If your retirement plan is to be financially secure and you don't have generous pension income coming to you, you'll probably want to learn how to invest, which for most people means moving beyond a savings account and certificates of deposit to stocks and bonds, establishing a strategy and using investment vehicles such as Roth IRAs.
Taking control of your financial future can make your retirement much more comfortable and less stressful. Here's a guide to what you need to know about how to invest.
Are you ready to invest?
First things first, though: Not everyone is quite ready to invest. Here's a handy checklist to review before investing -- make sure the statements below apply to you:
- You're not currently saddled with high-interest rate debt, such as credit card debt. If you are, pay that off first.
- You have a fully loaded emergency fund, or you know how you'll be able to handle an unexpected big expense. Don't put the only extra dollars you have in the market, as you might need them for emergencies.
- You understand that the value of your holdings will fluctuate and that sometimes you'll lose money. The stock market will occasionally stagnate or head south for a while, and bond prices rise and fall in relation to the economy, too.
- You're willing to do some math. For example, it's good to be able to know what portion of your portfolio each holding represents and to notice as the proportions change.
- You won't need any of the money you invest in the stock market for at least five years, if not 10 or more. That type of time frame is important so that you can ride out any downturn and won't have to sell when prices fall.
- You can tell the difference between a balance sheet and an income statement -- and you know where to find them. If you want to choose individual stocks in which to invest, you'll need to be able to make sense of each company's financial statements to see how healthy and promising they really are. (If you opt for simple index funds, you don't need to learn all this.)
- You know that it's much more important to understand and follow a business than to just follow stock prices each day. After all, you're buying part of these businesses.
- You have a long-term investment horizon, aiming to hold on to your stocks for years, as long as they remain healthy and growing. It's tempting to chase a quick buck, but that's not how most fortunes are built.
- You know to compare your performance to a benchmark such as the S&P 500 index. If you're not beating your benchmarks, you need to rethink your strategy or opt for simple index funds -- more on them later.
Your investing checklist
Before investing in any company, you should:
- Know the company's major products, services, and competitors.
- Be able to explain exactly why you're buying stock in the company and what would make you sell it.
- Understand its competitive advantages.
- Be familiar with its risks and challenges.
- Have studied its financial statements and assessed various measures (such as profit margins).
- Have multiple sources of information about it.
- Expect to continue monitoring the company, including by reading its quarterly reports.
Opening a brokerage account for investing in stocks and bonds
A brokerage account is what you will need to trade stocks -- and you can very likely buy and sell bonds and bond funds with it, too. You can also buy newly minted bonds directly from the government through its TreasuryDirect site, and you can buy shares of some stocks directly from their companies or their agents, as well, through dividend reinvestment plans or direct investment plans (sometimes referred to as "drips").
With most major brokerages these days, you can open an account online, over the phone, or in person. Once you have an account, you can fund it with money and then proceed to buy and sell stocks, funds, or other securities.
When you're ready to open an account, choose your brokerage firm carefully, selecting one that best suits your needs. You might take into account considerations such as the trading commissions charged (many charge $7 or less per trade these days), the breadth of mutual funds available, the range of research products available, the minimum initial deposit, and whether you need a brokerage with brick-and-mortar locations or are OK with a solely online one.
How to invest -- the easy way
Most people don't have the time, energy, or interest in becoming a hands-on investor, carefully studying companies and deciding when to buy and sell various stocks. That's perfectly fine. For most people, it's best to invest in an inexpensive broad-market index fund, such as one based on the S&P 500 that will deliver roughly the same returns of the overall stock market.
Investing profitably doesn't have to be complicated. You can simply opt for one or more low-fee, broad-market index funds. Each tracks a particular index, giving you the approximate return of the index, minus fees, which can be kept extremely low with certain funds. The Vanguard 500 Index Fund (VFINX), for example, tracks the S&P 500 index, which is made up of 500 of America's biggest companies that together represent about 80% of the entire U.S. stock market's value. You can go even broader with the Vanguard Total Stock Market Fund (VTSMX), which encompasses all of the U.S. stock market, including small companies, or the Vanguard Total World Stock Index Fund (VTWSX), to invest in the world market. These are examples from Vanguard, but there are several other brokerages or fund families offering low-cost index funds, too -- very possibly including some available to you via your brokerage or workplace.
You can also opt for exchange-traded funds, or ETFs, that focus on the same indexes -- such as the SPDR S&P 500 ETF (NYSEMKT: SPY), Vanguard Total Stock Market ETF (NYSEMKT: VTI), and Vanguard Total World Stock ETF (NYSEMKT: VT). You can balance out your portfolio with bonds via index mutual funds and ETFs, too. The Vanguard Total Bond Market ETF (NYSEMKT: BND) is one such option.
The beauty of index fund investing is that it's easy, cheap, and delivers returns that beat many more expensive alternatives. Plunk your money regularly into index funds and, voila, you're done. It's the perfect kind of investing for most of us.
If you're wondering just how effective index fund investing can be, know that the stock market has averaged long-term annual gains of close to 10%, though over your investing period, you might achieve more -- or less. The table below shows how much you can accumulate at different growth rates when you make annual investments of $10,000.
Growing at 4%
Growing at 8%
Growing at 10%
If you want to profit from the growth of America's economy and build wealth in stocks, using index funds is a powerful way to do so.
Some other mutual funds can make sense as well. These include "target-date" or "lifestyle" funds, which distribute your money across various stock and bond index funds according to when you aim to retire, adjusting the allocation (reducing your stock exposure and increasing your bond exposure) as you approach retirement. There's a good chance your 401(k) or another retirement plan work offers them. If not, you can invest in them either through a brokerage or a mutual fund company that offers them.
How to invest -- the more complicated way
If you'd like to aim for higher returns than the market average, you'll want to add some individual stocks to your portfolio. You'll need to know how to buy and sell them through your brokerage, too.
Two of the most common kinds of orders you might place with your brokerage are the "market" order and the "limit" order. A market order tells the brokerage that you want to buy or sell the specified stock at the current, best-available price, whatever that is. With a limit order, you have more control, as you get to specify that the stock must be bought for no more than a certain price, or sold for no less than a certain price. Of course, if the stock doesn't rise or fall into your desired range, the trade won't be executed. With most big, often-traded stocks, market orders are fine and will typically be filled within seconds. For less-frequently traded stocks or ones that can be volatile, limit orders can be useful. Limit orders are also good if you know that you want to buy or sell a stock, but not at the going price.
Some other kinds of orders can be helpful when selling, too. The "stop" or "stop-loss" order, for example, lets you put a rule into effect to sell a specified number of shares of a stock that you own if it hits a certain level. So if you own shares of a stock that's trading around $80 per share, you might place a stop order to sell them at $70. That way, if you're not paying attention (perhaps if you're on vacation or you just tend to not keep up with your investments) and the stock starts falling, you'll get out of it before you lose too much. Be careful, though, because if you set the stop too close to the current price, normal volatility might get you ejected from a healthy company that you wanted to own long term. Many great stocks can be volatile from day to day, while rewarding long-term investors handsomely.
What to look for in stocks
For the best results as you study any stock of interest, ask yourself these two questions:
1. Is this a strong, high-quality company?
2. Is its stock priced attractively right now?
If you don't address both questions, you might end up buying significantly overvalued shares of a wonderful company, or you might buy into a troubled business at what seems like a bargain price. Investors have lost many dollars doing either or both of those things.
The first question is much easier to answer than the second. Companies such as Costco, CVS Health, and Boeing have solid reputations and growth prospects. But at what price is each a good buy?
Conveniently, most measures used to evaluate companies are related to either quality or price. Quality-related measures reflect a company's profitability, growth, and health. They include sales and earnings growth rates, profit margins, return on equity (ROE), return on assets (ROA), inventory turnover, market share, and management quality, among other things.
Price-related measures help you determine whether the stock is overpriced, underpriced or priced just right. They address a company's valuation or stock price and include its market capitalization, enterprise value, price-to-earnings (P/E) ratio, and price-to-sales ratio. Of course, it's much easier said than done to figure out what a company is worth.
The simplest of measures that investors use to get a handle on a stock's valuation is its P/E ratio. The lower the P/E, the more attractive the stock – in general. It's important to remember that P/Es vary by industry, so a car stock might be a bit pricey with a P/E of 16, but a faster-growing software company would be more attractively priced with a P/E of 16. Keep in mind, too, that if a stock falls for good reason, its P/E will drop, too. Not every low P/E is a bargain, and some companies with seemingly steep P/Es can be great values. The more you learn about a company, and the more measures you evaluate, the more effective an investor you'll likely be.
Some investors believe that as long as you've got a great company, the price isn't that important. They figure if an overvalued company keeps growing, it'll eventually grow into and surpass its price. This can happen, but it can take a long time. And sometimes it doesn't happen; the stock may instead fall closer to its fair value. Even if the stock grows, it might not do so very briskly, if it's already overvalued. Most successful investors recognize that buying at an attractive price is vital to reduce risk and maximize gain. They call it seeking a margin of safety.
When to sell stocks
Be sure to have a handle on when to sell a stock, too, as it's not enough to just buy a great stock. You should aim to hold for the long term, but sometimes selling is best. After all, profits are only reaped when you sell, and holding on to a stinker for too long can hurt you.
So when should you sell? Well, don't sell just because a stock or the market is falling, or you've heard some rumors, or someone tells you to sell. Here are some times when selling can be the right thing to do:
- If you can't remember why you bought it.
- If you don't know exactly how the company makes its money.
- If the reason you bought a stock is no longer valid. Maybe it's no longer growing briskly, or it's moving in a new direction that doesn't seem promising.
- If it has some persistent troubling characteristics, such as shrinking profit margins or management that doesn't inspire confidence. Short-term problems can be OK, but keep an eye out for long-term ones.
- If the stock has become significantly overvalued relative to what you think it's worth. But consider the tax consequences, and if you expect continued growth for a long time, you might want to hang on.
- If you find a much more attractive place to invest your money.
- If your calculations suggest that a holding is now fairly valued and another stock appears to be undervalued, you stand to gain more in the other stock. Also, this rule isn't rigid: If the fairly valued stock is likely to keep growing at a good clip, while the undervalued one isn't likely to grow too briskly, you might want to consider keeping it and enjoying more growth.
- Consider tax effects. The IRS will be after any gains but you can also be strategic in offloading any losses to reduce your tax bill, this is often called tax loss harvesting.
- If a stock is your only holding. Portfolios should be diversified, but not over-diversified. For many people, eight to 15 stocks are about right. If one holding grows to represent more than, say, 30% of your portfolio, consider selling some of it.
- If you'll need that money within five (or even 10) years. In that case, it should be in a less volatile place than the stock market, such as a money market account or CD.
- If you're only hanging on to the stock for emotional reasons, such as because you love the product or your grandfather worked for the company.
Stocks have handily outperformed bonds over most 20- and 30-year periods. Between 1802 and 2017, for example, stocks averaged annual post-inflation gains of 6.8%, while bonds averaged just 3.5%, according to the research of Jeremy Siegel. It can still make sense to include some bonds in your portfolio for diversification, especially if you're in or near retirement. Here's a quick introduction to bonds.
Bonds are essentially long-term loans. If a company or government issues bonds, it's borrowing cash and promising to pay it back at a certain rate of interest. Bonds sold by the U.S. government's Treasury Department are called Treasuries. State and local governments issue municipal bonds, while businesses issue corporate bonds. So-called "junk bonds" are those issued by not-so-solid companies that have to offer generous interest rates in order to draw investors willing to bear the risk that they'll default.
If you buy a $1,000 bond with a coupon rate of 5%, you'll receive $50 per year in interest payments. When the bond matures you'll be repaid your principal (the sum you originally loaned, the bond's par value). Most corporate bonds have a par value of $1,000, while government bonds can run much higher.
Bond investing doesn't necessarily mean that you only buy a bond when it's first issued and then hold it to maturity, for several years or decades. Instead, bonds are often traded between investors, with their prices rising and falling in reaction to prevailing interest rates. When rates fall, people tend to bid up bond prices. After all, if banks are offering 2%, a 5% bond will be appealing. When interest rates rise, newer bonds with higher interest rates will be more appealing than older bonds with lower rates. If you hold a bond to maturity, you'll generally experience little to no volatility, but if you're dealing with bond mutual funds or are buying or selling bonds in the secondary market, know that their prices can indeed rise and fall, and meaningfully.
If you're looking for investment income, consider dividend-paying stocks as well as bonds. (More on them below.)
Finally, let's review some investment strategies. Two approaches you'll often read about are growth investing and value investing. Growth investors favor fast-growing companies and are willing to pay a lot for stock in them. They'll often ignore steep valuations, (such as when a price-to-earnings (P/E) ratio is way above the market, industry, or company average) expecting the stocks' values to keep rising as the companies keep growing. This approach is risky, as the stocks or the overall market might pull back sharply. And not all companies keep growing, either.
Value investing, on the other hand, demands a margin of safety, as investors seek bargains, aiming to buy stocks for significantly less than their estimated worth. These investors focus on fundamentals of companies, such as free cash flow, profit margins and dividends, and the growth rates of each, and will often crunch a lot of numbers to get a sense of whether a company is fairly valued or under- or over-valued.
You might also be a dividend investor, favoring companies that pay their shareholders a portion of profits every month or quarter. Dividend-paying companies tend to be larger and more stable than others, because they've committed to giving their investors regular payouts. If you build a portfolio of strong dividend payers, they can deliver cash infusions during your retirement. (You can just reinvest the dividends until retirement.) A $400,000 portfolio with an average dividend yield of 3% will generate $12,000 annually -- and dividends tend to increase over time, too.
Note that some companies can reflect two or more of the qualities above. A rapidly growing stock, for example, may be undervalued significantly at some points -- and might even offer a dividend.
Another smart investing strategy is to make use of tax-advantaged retirement accounts such as IRAs and 401(k)s. There are traditional and Roth varieties of each. With a traditional IRA or 401(k) account, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes as well. For example, if you have taxable income of $50,000 and make a $5,000 contribution to a traditional IRA or 401(k), your taxable income shrinks to $45,000 for the year. The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is the tax bill postponed, but it's often reduced.
A Roth IRA, on the other hand, has the potential to be much more powerful. You contribute post-tax money to a Roth IRA, so your taxable income isn't reduced at all in the contribution year. (Taxable income of $50,000 and a $5,000 contribution? Your taxable income remains $50,000 for the year.) Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- when it's yours tax-free.
Spend some time reading up on investing strategies and see which ones make the most sense for you, given your goals, temperament, and preferences.
And finally, remember that one of the most important pieces of advice about investing for beginners is this: Just get started. Don't be intimidated, because you can stick with simple investments such as index funds. They can help you sleep well at night while making your retirement more secure.