Dylan Lewis: Hey, there, I’m Dylan Lewis, and in this FAQ,
we’re talking about how you can invest your money. Regardless of which
way you go about putting your money to work, you’re going to need a
few things: a brokerage account, the right mindset and money you won’t need in the next
three to five years. Investing is a great way to build wealth, but it’s important to
make sure you’re starting on solid footing. Generally, it’s best to only invest after
you’ve set aside some savings in an emergency fund and paid down any high interest debt.
Having three to six months of living expenses on hand is helpful in case anything unexpected
happens. And paying down high interest debt is a guaranteed return that’s hard to beat
by anything that you’d invest in. Taking care of those things first also allows
you to take the long-term approach to investing. There are years where the economy is doing
well and the stock market is up and years where it’s down. If you’re only investing
money you don’t need in the short-term, you can weather that volatility and know that
long-term, growth is on your side. Also, if you’re investing money you might
need soon, it could put you in a position where you have to sell investments at a loss
because you need to make a mortgage payment or pay a medical bill, and nobody wants that.
That’s all to say that temperament is key; it is the most important thing when it comes
to investing. If you’re going into things with the right mindset, you can go ahead and
open a brokerage account. Now choosing where to open a brokerage account
will largely depend on what you’re interested in investing in, though it’s hard to go wrong
with the major discount brokers and major institutions like Vanguard.
If you want a rundown of the major brokers, check the description for a link of our Broker Center.
Opening a brokerage account is typically a quick and painless process that you can
do in a matter of minutes. You can easily fund your brokerage account via an EFT transfer
by mailing a check or wiring money; there are a couple things to keep in mind though.
First, determine what kind of brokerage account you need. For most people that are starting out,
this means choosing between a standard brokerage account or an individual retirement
account. The main consideration here is why you’re investing and how easily you want to
be able to access your money. If you want easy access or are just investing for a rainy day,
you’ll probably want a standard brokerage account. On the other hand, if your goal is
to build up a retirement nest egg, an IRA is a great way to go. These accounts come
in two varieties, traditional or Roth. Traditional IRAs are funded with pre-tax money,
which lowers your taxable income in the year you contribute, but the money you take out in
retirement will be taxed. Roth IRAs are funded with after-tax dollars, so there’s no immediate
tax benefit, but you can withdraw the money tax-free in retirement.
If you’re thinking in years, go with the standard brokerage account. If you’re thinking in decades,
it might make sense to start an individual retirement account. The great thing is,
you don’t have to choose, you can do both as long as you continue to save money and both account
types will allow you to buy stocks, mutual funds, bonds and ETFs. So, that’s what
you need to start investing. Now, on to what you can invest in.
When most people think investing, they think stocks and bonds, it’s what they hear all
the time in the news. So, we’re going to [quickly] define both of them. A stock is an equity
stake in a business. Owning a share of a company means you’re a part-owner and you’re entitled
to a sliver of the company’s profits. If the business succeeds, you enjoy your
stake in the business being worth more. A bond is really debt, if you buy a bond,
you’re loaning a sum of money to the issuer for a predetermined period of time, in exchange,
the issuer promises to make regular interest payments at a predetermined rate until the
bond comes due and then repay what you lent them upon maturity.
There are other ways to invest, but stocks and bonds are generally the most common. Now,
you can put your money to work in stocks and bonds in several different ways. You can buy
individual stocks and bonds, mutual funds that hold stocks and bonds and ETFs that hold
stocks and bonds. We’re going to explore all three options and talk about
the pros and cons of each. One of the most popular investing vehicles
out there is the mutual fund. Mutual funds are a collection of stocks, bonds or other
securities that investors can buy a share of and they’re wildly popular because rather
than having to choose individual stocks or bonds a single mutual fund can instantly give
you a well-diversified set of investments. You can find mutual funds that invest in stocks,
bonds as well as other types of investments such as commodities. Within each category
there are a variety of subtypes, such as, growth stocks, value stocks international
stocks and a variety of risk levels. If there’s something you’re interested in
investing in, there’s probably a mutual fund for you. Most funds are available to all investors
even those who only have modest amounts to invest, which increases investing access for many.
Beyond that basic definition, if nothing else, the thing you need to know about mutual
funds is that they’re actively managed mutual funds and index funds. We generally prefer
the latter. Actively managed funds have a manager who’s trying to follow a specific
strategy to try and provide superior returns. Unfortunately, many of them don’t succeed.
Most research shows that due to short-term mindsets, active trading and high fees, actively
managed funds tend to put up worse returns than the major stock market
indices like the S&P 500. That’s why many investors, like us, prefer
to put our money into index funds. An index fund manager’s job is to simply match the
index the fund tracks which takes significantly less time and effort than the analysis and
portfolio management involved with actively managed funds, because of that, index funds
typically have significantly lower costs and are virtually guaranteed to match the long-term
performance of their underlying index. If you’re interested in mutual funds, be sure
to keep an eye on the returns over the one-, three- and five-year period and how they compare
to the S&P 500 or the funds relevant benchmark. You should also look at the fund’s expense ratio.
Basically, how much you have to pay the person managing the fund. If it’s high,
the fund better be putting up better returns than the S&P 500 or its relevant
benchmark, net of fees. Mutual funds are great for beginners.
They allow you to instantly be diversified and you’ll earn returns that beat most professional
investors. For example, the S&P 500 mutual funds like the Vanguard VFINX, have allowed
folks like you and me to instantly own a piece of the 500 largest publicly traded companies
in the U.S., enjoy annualized returns of 10% per year and pay very little to get started.
Another very popular investing option for folks is the ETF, or exchange-traded fund.
ETFs and mutual funds are basically siblings, mutual funds are offered directly through
mutual fund companies and many brokers also offer access to certain index mutual funds
in their brokerage accounts. ETFs trade directly on stock exchanges, allowing anyone with a
brokerage account to buy or sell shares at any point when the stock
market is open for trading. Like, mutual funds there are thousands of
ETFs out there. So, it’s important to understand what you’re looking at when you’re looking
to buy. The important metrics are also very similar to mutual funds. You want to look
at your performance and your fees. Each ETF publishes an annual expense ratio, which represents
the percentage of the total fund assets that goes towards covering the cost that the ETF
incurs every year. Smaller expense ratios mean more money staying in your pocket.
And the biggest and most efficient ETF providers have expense ratios for their funds that can
be less than 0.1%. Some high fee ETFs are worth paying for, but only because their returns
beat their benchmark even when you factor in those fees.
If you’re new to investing, ETFs are a great place to start because they’re widely available
across brokerages, and unlike some mutual funds, there generally aren’t account minimums
associated with buying them. ETFs and mutual funds allow the average investor
to easily and cheaply be invested and diversified, buying baskets of stocks and bonds at once
rather than picking and choosing them one-by-one. And because of that they are one of the best
tools for new investors, but they are not the only options.
Most of us are used to borrowing money in some capacity, whether it’s mortgage on our
homes or bumming a few bucks off a friend when we realize we’ve left our cash at home.
Just as borrowing is a part of life for everyday people, it’s a practice companies and municipalities
uphold as well. Even the federal government does it. How? By issuing bonds.
Bonds come in several varieties: corporate, municipal and government. Though their nuances
might differ, they’re all generally the same; debt instruments used to raise money.
When an organization issues a bond, it asks for a certain investment of money, it then promises
to pay back that investment plus interest over a specified period of time. For example,
you might buy a ten-year $10,000 bond paying 3% interest. The issuer, in exchange, will promise
to pay you interest on that $10,000 every six months and then return
your $10,000 after ten years. There are two ways to make money by investing
in bonds. The first is to hold the bonds until their maturity date and collect interest payments
on them, bond interest is usually paid twice-a-year. The second way to profit from bonds is to
sell them at a price that’s higher than what you pay initially. For example, if you buy
$10,000 worth of bonds at face value, meaning you paid $10,000, then sell them at $11,000
when their market value increases, you can pocket the $1,000 difference.
Stocks and ETFs are traded on public exchanges, so they’re fairly easy to buy and sell. Now,
bonds on the other hand, aren’t traded publicly but rather trade over-the-counter, which means
that investors must buy them from brokers. The problem with the system is that because
bond transactions don’t occur in a centralized location, investors can have a harder time
knowing whether they’re getting a fair price. The Financial Industry Regulatory Authority,
or FINRA, regulates the bond market to some extent by posting transaction prices as that
data becomes available, but investors can sometimes experience a lag in getting that
information, this isn’t a reason not to buy bonds, but it’s something to be aware of.
When it comes to bonds, the things you want to focus on are the bond rating. Now, this
is a score of sorts that measures the financial strength of the entity issuing the bond.
There are three major bond rating agencies: Standard & Poor’s, Moody’s and Fitch. And these
agencies use a combination of letters, numbers and symbols to indicate the creditworthiness of
bond issuers. Ratings tend to follow the general grading system, As are great, and everything
else that follows is progressively worse. Generally speaking, the higher a bond’s
rating, the safer it is as an investment. But higher rated bonds also tend to offer
lower interest rates than bonds with lower ratings, and that’s because investors are
rewarded for taking on additional risk. Although bonds are generally considered a lower risk
investment than stocks, they are by no means risk-free. All it takes is for a bond issuer
to default and you as an investor will be out some money.
Bonds generally offer stability and predictable income, but they come with some disadvantages.
For one thing, bonds require you to lock your money up for extended periods of time.
For example, if you buy a bond with a ten-year term. You’re committing to keeping
that money invested for ten years. And because bonds are a relatively long-term
investment, you’ll face what’s called interest rate risk when you buy them. As we learned before,
each bond pays a certain amount of interest, but what happens if you buy a ten-year
bond paying 3% interest, and then a month later that same issuer offers bonds at 4%.
Suddenly, your bond drops in value, and if you hold it, you’ll lose out on potential
earnings by getting stuck at that lower rate. Additionally, bonds aren’t all that conducive
as long-term investments, because they won’t grow in the same way, that’s because the return
on investment that you’ll get with a bond is substantially lower than what you’ll get
with stocks. Consider this, between 1928 and 2010 stocks averaged an 11.3% return, while
bonds averaged just a 5.3% return. Now, imagine you’re able to save $300 a month
for retirement over a 30-year period. If you load up on bonds, an average that 5.3% return
during that time, you’ll wind up with just over $250,000 nest egg. But if you go with
stocks instead and score an average annual 11.3% return on your investment, you’ll
grow your retirement account to over $750,000. And that’s important, because without that
growth, you’ll have a hard time keeping up with inflation and maintaining your buying
power when you’re older. We talked before about mutual funds and ETFs
and how they give you access to hundreds of companies at once, but what if you want to
buy a specific company? That’s where buying individual stocks comes into the picture.
You can invest in individual stocks if and only if you have the time and desire to thoroughly
research and evaluate stocks on an ongoing basis. If this is the case, we want to 100%
encourage you to do so. If not, it’s totally okay to stick with ETFs and mutual funds and
call it a day. This video is more of a broad stroke look at investing basics. So, we’re
not going to go super in-depth on how to pick individual stocks, but we do have a lot of
other content on the channel about that. Here are the important concepts you need to
understand before you get started. Only invest in businesses you understand,
avoid high-risk stocks until you get the hang of investing and always avoid penny stocks.
Start out with established growing businesses with market-leading positions. For example,
Apple and Disney are great beginner stocks. They have businesses that are easy to understand.
Apple sells “i” products and has a software marketplace. Disney makes movies media and
owns theme parks, plus they’re growing profitable companies that aren’t going to disappear overnight
and they both pay dividends. I like to think the first couple of stock
purchases someone makes as a tuition payment in understanding how investing works. Like
anything, starting out investing is humbling and there are many mistakes to make along
the way, but if you choose stalwart companies like these, you’ll be able to learn how successful
businesses operate, how to read financial statements, like an income statement and a
balance sheet, and you’ll likely see your tuition grow as these
companies continue to succeed. If you focus on speculative growth companies
or penny stocks, you likely won’t see your tuition payment back. Start out with a base
of rock-solid, established businesses in your portfolio and expand into more growth-oriented
businesses as you learn more. For a quick checklist, look for businesses that you can
wrap your head around that also are growing their revenue, have a moat or an element that
protects them from competition, and a management team that you believe in and can trust.
For a more in-depth look at how to pick stocks, head over to our free starter kit, it covers
how to know you’re ready to invest, what specific metrics to follow and it has five great starter
stocks. You can get that over at fool.com/start. And for more information on investing in stocks,
bonds mutual funds and ETFs, check out the episode description, we’ve got links to our
comprehensive guides there. If there’s anything you think I missed or
you have an idea for a future video, drop it down to the comment section below and be
sure to hit that “like” button to tell YouTube that we are doing good stuff, and
“subscribe” to get more content like this in your feed. Thanks for watching and until next time, Fool on!