Welcome to the second blog post in this series about learning how to invest as a beginner. In this post, Clo Bare breaks down investing language into easy-to-read pieces so that anyone can understand basic investing vocabulary – not just the Brad’s and Joe’s who went to Harvard for finance. You’ll learn 9 basic investing terms and be able to pick your investments like a pro.
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Welcome back, friends.
You’ve made it to part two of How to Start Investing For Beginners. Give yourselves a pat on the back. Proud of you.
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So, we know what our different retirement accounts are. We’ve got an emergency fund going and you’re getting your employer match for your 401k (if you have one).
(If none of that rang a bell.. Go back and reread part one of this series here.)
What do I Invest in? First... Asset Classes
Now, let’s talk about asset classes.
An asset class is a just a fancy way of saying a grouping of a type of investment. These groupings are determined by the characteristics of the investments, and the investments within an asset class are subject to the same laws and regulations.
Types of asset classes include:
- Stocks/Equities (think buying Apple stock)
- Fixed-Income Investments (aka bonds)
- Cash/Money Market Funds (pretty self-explanatory)
- Commodities (like gold, silver, oil)
- And alternative which can include real estate, artwork, stamps, collectibles, etc.
What do I invest in? Stocks
One asset class you’ve probably heard of is stocks or equities. Stocks are basically a collection of individual shares of a company.
When a company goes public, it’s basically giving you the opportunity to own part of the company. As that company goes up in value, so do your shares. Stocks, as a whole, are one asset class.
Think about it this way.
Let’s say you want to be part owner of Clo Bare (a girl can dream), but you don’t want to like do anything. You just want to own a small portion of Clo Bare and benefit from any profits (or losses) that come with the territory.
Best way to do this??
Buying a small share of Clo Bare stock.
By owning that stock– now, you benefit from the ups (and downs) of the Clo Bare business… and best part? You don’t have to do anything but own that share of Clo Bare stock.
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Pretty cool, huh?
Now there’s pros and cons to stocks, and more specifically– individual stocks, aka buying and selling one stock at a time.
The Pros of Investing in Individual Stocks
- Many stocks pay dividends. What’s a divided you ask? It’s a small payment a company gives to you on a regular basis (monthly, quarterly or yearly) to say “hey, thanks for holding on to our stock.”
- You could potentially make a lot of money by picking the “winning stock” but many studies have shown that it’s an incredibly hard to do.
The Cons of Investing in Individual Stocks
- Risk! Even the best minds in finance struggle to consistently pick individual stocks, and it’s difficult to be fully diversified when investing in one stock at a time.
But let’s break this down further.
Let’s say you have all of your money invested in Apple. One random Tuesday morning as you’re enjoying your cup of coffee, you read in the news that Apple has gone completely bankrupt. They make some poor business decisions, and their stock value tanks.
Your investments in Apple? They also tank.
You’ve essentially put all of your eggs in the Apple basket, and now you have no eggs. I personally don’t like investing in individual stocks because of that. I prefer less risky investments that are more diversified.
What do I invest in? Bonds
Another common type of investment is called bonds.
Bonds differ from stocks in that when you buy a bond?
You don’t actually own any part of a company. Instead, you’re basically giving a loan to a company and they pay you a fixed amount of income based (a coupon) on the length in which you hold that bond. The returns on those are a lot lower, but they are also far less volatile than stocks.
But wait, Clo Bare, what does volatile mean?
Side Note Vocabulary Lesson: Volatility
Volatile means the rate in which the value of an investment goes up or down. You’ve probably heard that crypto is extremely volatile. That’s because it can skyrocket in price in the morning, and then completely sink that same afternoon. Sometimes it can do that even in an hour. It goes up and down, up and down, constantly. That’s volatile.
Why Bonds Are Generally Safe Investments
Bonds are pretty chill. Traditionally with bonds, don’t make a lot of money from them and you don’t lose a lot of money from them. These are considered relatively safe, especially if it’s a government bond, because the value holds pretty steady and you get steady payments from the owning the bond.
Experts typically recommend keeping a cushion of bonds in your portfolio to even out the volatility of your portfolio. The closer you get to retirement, the more important this becomes which is why many folks increase the amount of bonds they have in their portfolio the closer they get to retirement. That way the value of your portfolio stabilizes.
The way I think about bonds is– they’re for wealth preservation, not wealth accumulation.
Personally, I’m pretty far from retirement so I don’t invest in bonds right now.
Since I’m not planning on retiring anytime soon, I have a higher risk preference. I’d rather choose investments that make me as much money as possible between now and when I retire. Whether or not you use bonds, depends on your risk preference and your timeline.
Another type of investment is called a mutual fund. Mutual funds are different from stocks and bonds in that they have many different stocks or other assets within the fund.
What do I Invest in? Mutual Funds
I like to think about mutual funds as boxes of chocolates, whereas stocks and bonds are the individual pieces of chocolates.
When you buy a KitKat, you’re buying a stock. When you’re buying Snickers, you’re buying a stock. When you’re buying a Butterfinger, you’re buying a stock. But when you purchase a mutual fund, you’re buying an entire box of chocolates or a bag of candy with thousands of different stocks, bonds, and other assets within it, depending on the type of mutual fund you purchase.
Mutual funds can be great because they’re totally diversified. If Apple fails, it’s not as big of a deal because you didn’t put all of your eggs in the Apple basket. This is great in terms of diversification and the performance of your portfolio because it makes your investment safer. If one company tanks, you have hundreds of other companies cushioning that blow and maintaining the overall value of your portfolio.
Not All Mutual Funds Are Created Equal
Some mutual funds are actively managed by a professional, like a Brad or a Joe who went to Harvard for finance. They are actively trading in the account every single day to try and get the investor as much return as possible.
Buuuut there are some downsides to actively managed mutual funds.
Most of the time, these actively managed mutual funds don’t actually outperform passively managed mutual funds in the long-term. They have higher fees too, so even if your fund loses value in a year, you still have to pay Brad or Joe a salary for managing that mutual fund.
Gross, right? Now… let’s talk about my all time favorite type of investment.
Investing Vocabulary: Index Funds
Another type of mutual fund is called index funds. And if you know me at all, you know that I love index funds.
Index funds are designed to mirror an index, like the S&P 500, which is the standard that contains 500 of the largest publicly traded companies in the US. An S&P 500 index fund is going to perform how the S&P 500 is performing in a given year. The S&P 500 has returned about 10% on average every year since its inception.
Why I Love Index Funds
Studies have shown that actively managed mutual funds – the ones that Brad or Joe are actively trading in – don’t actually beat the market very often.
Why? Because it’s really, really hard to beat the market.
What do I mean when I say “beat the market”?
If the entire stock market returns an average of 10% in one year, actively managed mutual funds are trying to beat that 10%, or whatever “benchmark” they’re trying to beat.
They’re trying to get as high of a return as humanly possible.
Unfortunately for them, we really can’t tell what’s going to happen in the future, so most of these mutual funds fail to beat the market.
Actively managed mutual funds over the long term fail to beat the market MOST of the time.
Index funds outperform these expensive actively managed mutual funds 80% to 90% of the time.
Read that again.
80-90% of the time?!?
I don’t know about you, but to me, that’s a no-brainer. I would much rather invest in something that is known to continually perform according to the market.
We want to BE the market… not beat the market.
This is what we call lazy investing. And one of the few times we are ever rewarded for being lazy.
These funds are designed by an algorithm or set up by a fund manager once, with low maintenance. With how low maintenance these funds are, you pay MUCH lower fees. Like almost an entire 1% lower or more in some cases.
The last asset class I want to talk about is ETFs. These are exchange-traded funds.
See the word “fund” again?
We’re purchasing another box of chocolates.
What do I invest in? ETFs
ETFs are different from mutual funds because they can be traded all day long, so they trade like a stock. It’s kind of a new investment class.
You can buy ETFs that are index ETFs, meaning there are certain ETFs that mirror indexes and are passively managed.
For example, VTSAX is an index fund that mirrors the entire market. VTI is an ETF that mirrors the entire market. They’re basically the same thing, but they have different expense ratios and they’re available for purchase at different times.
How to Purchase ETFs
You can purchase ETFs all day long, but if you wanted to purchase VTSAX, you would have to purchase it at the end of the trading day. You can place your order anytime, but the purchase will not go through until the end of the trading day.
Technically, you could day trade ETFs if you really wanted, buying when they’re low and selling when they’re high. But let’s be real. That’s not really something that I recommend doing.
I prefer to buy and hold. Like I mentioned before, worrying about timing the market is not my thing, and I don’t recommend it.
If you want to learn more about ETFs, check out this video here.
What Do I Invest In? Target Date Funds
There’s one more type of asset class I want to cover before we call it quits: Target date funds.
Think about target date funds as funds made of funds. To continue with our metaphor, they’re boxes of chocolates that have boxes of chocolates inside of them.
I know, I know. That’s a bit confusing, isn’t it?
The reason I want to talk about them is because if you have a 401k, chances are there are target date funds inside of them.
What Makes Target Date Funds Special
Target date funds are interesting because they’re one of the only types of investments that contain other funds inside of it. They could have index funds or they could have expensive mutual funds. Target date funds are usually less expensive than actively managed mutual funds, but more expensive than ETFs and index funds, depending on what type you purchase.
And sometimes– there are double fees. Not only are you paying a fee for having a target date fund, you could also paying a fee for whatever investments are inside of your target date fund. MOST target date funds don’t follow this structure and you only pay the fee of the target date fund itself, but if you’re not sure? Call your brokerage to ask.
How do you know your fund is a target date fund?
Target date funds have a year assigned to them. You’ll see the target date fund 2050, for example. That means that 2050 is supposedly the year you plan to retire. Theoretically, you pick the target date fund that is designed for the year that you retire. That target date fund will then automatically rebalance the fund as the years go on so you’re properly allocated for your risk preference and time horizon.
Why I Don't Use Target Date Funds
Target date funds change the longer that you hold that fund. The longer you hold the target date fund, aka the closer that you get to retirement, the amount of bonds that you have in the target date fund is going to increase.
That’s why I personally don’t care for target date funds, but there are some good ones out there. You just want to make sure that you’re not paying high fees and that it has the type of investments that you want in it.
Who Should Buy Target Date Funds
Target date funds are really great options for people who want a completely hands-off approach to investing. You essentially buy the fund and forget about it until retirement.
I don’t recommend you actually forget about it, though. Check it every couple of years to make sure it’s performing how you want it to perform. If it’s not, then pick a more aggressive target date fund or start picking your own investments.
Remember: Typically we want to stabilize our retirement fund closer to retirement with more bonds. But if you’re several years/decades away from retirement? You may not want a large allocation of bonds.
You don’t want to end up at your intended retirement age and not have enough money saved because you picked too many bonds early on.
The bottom line for all of this is that you really need to know what you’re investing in. Are there fees for the target date fund? Are there fees for the investments inside of your target date fund? What is the expense ratio? These are important questions to ask because fees can really eat away at your retirement portfolio.
Let's recap. What do I invest in???
TLDR: What you invest in is going to depend on what your risk preference and timeline is. No two portfolios are going to be exactly the same but the more you dive into learning what to invest in? You’ll realize it’s less about the math, and more about the language.
And if you’re ready to learn more?
I’ve got a free investing class coming up for you! Check it out here.