Ground Rules
Before I start, I want to lay out some basic ground rules. This is a beginner’s guide. There is a lot to learn and know about investing. There is no way to cover it all in one post. We have heard from many of our readers and listeners of our podcast that they really enjoy the information about investing, but they don’t know where to start. Based on that feedback, I decided to write this post to cover the basics. In the future, I may expand upon this post, but for now, I will be keeping it very high level and simple to help the person that has never done it before and wants the start today. So please, do not write comments telling me that I forgot things like options trading, day trading, or any other investment products that would fall outside of “the basics.”
Investment Options
Stocks
Stocks are individual pieces of a company. When a company decides to go from being owned privately to being owned publicly, they sell “shares” of the company in the form of stock. When you buy a stock, you own a small piece of that company. The value of your share will fluctuate with the success and failure of the company and the demand for shares.
Stocks are issued in fixed amounts, meaning there are only so many shares issued. Therefore supply and demand will dictate the value. If many people want the stock shares and there are not a lot of sellers, then the value goes up and vice versa. To sell a stock, there has to be a buyer. To buy a stock, there has to be a buyer. This makes individual stock trading a little riskier than the choices below. If you have all of your money in one company and the value of that company goes to zero, then you lose all of your money (ex. Enron)
Mutual Funds
Mutual funds are a product that is comprised of many companies. There are thousands of mutual funds out there, but the basic makeup is the same in that they are made up of many individual companies. The number and type of companies will vary from fund to fund.
Types of Mutual Funds
There are basically two types of mutual funds in terms of how they are managed and what that will cost you:
- Actively Managed Funds: A high-paid team of people manages these funds. They do a lot of buying and selling stocks inside the fund to beat the market’s overall return. The cost of the highly paid managers and the tax implications of buying/selling stocks are passed onto the holder of the funds in terms of an expense ratio (fee). Actively managed funds have high fees, which means holders of the fund will lose part of their return every year. Over time, this can be extremely costly.
- Passively Managed Funds: Computers manage these funds. They trade less often, and computers are way cheaper than people. The most common of this type of fund is an Index Fund. Index Funds are designed to mirror certain stock market segments (S&P 500, Nasdaq, etc.). The computers that manage these funds will constantly reallocate to keep them in line with whatever they are designed to mirror. Index funds, in particular, are self-cleansing in that if a company is performing poorly, it will be removed from the index and replaced by another company. In that regard, mutual funds are a much safer investment as you are not fully exposed to the fate of a single company. As I mentioned earlier, there is less trading inside passively managed funds, and no expensive fund managers are running them. Hence, the fee for the consumer is significantly less and will not cut into your overall return.
Who Are Mutual Funds Good For?
Mutual funds are an excellent way for newbie investors to dip their toes in the market. There is less risk (there is always some risk with investing) than individual stocks, and when done right, there are little to no fees involved. If you are looking to start investing in mutual funds, I would suggest low-cost index funds. Low cost means an expense ratio (you can see this if you google the fund’s name) that starts with .0_ _.
One last thing to know about mutual funds: they are bought and sold at the end of a trading day. You can not trade mutual funds like you do a stock (during the day at the price you choose). The value of the fund is determined at the end of the day. If you place your buy/sell order during the day, it will execute at the close.
Examples of Low Cost Index Mutual Funds:
- Vanguard 500 Index Fund (VFIAX): Expense Ratio = .040: Tracks the S&P 500.
- Vanguard Total Stock Market Fund (VTSAX): Expense Ratio = .040: Tracks the entirety of the US stock market.
- Fidielity 500 Index Fund (FXAIX): Expense Ration = .015: Tracks the S&P 500.
- Fidelity Zero Total Market Index Fund (FXROX): Expense Ratio = .000: Tracks the entirety of the US stock market.
Exchange Traded Funds (ETF’s)
I will keep this one short. ETF’s are basically the same thing as mutual funds except for one big difference. You can buy and sell ETF’s througout the trading day like you can with stocks. As I mentioned, mutual funds trades only occur after the market closes at 4 PM each day. Like mutual funds, ETF’s are comprised of numerous compnaies and also like mutual funds there are active and passive ETF’s (and the same downside for the actiely managed funds).
Examples of Low Cost Index Fund ETF’s:
- Vanguard S&P 500 ETF (VOO): Expense Ratio = .030: Tracks the S&P 500.
- Vanguard Total Stock Market ETF (VTI): Expense Ratio = .030: Tracks the entirety of the US stock market.
Bonds
Bonds can also be complicated and are certainly worth a full post by themselves to fully understand. The basic thing to know about bonds is that you are buying someone else debt. When you buy a bond, you are loaning money to the entity that is issuing the bond. It is a way for companies, governments, and others to raise money by selling debt at an agreed-upon interest rate.
The value of the bond will fluctuate like stocks, mutual funds, and ETFs based on supply and demand. In addition to the value of the bond itself, the issuer of the bond will make periodic payments to the holder of the bonds (usually 2x a year), which is where the “fixed income” tag that is often tied to bonds comes from. The bondholder would get a return from the interest payment and potential return if the value of the bond increased based on demand.
Who Are Bonds Good For?
As a new investor, you should not get into direct purchases of bonds. However, if you want to hold bonds as part of your portfolio, my advice would be to do so using low-cost mutual funds and ETFs.
Bonds are usually used as a hedge in a portfolio, meaning that they often go up when stocks (mutual funds and ETFs) go down. Holding bonds can lessen the blow during down market times, but they can also limit returns during up market time. Therefore, young investors should maximize gains and limit their exposure to bonds. As you get near retirement, if you are more risk-averse, you can add bonds for the reasons I mentioned. I will not list bond funds here as if you are new to investing, I would advise starting with an all-equity (stock-based) portfolio using mutual funds and ETFs.
Account Options
401K/403B/457 Plans (Traditional & Roth)
What Are They?
All of the above-mentioned retirement plans are offered through your employer. When you enroll in a plan like those listed above, money will be deducted from your paycheck (pre-tax for Traditional and post-tax for Roth) and invested in the market, most often through mutual funds of your choosing.
The difference between the above three plans lies mainly in what type of employer you have. Most for-profit employers offer 401K’s, and most non-profit employers offer 403B’s. Additionally, many municipalities will offer 457’s in addition to 403B’s, which is a huge benefit for those employees because you are allowed to contribute and max out both. The maximum contribution for all three plans in 2021 is $19,500. If you have the option of the 403B AND 457, you can contribute $39,000.
Traditional vs. Roth ?
With the Traditional version of each, the money is deducted pre-tax and will grow tax-free until you start to withdraw it in retirement. Only then will you be taxed on that money at whatever tax rate you are in when you withdraw the money.
With the Roth version of each, the money is contributed post-tax, meaning that you pay taxes on it via your regular payroll tax deductions. The money is then invested in the mutual fund (s) of your choosing and will then grow tax-free and deducted tax-free since it was taxed already.
How to Enroll ?
Many employers will automatically enroll you in these plans as part of a new initiative to encourage people to start investing when they are young. These are called opt-out plans. The best way to know is to speak with your HR department and make sure you are enrolled.
Once enrolled, you will determine what percent of your check is pulled out each pay period and its investment. As I mentioned earlier, I would recommend one or two low-cost index funds that mirror the broader overall US stock market.
Many companies will offer an “employer match” program. In this case, the employer will match your contribution up to a certain amount. Any match is essentially free money and equal to a raise of the same amount. So make sure you contribute enough to earn the match right from the start!
Traditional & Roth IRA
What Are They?
IRA’s are retirement investment plans offered outside of your employer. If you do not have access to a 401K/403B/457 or maxed out your contributions to those, you can and should contribute to one of these plans. As with the plans mentioned above, the difference between Traditional and Roth lies in when you are taxed. And like the plans above, the Traditional is pre-tax, and the Roth is post-tax. Here is a great infographic from Schwab that describes each plan in detail. Contributions to any combination of IRA’s are capped at $6000 per year in 2021.
Anyone with earned income can contribute to a Traditional Ira. The Roth IRA has earned income limits which can be found here. If you are eligible for a Roth, I would strongly advise contributing to one as early as possible, even if you already contribute to a workplace plan. Having pre-tax and post-tax money available in retirement is a huge advantage. Additionally, Roth contributions (not the gains) can be withdrawn penalty-free at any time, so you always have access to the money you contributed.
How to Enroll ?
Go to any brokerage (Fidelity, Vanguard, Schwab) and follow the prompts to set up and fund your account. As will be the theme throughout, I recommend choosing a few low-cost Index Funds. I also prefer regular monthly contributions (called dollar-cost averaging) vs. lump-sum investing. But that is a personal preference, so do whatever feels best for you.
Brokerage Account
What Are They?
A brokerage account is a non-retirement vehicle to invest in with any “extra” or “fun” money you have. Inside of an account like this, you can buy/sell stocks, mutual funds, ETFs, commodities, or any other openly traded product. There is no tax advantage or disadvantage to an account like this, and there are also no yearly contribution limits.
A brokerage account is not where I would recommend starting your investment journey. But rather a good goal to shoot for. I only started investing in one after I maxed out all of the investment account available for my wife and me. Once you have done that and other foundational money steps, such as having a proper emergency fund, then put any additional money you want working for you into a brokerage account. Here is a surprise, I would once again choose low-cost Index Funds.
How to Enroll ?
To enroll in a brokerage account, follow the same steps outlined above for IRAs. Just make sure when you go to the brokerage website of your choice, you choose a “brokerage account.”
Healthcare Savings Account (HSA)
The last one I am going to mention is a little treat that many people have but don’t use. The HSA, which is short for Healthcare Savings Account. This is available for people who have high deductible health plans (see eligibility requirements here).
The beauty of the HSA is that the money you contribute goes in tax-free, is invested (low-cost index funds), grows tax-free, and is withdrawn tax-free as long as you use it to pay medical bills. The other sneaky benefit is that you can pay your medical bills now, keep the receipts, and allow your HSA money to stay invested for the long haul to grow. Then, down the road, when you need the money for retirement, you can submit all of your past receipts and take your money out tax-free after potentially decades of growth. WOW!!! If you are eligible for this plan, make sure you use it.
Where To Start
Now that you know the basic products, where should you start? This is the sequence I would advise (to learn more about how I save and invest, click here):
#1: Contribute To Your 401K To Get The Employer Match
#2: Max Out Your Roth IRA
#3: Max Out The Rest Of Your 401K/403B
#4: Max Out Your HSA
#5: Contribute Whatever Is Left Over To A Brokerage Account
There you have it. Please remember that this is a broad and basic overview of investing. I could write a post on each item listed here as well as the many others that exist. This post is for beginners. I encourage you to take action and start investing today. The sooner you start, the sooner your money and the power of compounding will work for you! Please comments below with any suggestions or questions.
The post The GFGB Beginner’s Guide To Investing appeared first on The Fat & Broke Podcast.
