Make getting started investing easy with these investing basics and don’t overcomplicate meeting your financial goals
Ah investing, the Holy Grail of topics for the financial blog. Just about every personal finance blog on the ‘net has a section on investing basics, no matter what the blog’s main focus. Some of the most popular sites on the internet revolve around the topic. Yahoo Finance gets more than 70,000,000 unique visitors every month!
As an investment analyst for nearly 10 years, I’m going to tell you a dirty little secret of investing. Despite what the television and web may want you to believe, picking great investments is not as important as how or when you invest.
I have worked for multi-million dollar venture capital firms, analyzing investments in start-up businesses, and I’ve worked as an analyst for financial advisors. I hold the Chartered Financial Analyst (CFA) designation and have spent years looking for the perfect portfolio. I can tell you one thing, investing can be really easy or it can be really difficult.
Some of the best investing strategies I’ve seen have been extremely simple. You put a set amount of money aside every month across a few different types of investments and never even have to look at them until retirement. I’ve also seen really complex strategies involving data-driven analysis and constant management.
Guess what? The investing basics strategy wins out most of the time!
I talk about how to analyze startup companies and some of the more complex investing strategies on our sister blog, Crowd101.
This post is all about investing basics, getting started investing and understanding how to make 80% of the return with just 20% of the effort. The article is part of a series I put together, a five-week personal finance fix.
Check out the rest of the articles in the five-week personal finance fix:
Learn how to set financial goals and a budget you can actually keep
Learn how realistic retirement planning can help you get to your sandy beaches faster
Check out these 16 easy money tax tips for year-round savings
Learn how much insurance you actually need
Personal Finance Fix Week 2 – Investing Basics
Investing sometimes gets a bad name, especially when the stock market collapses and takes the economy down with it. A lot of people avoid investing altogether but the truth is, everyone invests. They just don’t know it.
Every time you sacrifice your time or money now for the potential to get something in the future, that’s investing. Going to college, giving up those years you could be working and paying tuition to get a better job, that’s investing in your future. Paying a little more for a quality electronic device, hoping that it will pay off with a better experience and longer use, that’s investing.
Investing is nothing more than taking a little risk for a return down the road. The trick is to figure out how much return you need and how much risk you are willing to take.
Investing Basics: Risk and Return
Investing is a lot like traveling. If your goal is to get to a specific destination, say DisneyLand from Chicago, then there are several ways you can get there; by plane, train or automobile, depending on your specific circumstances.
Investing is about getting to your financial destination; whether it’s retirement, paying college tuition or going on that dream vacation. There are many ways to accumulate enough money to reach your goals but not all of them may be appropriate given your situation.
The problem most investors run into is they set out on their financial journey without knowing where they are going! They have no idea how much they need to reach their goals or the best way to get there. You wouldn’t set out on vacation without knowing where you’re going, why would you do it with your financial journey?
People understand that they need to invest for retirement but give no thought to how much they actually need or a plan to get there. They throw all their money into stocks or any other risky investment without an idea about what they really need.
The first thing you need to do is figure out where you want to go. Bankrate has a helpful nest egg retirement calculator that shows how much you need at retirement. You can play around with the numbers to use the calculator for different goals. The general rule of thumb is enough to pay for 80% of your current living expenses so if you currently live on $40,000 a year, you would want to have $32,000 a year in retirement. It’s a little over-simplified but a good starting point to planning.
Another rule of thumb is that your annual expenses in retirement should be about 4% of your total wealth. That means, you withdraw 4% of your investments each year in retirement. It’s a helpful rule because it helps to understand how much money you need to start with in retirement. If your expenses will be about $32,000 then you’ll need investments totaling about $800,000 ($32,000 divided by 0.04).
Having an idea of where your financial destination is and how much you need to get there makes planning your journey all the easier. Investing is just the plane, train or automobile you use to get there.
Investing Basics: How Much Risk Do You Need?
One of the most important concepts in basic investing, and the most often overlooked, is risk. To make money off your money in investing, you are going to have to take risks. Unless you put everything in a savings account or U.S. government bonds, your investments will have risk.
The $64,000 question is, “which investments do you need for your goal?” You see, each type of investment, called an “asset class” will pay a different level of return and will entail different risks. Some asset classes will offer very little in how fast they make your money grow but will be very safe. Other asset classes may offer the potential for a big payday but may also lead to a total loss.
Given the annual rate of return you need to reach your financial goal, you can decide which asset classes to use in your investment portfolio.
Investing Basics in Bonds – Loans to Companies and Countries
When a company or country needs money, investors lend it money in the form of a loan called a bond. The company then pays a set percent, say 3%, on the loan every six months until the end of the loan’s life. When the loan comes due, the company returns the amount it borrowed.
These loans are rated on a scale, from safest to most risky, according to the financial health of the company or country. Some loans, like those of McDonald’s or countries like the United States, are extremely safe because you’re almost guaranteed to be repaid. Other loans, like those of near-bankrupt companies or countries, are not as safe. The potential for return depends on that level of risk.
Returns for the safest bonds are generally under 3% or 4% while other bonds may pay up into double-digit returns. Be wary of bonds offering more than a 7% return as this means there is a high level of risk.
Investing Basics in Peer Loans – The New Fixed Income
Peer loans have only started to gain popularity as an investment and many people are still weary of the risk. These loans to individuals are really little more than bonds except to a person instead of to a country. There is some additional risk but you are also offered an additional return for that risk.
The safest loans, those to people with extremely high credit scores, generally pay around a 5% return while a portfolio of riskier loans may offer a 12% return or higher.
Investing in personal loans through Lending Club is becoming a great bridge between ultra-low interest rates in bonds but the riskiness of stocks. Loans cash flow within a month and can help smooth your portfolio risk away from stocks.
Investing Basics in Stocks
Stocks are what everyone thinks of when talking about investing basics but may actually be a very small part of your portfolio. Share ownership in companies has paid an average annual return around 7% over the last several decades but also entails a lot of risk, both emotionally and financially. Not only can a company default and wipe out your financial investment but the emotional toll from watching your nest egg drop can be overwhelming for some people.
A previous post on how the rich stay rich shed some light on the surprising fact that wealthy people actually hold little of their money in stocks, only about one-sixth their total wealth.
One of my favorite new ways to invest is through Motif Investing and its innovative way to buy stocks online. Through Motif, you can buy 30 stocks for one commission and instantly lower your risk compared to buying individual stocks. By investing in the group of stocks, you smooth out the ups and downs and avoid panic selling your investments.
Investing Basics in Real Estate
Few asset classes have made more families wealthy as real estate. While the jury is still out for most whether your primary residence is a good investment, owning commercial or residential-rental real estate can definitely help you get to your financial destination.
Direct ownership in real estate, buying the properties to manage yourself can bring a lot of headaches but also has its advantages. For most people, indirect ownership through a mutual fund or exchange traded fund is the better route. The NAREIT Equity Real Estate, an index that tracks indirect real estate investment, has returned an annual 9% over the last 30 years.
Crowdfunding – The New Venture Capital
While the wealthy are able to invest freely in start-up companies and other high-risk alternative investments, regular investors have been blocked by regulation. This is changing with crowdfunding and the eventual passage of Title III of the JOBS Act.
Crowdfunding through sites like Kickstarter has boomed over the last few years but equity crowdfunding, where a company sells an ownership percentage for investment, is still relatively new. As with investing in any small business or start-up, the risk of total loss is very high but the returns can also be very high. Average annual returns for a portfolio of crowdfunding investments can range from 11% to well into the double-digits. Check out my other blog, Crowd101, for more information on raising money or investing in crowdfunding.
Investing Basics and the Easiest Investment Strategy You’ll Ever Find
Despite everything the TV or internet will tell you, investing basics can be surprisingly easy for most people. While it’s fun to watch Jim Cramer punch buttons and scream, “Buy, Buy, Buy!” on his CNBC program, you may not need that level of attention in your own basic investing strategy.
Don’t get me wrong, you can do very well picking stocks and some analysts are able to do it consistently.
While you can do well picking stocks and other investments at opportune times, the fact is that most people do not have time to read through hundreds of pages of annual reports and financial statements. Fortunately, you don’t need to!
After finding out where you want your financial destination to be, you may find that you only need a modest annual return to get there. If you only need an average 4% return to achieve your financial goals then there is really little need to take the risk of investing in start-up companies or putting a lot of your money in stocks.
Instead of picking individual stocks or bonds for your investment portfolio, the simplest strategy is to buy an exchange traded fund (ETF). These funds trade like stocks but share characteristics of mutual funds. Instead of having to decide which company makes for the best investment, you can spread your money out over all the companies in the group and lower your risk substantially.
I have included some of the most popular and cost-effective ETFs for three of the above asset classes. There are no funds that invest in peer loans or crowdfunding, so you’ll have to take care of that on your own if you want to add the investments to your portfolio.
iShares Core U.S. Aggregate Bond ETF (AGG)
iShares iBoxx Investment Grade Corporate Bond (LQD)
Vanguard Total Stock Market ETF (VTI)
SPDR S&P 500 ETF (SPY)
Vanguard REIT ETF (VNQ)
SPDR Dow Jones International Real Estate (RWX)
What’s more, you really do not even have to worry about how well your investments do from one year to the next. Investing is a decades-long process and the simplest form of investing is the buy-and-hold approach. With this strategy, you buy a certain amount of each investment without worrying about the ups-and-downs of the markets. You hold the investments until you’ve reached your retirement age or goal.
There’s obviously more to investing than a four or five-page post but I’ve tried to get the basics down as a start. We’ll cover other areas like how to assess your own tolerance for risk in future articles. I will also be starting a series this week on analyzing stocks and companies for those of you that want to reach for a little higher return.
Want to know how to put your investing basics plan to use? Check out this next article on Getting Started Investing: How to Buy Stocks Online