working with a commission-based advisor, you are not charged for meeting with an advisor. A fee-based advisor may charge an hourly rate, a flat retainer fee or a percentage of assets under management (AUM).
  6. Know your goals. The advisor will ask a lot of questions about your short-term and long-term goals — everything from when you plan to purchase a second home to what your plans are to send children to college. The advisor will take all of this information, as well as copies of your insurances and financial records, and begin developing a plan for you to review. This may take a week or two and will require a second meeting.
  7. Consider your options. The purpose of the second meeting is for the advisor to present a colorful game plan for your future. The plan is designed to show you how much you need to save and invest in order to meet the many goals you set forth. The plan also can make specific investment recommendations in order to meet those goals. Ask about other options, the reasoning behind the plan and success stories about the recommendations through the telescope of other investors. Now it's up to you.
  8. Figure out next steps. Take the plan home and sit on it a while. Decide your next step. Do you agree with the advisor? Can the plan be tweaked? Should some of the goals be taken off the table?

Alternatives to a Financial Advisor

Another option for beginning investors is to use a roboadvisor. This is an online, non-human wealth management advisory service. One advantage to a robo advisor is you may be cutting down on fees, which typically are in the 1-3 percent range. You may also be saving on annual account fees, which typically are in the $35-$50 range per account.

A disadvantage to a robo advisor is you don't have human interface. Some people like to discuss their investments with someone who has experience in issuing financial advice and who can help formulate a long-term plan that fulfills your risk tolerance and life goals.

Fees and Risks Beginning Investors Need to Know

So what's this investing going to cost and how do I make money? These may be the two most common questions of beginning investors. And they may be the most important as well.

Making money on your investments is the goal of every investor (common sense, I know). It's the goal of the financial advisor helping you. It's the goal of the firm your advisor works for. And it's the goal of the people who manage the funds that you invest in. So the good news is that everyone wants everyone to win. But make no bones about it — no guarantees can be made that your investment will earn a positive return. But people do make money.

Here are Some Tips:

  • Understand your risk tolerance. Basically, this is how much are you willing to lose? An advisor can help you determine this by asking you many financial questions.
    Have an idea of what you would like to make. Is it 5 percent? 10 percent? Your advisor can put together some mock portfolios that might get you to your number, net of fees and expenses.
  • Making money in the stock market doesn't happen overnight. You should be looking at the long haul.
  • Meet with your advisor once or twice a year to review your portfolio, make changes and rebalance if necessary to keep you on your target goals.
  • Remember, if the value of your portfolio is down at any given moment, you still have not lost money. You only lose or gain money when you sell. Think tortoise and hare.

How Much Does It Cost?

This is a crucial question to ask your financial advisor. It's extremely important to know what fees and expenses are going to be charged and when those charges will be reflected in your account(s).

Expect four or five different fees associated with your account:

  • Annual account fee or custodial fee. This fee is assessed once a year and typically ranges from $10 to $50 per account. It never hurts to negotiate a fee reduction or a waiver with your advisor.
  • Investment management (advisory) fee. These normally are a percent of the total assets being managed. The percent varies, but typically are around 1 percent, but can climb as high as 1.75 percent.
  • Front-load fee. This is what mutual funds charge per share at the time of purchase. A 5 percent front-load fee on a $10 share will result in your share value being $9.50. An expense fee is paid in addition to the load.
  • Back-load Fee or Surrender Fee. If the mutual fund does not charge a front load fee, then it most likely charges a back load fee (there are no load funds that charge no fees). Back load fees are charged when you sell the mutual fund, but typically decrease each year you hold the fund. For example, the first year of the fund may charge 5 percent, and that can be reduced by 1 percent for each successive year.
  • Expense Ratio or Internal Fee. This is a fee to the mutual fund managers. It costs money to put a fund together and that cost is passed on to investors. If you have an expense ratio of $.90, you will pay $9 per year for every $1,000 invested.
  • Transaction Fee. This is a fee you pay every time a buy or sell transaction occurs with a stock or mutual fund. It typically can range from $9.95 to $50 per trade. Remember, this fee can be charged at both purchase and sale.
  • The bottom line is it costs money to make money. All in, you may be paying 3-4 percent per year on your portfolio so if you want to net 6 percent, the value of your portfolio will need to earn upward to 10 percent.

What to Look For When Buying Specific Stocks

For investors, buying ownership in a company is exciting. Sure, there's a risk, but that kind of adds to the excitement. And there are ways to mitigate that risk. Stick with me on that point.

People have varying reasons when they opt to buy individual stocks. They could have an emotional attachment to the company, they might work for the company, they might like the way the company is run or they might like the cool products it manufactures. There are no “wrong reasons” to buy a stock, as long as you do some research and are aware of the “buyer beware” caveat.

With that said, two key ways to mitigate the risk of stock ownership is 1) buy dividend producing stocks and 2) place a stop order on the stock.

Dividend Stocks

Buying stocks of companies that historically pay a quarterly dividend (for 10 to 20 years, not the last four quarters) can result in some income from that stock each quarter, even if the price per share drops. For example, if you buy 100 shares of stock at $20 per share, you have $2,000 invested. If the share price dips to $19, your stock value is now $1,900. However, if for each of the four quarters during that drop, the company paid a $.05 per share dividend per share, the value of your stock portfolio is $1,920. Not a significant difference, but it softens the blow.

Stop Order

This is one of the more common tactics to reduce the risk of a substantial stock loss. How it works. If you purchase 100 shares of stock at $20 per share, you can put a stop order (also called a stop-loss order) at say $19 or $18, whatever value you are willing to risk. If the stock dips to that loss amount, it is automatically sold. Yes, you have incurred a loss, but you also have not held on to a dog of a stock that can keep going lower.

Hopefully this has demystified the process of investing as much as possible. How did you get started in investing? Let us know in the comments.

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4 years ago

I think robo-advisors are a great place to start for beginner investors! They are inexpensive relative to traditional financial advisors, invest in low-cost passive index funds, have a very low minimum account size (or none at all), and many provide additional services such as tax loss harvesting. I personally like Wealthfront, but there are a lot out there!