If you've decided to start investing -- congratulations! By setting aside some of your money now in investments that could appreciate over time, you'll set yourself up for greater financial security in the future.
Now that you've decided that you want to invest, it's important to devote some time to learning how to invest. With that in mind, here are some basic concepts you should know before you get started.
Why should I invest?
The easy answer to the question is: to create wealth. As a whole, stock investments have historically returned more than 9% per year, on average. If you invested $10,000 at this return rate for 40 years, it would grow to nearly $315,000.
Investing can help you reach your financial goals, such as paying for your children's college education, passing wealth to loved ones, or building a nest egg for your own retirement. There are many potential reasons to invest money.
How much should you invest?
There's no one-size-fits-all answer to this question. Including retirement accounts, I generally suggest that you should aim to invest at least 10% of your income. In other words, if you contribute 4% of your salary to your 401(k), it could be a good goal to set aside 6% of your income to invest on your own.
The important thing is that you start as soon as possible, and make it a habit. When I started investing, I had $100 transferred into my brokerage account from every paycheck, automatically. This may not sound like much, but it sure can add up over time. You may be surprised at the long-term impact you can make by investing a seemingly small amount of money while you're young.
The basic types of investments
There are hundreds of things you can invest in, ranging from stocks and bonds to artwork and collectible coins. For our purposes, we're going to focus on investments you can choose in your brokerage account, or in your retirement plan at work. These generally include:
- Stocks: Also known as equities, stocks represent partial ownership of one or more companies. If a company does well, the stock can increase in value. Stocks have high return potential over long time periods but tend to be more volatile than other investments.
- Bonds: Also known as fixed-income investments, bonds are designed to create a steady stream of income. While bond values are somewhat vulnerable to interest-rate fluctuations, bonds are generally more stable than stocks, but with lower return potential.
- Cash: In addition to physical cash, this category includes investments like CDs, money-market accounts, and savings accounts. Cash investments have the lowest risk, but also the lowest return potential.
- Mutual funds and ETFs: Mutual funds and exchange-traded funds pool money from many investors and then invest it in an assortment of stocks, bonds, or other investments. For example, an S&P 500 ETF would invest in all 500 stocks that make up the index.
Asset allocation: Stocks vs. bonds vs. cash
Since stocks are highly volatile but have the most return potential, they are more appropriate for younger investors. In contrast, bonds are designed for predictability, making them better for older investors with lower risk tolerance. Cash investments are typically not a good idea unless you have lots of near-term liquidity needs. Determining the appropriate asset allocation for your investment strategy is a critical step to take.
Should I invest actively or passively?
There are two main methods of investing. Active investment refers to picking individual stocks and bonds or buying mutual funds that are actively managed by professionals. In other words, an active investor's goal is to beat the market.
On the other hand, passive investing means simply trying to match the market's performance, generally through funds that track indexes. For example, an S&P 500 ETF (mentioned in the prior section) is a passive investment vehicle.
The question you need to answer is how much time you want to spend on investing. If you have the time and desire to research individual stocks, active investment could be the way to go. If not, there's nothing wrong with passive investing. In fact, billionaire investor Warren Buffett believes that passive investing is the best way to go for many people.
How to choose stocks to invest in
If you choose to invest in individual stocks, the first thing you should understand is the difference between investing and speculating. Investing is a long-term activity, designed to achieve sustained returns that can compound over time. Speculating is akin to gambling -- trying to chase a quick payday.
With that in mind, there are certain types of stocks that make excellent long-term investments, especially for beginners. There are many things to look for in your first stock investments, but just to name a few: You'll want to learn basic ways to value stocks, identify durable competitive advantages, and understand how a business makes money. Of course, our writers at The Motley Fool regularly suggest some good beginner stocks, like these examples.
How to get started
Once you've learned the basics, and you've come up with your game plan, the next step is to open a brokerage account and put your plan into action. Be sure to shop around, as different brokerages charge different fees and offer different features. As a new investor, you'll want a brokerage which offers access to investment research and educational features, in order to help with stock selection and to answer any questions you might have along the way.