So you want to invest! In what? What kind of account? What type of investment? How much risk are you willing to take? What are your goals? Yikes! There is a lot to consider when it comes to investing. Before you dive in, it’s important to understand why you think you need to invest. It may be better to save than invest. What’s the difference? Glad you asked!
Saving and investing are often used interchangeably but they are not the same. Saving is keeping your money in a safe, typically FDIC insured account. Your money is accessible and there is very little risk. Saving is most appropriate for short term goals such as your rainy day fund, emergency fund, saving up for household items or a car you want to buy in the next year. In these cases the priority is that the money is safe and accessible and won’t lose value. Just don’t expect much interest or growth since it is such low risk.
Investing is for longer term goals like retirement, college, or maybe a down payment on a home (if that is still several years away). It involves higher risk and usually higher returns, but they are not guaranteed. When you’re considering investing, think about what would happen if you lost money: investments can, and do, lose money. Since you are putting your money at risk, it does come with the potential for greater growth (gains) but you must be able to absorb near term ups and downs. That’s why investing isn’t really appropriate for say, an emergency fund. When you need that money in an emergency you can’t wait for the stock market to rebound. You need it now!
Once you’ve determined your goals are appropriate for investing there are several types of accounts you can use that have different purposes and tax treatments. A couple of well known examples are 401(k) Plans and Health Savings Accounts (HSA). These are often offered by companies to their employees to provide a tax efficient way to save for retirement and healthcare costs. Other accounts for investing would include individual retirement accounts (IRA) and brokerage accounts (offered by financial institutions).
Once you decide where to invest, the next question is what can you invest in? Well, the sky is almost the limit but here are a few of the most popular. Stocks are shares in a single company, “Apple” or “Wal-Mart” for example, that offer an opportunity for the public to invest in their company and share in the profits / losses. Not all companies offer public investment opportunities, these are called “privately held.” Investing in a single stock carries a lot of risk because if something happens to that company, you could lose your money. (Remember Enron?)
Bonds are a type of investment that are essentially a loan from an investor (you) to a company or municipality (city, state, school, etc.) They typically provide a “fixed income” (or steady stream of payments) to the investor as a return on their investment. They are usually considered lower risk investments compared to stocks.
A mutual fund is a professionally managed investment that holds potentially hundreds of company stocks in a single fund. Exchange traded funds (ETFs) are similar to mutual funds; they hold stocks in many different companies but are traded on an exchange to make buying and selling easier. A specific type of mutual fund or ETF is an index fund; these are funds designed to mimic an entire index, like the S&P 500, rather than having a fund manager picking stocks they think will perform well. Index funds tend to have very low fees. Both mutual funds and ETFs carry less risk than individual stocks because the risk is spread out among several companies. Other things you can invest in are real estate (homes, land, buildings, etc) commodities (gold, oil, etc) and art. All of these investments are available on the public markets where anyone can participate.
Once you select the type of account and the type of investment, determining how much to invest where is your next decision. You have to decide on your asset allocation, which is the specific mix or percentage of investments (stocks, bonds, cash) you want to own. Different investments have different levels of risk. Generally, the greater the risk of the investment, the greater the potential for gain, but also the greater possibility of loss. The amount of risk you are comfortable taking is your risk tolerance. The amount of risk appropriate for your situation is called your risk capacity and will depend on things like your age, job, savings, family details and timing of your goal. The key to investing is diversification; this means spreading your risk and not putting all your eggs in one basket. If you put all your money in one stock and that company goes bankrupt, you lose all of your money. If you put your money in a mutual fund or ETF with hundreds of companies and one company goes bankrupt, the impact to you isn’t good, but is pretty small overall. You can invest with a broker or on your own online. The broker/advisor will cost more because you are paying for their expertise. One very important item to pay close attention to on all investments is the fees you pay, they can erode some of the return on your investment which when compounded can have a significant effect on your return.
Once you begin investing, be sure to revisit your asset allocation and ensure the amount of risk in your portfolio still aligns with your goals. Life happens, things change and investments go up and down.