A Guide To Understanding Your Investment Options
Investing is more than just about making money. It is about providing you with the means to shape your life the way you want to. Whether that means buying a home, paying for your children’s college education or simply enjoying your retirement years, wisely investing your money can be the difference between making it happen or not.
If you know little or nothing about investing, this can be a daunting proposition. You may even feel so overwhelmed by all your choices that you do nothing, which could have harmful consequences for your future. This guide is designed provides you with what you need to get started with investing, presented in a way that is easy to read and understand.
Table of Contents
Starter Investment Concepts
Before you can properly judge your investment options, you need to know how to judge them. Here are some basic investment terms that will help you do this:
Return relates to the amount of profit that you earn from an investment. In essence, it is the percent of the principal capital that you invested that gets returned to you. So, if you invest $100 and receive a $10 profit, your return is 10%.
Return can be expressed in various ways, such as what you receive at the end of the investment term (when you either sell or redeem it), or at some specified interval, such as monthly or yearly.
When comparing returns of different investments, it is important to look at more than just one point in time. Experts typically recommend looking at historical returns over time to better understand an investment’s potential future performance. This will give you a much better idea of what to expect from an investment.
However, you should always be mindful that returns on investments cannot be guaranteed, regardless of where or when you invest.
Closely related to the concept of return is risk. This means how likely you are to lose some or all of the principal that you invested. Generally speaking, the higher the risk, the higher the return you will receive. This means that the safest investments usually offer the lowest returns.
When judging an investment, you need to weigh the return that you will receive against the risk that you will face by owning it.
Diversification is a means that some investors use to strategically balance return and risk. Instead of holding just one type of asset, such as stocks, bonds or alternatives, these investors diversify their portfolios by owning a broad collection of assets in different categories.
The objective of diversification is to create a mixed portfolio of investments that have different return potential, different risk profiles and different behaviors depending on market conditions. With a balanced and diversified portfolio, investors are mitigating risk and ensuring that their portfolio can withstand various economic cycles.
Active vs Passive Investing
There are two ways to invest: actively or passively. Active investing involves continuously making investment decisions in an attempt to outperform the market. Passive investing, on the other hand, involves making an initial investment decision and sticking with it, making at most a few adjustments along the way.
Public vs. Private Market Investing
Some investments, such as stocks and bonds, are bought and sold through government-regulated public markets, such as a stock exchange. While a public market can offer you a sense of security, investments bought on private markets can often offer greater growth potential. Not all private market investments are appropriate for beginning investors and some are also limited to high net-worth individuals, but they are worth looking into as you develop your investment strategy.
When To Get Started
Start Early, Invest Regularly
Many people feel that investing is something that they can put off until some unspecified time in the future when they are better off financially. But many investments compound in value. This means that their proceeds get systematically reinvested, and it can result in an investment growing many times the size that it started. This is true not just for interest-earning investments, but also for investments like stocks.
Returns from stocks, of course, vary greatly, but on average stock investments earn around 10% per year. By using this investment calculator, you will see that if you invest $1,000 every year in the stock market for 30 years — with a total contribution of $30,000 — you would have a balance of somewhere around $180,000. But to receive a comparable balance in 10 years, you would have to invest nearly $10,000 each year, with a total contribution of close to $100,000.[HS1] [CC2]
The power of compounding interest means that investing small amounts regularly over time tends to provide higher overall returns than investing larger amounts on an irregular basis.
The Importance of Thinking Long Term
One of the most important traits that separate good investors from poor ones is the ability to think long-term. Before you begin investing, you must understand that the investments that offer the best returns experience periods of highs and lows. As mentioned before, stocks historically average a 10% return. But there are times that the returns are much higher than this and there are times that they lose money. Sometimes they lose a considerable amount of money.
But good investments almost always rebound. So, it is important to have patience and have confidence in knowing that your investments will likely generate returns on par with historical averages.
How To Get Started
For most people, the hardest part of investing is getting started. Making a financial commitment is difficult and scary, especially when you don’t feel knowledgeable enough. A way of making this easy is to start out small and with passive investments that don’t require as much hands-on management. As demonstrated above, even a small investment, when made regularly over a long period of time, can generate a lot of money.
While some investments require significant minimum contributions, others have very low minimums. There are even some investments that only require a few dollars to begin. The important thing is to start. Then, once you feel more comfortable about investing, you can increase your contribution.
Here are several passive investment options:
Employer-Sponsored Retirement Plans
If your employer offers a 401(k) retirement plan, this can be an excellent way for you to start investing. These plans automatically invest a portion of your salary, and what is great about them is that your contributions and earnings are tax deferred. You only pay taxes on them after you retire, when you will likely be in a lower tax bracket. Your employer may even partially or fully match your contributions.
Individual Retirement Accounts (IRAs)[HS3]
IRAs are another type of retirement plan. This one you invest in directly. Like with 401(k) plans, you contribute a portion of your earned income to them, and your contribution (and your earnings from them) can be tax deferred. There are many different types of IRAs, each with their own features and stipulations. These include traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs.
A robo-advisor is a low-cost online stock market investment service that uses advanced computer techniques to match you to investments that will meet your goals. They can also automatically contribute for you and adjust your investments when necessary, and they can be a great tool if you are unsure what to invest in.
Alternative Investment Platforms
Automated alternative investment platforms form a lesser known but fast-growing option for investors. They work similarly to robo-advisors or some stock trading platforms that let you contribute regularly to your accounts and invest on your behalf. The main difference is the asset category they operate in.
Alternative investment platforms allow you to invest in assets outside of the typical stocks and bonds markets such as real estate, private equity, venture capital, collectibles and more. Several of these newer platforms provide the option to contribute passively over time through automated deposits into your accounts, growing your portfolio.
What Are Your Investment Options
There are many good investment options available, each with its own set of risks and returns. When deciding what to invest in, it is important to understand that you do not have to choose just one type of investment. As mentioned above, it is beneficial to select a combination of investment assets. So, if one goes down in value, your portfolio can sustain it, especially as some of your other investments may go up at the same time.
Here are the most common types of investments:
Stocks are shares in a publicly traded company, which you can buy from a traditional or online broker. When you buy them, you become a part owner in the company, with the value of your holdings going up or down depending on how the market values the company at any given time.
If you do not know much about business or the stock market, figuring out which stocks to buy can be difficult. Fortunately, there is a type of investment that makes this much easier: stock funds. With stocks funds, investment experts create what is called a security, which is a tradable investment instrument. [HS4] This security represents a collection of stocks, which can be broad-based or focused on specific types of stocks, and they are usually less risky than individual stocks.
The following kinds of stock funds are available:
Mutual funds are funds that are actively managed by investment professionals. Unlike stocks, you buy them from investment companies instead of on an exchange.
Exchange-Traded Funds (ETFs)
ETFs are like mutual funds but they are traded on exchanges. Because they tend to be more passively managed in comparison to mutual funds, they generally incur less management fees. They also tend to incur lower capital gains taxes than mutual funds because they engage in less transactions.
An index fund tracks a particular stock index, such as the S&P 500, and your holdings rise or fall based on the value of this index. Index funds can be mutual funds or ETFs, and because they are passively managed, they usually have low management fees.
Fixed-income securities are, in essence, loans that you make to either a government or a corporation. Unlike stocks, which come with the risk that you could lose principal, fixed-income securities focus on preserving principal while promising you a fixed return at a set time in the future. Because of this, they are generally safer than stocks but offer less return.
The price of bonds generally rises when the stock market falls and falls when the stock market rises. This makes them a valuable component in a well-balanced investment portfolio.
Here are the most common types of fixed-income securities:
Corporate bonds are issued by companies to raise money. You can judge them by their ratings, with those with a AAA rating being the most likely to fulfill their obligations. Ordinary investors should stay away from bonds rated BB or lower, which are called junk bonds, as they are the most likely to fail to meet their obligations.
Municipal bonds are issued by cities, counties and states to raise money for their needs. They are rated much like corporate bonds and have the advantage of offering tax-free returns.
U.S. Treasuries are similar to municipal bonds but are issued by the federal government. While they do not offer the same tax advantages of municipal bonds, they are generally the safest fixed-income security.
Alternatives are investments that include:
- private equity and venture capital
- hedge funds
- real estate
- tangible assets
As opposed to stocks and bonds, alternatives are generally offered on private markets instead of public exchanges. They also tend to offer both higher returns than other investments and higher risks. The one exception is real estate, which generally offers both high returns and low risk though it can require a significant upfront investment.
While alternatives are great for diversifying your portfolio, most are not suitable for beginning investors, either because of their inherent risk or the large amount of money required. Some types of alternative investments, in fact, are limited by law to accredited investors. This means individuals who have earned $200,000 for two consecutive years ($300,000 for couples) or have a net worth of $1,000,000, not including the value of their home.
In recent years however, technology and changes in federal regulations have spurred the emergence of a new category of investment platforms who now offer non-accredited individuals the option to invest in private alternative assets without the high cost of entry. DiversyFund is one of them, offering all investors the same opportunity as wealthy ones to invest in private market assets starting with their multifamily real estate investment trust (REIT).
Understanding your options is the key to making investing less daunting. By applying what you have learned here to your own situation, you can set yourself on a path toward making your dreams a reality.