Investing Basics: 5 Simple Things You Should Understand
There’s a lot to learn about the economy, how the stock market works, and what the hell a PE ratio is before you’ll be an expert on investing, but you should at least be aware of a few fundamentals if you want to eventually take your basic knowledge to the next level. Maybe you have an old 401(k) that you don’t know what to do with or you have cash sitting in the bank that you’d like to put to work. Start here.
What’s the difference between a 401k (or 403b) and an IRA?
There are a few. There are also a lot of similarities. One (or both) may be right for you, but how do you determine this? One of the main differences is that your 401k or 403b through work is employer-sponsored which means the company that you work for chose a plan for its employees (whether with Fidelity, John Hancock, Merrill Lynch or countless others). Your employer may match part of your contributions inside of this plan. Some employers match the first 5% you contribute, while others match just a small portion of the percentage that you put in. The “plan” typically offers 25-50 investment options (usually all mutual funds) and just one assigned advisor. An IRA stands for Individual Retirement Account. And it’s just that — “individual”. It’s your own self-directed account without restriction. Nobody is matching your contributions and therefore cannot tell you how to invest. You’re free to choose from virtually unlimited investment choices and you can even hire your own financial advisor to help manage it. Understanding your employer’s match will help you determine how much to contribute to your 401(k) and how much you may want to invest elsewhere without restriction. Of course, getting additional money from your employer beyond your salary is a good thing. When you leave your job or retire you’ll be free to take this money with you by rolling it into your IRA or new 401(k). The choice is yours so make the right one!
When is the best time to invest?
It’s commonly believed that If the stock market is down, it’s a bad time to invest. This isn’t necessarily true. If you are investing to grow your money over the long term, the best time to buy into the stock market is when prices are low. It’s like shopping for something you need anyway during a sale. When prices of the stocks you now own go up, you’ve just made money. You bought more shares of said stock for your $1,000 than someone else who put $1,000 in when prices were higher. It’s basic math. Now, keep in mind that just because a stock price has dropped, doesn’t necessarily mean it’s a good buy. It’s always important to look at the company, the stock’s value compared to the market, etc. Sometimes stocks are down just because they suck and buying them could be a huge risk. Always do your research or talk to your advisor before picking stocks or mutual funds.
Is the money in my 401(k) safe?
We’ve heard it hundreds of times, “My money is in my 401(k) through work, so it’s safe”. Surprisingly a lot of people assume because their money is inside their company’s plan, that it must be “safe”. This couldn’t be more false. Investing is never 100% safe or protected from downside (unless you’ve purchased some sort of fixed product from an insurance company because they literally provide actual guarantees). There will be conservative options within your 401k plans such as cash, money market funds, or government securities, but if you are invested in a mix of securities inside your 401k, there is no protection to loss. What you may also not know is that even if you are still working for your company, you may be allowed to do an in-service distribution (or rollover to your IRA). If allowed, this enables you to choose your own investments and advisor.
When should I start saving or investing?
Or how about this one, “I don’t make enough to start saving or investing”. Even if you are working 40 hours a week and just making enough to pay your bills, there’s usually a little wiggle room to start putting money away even if it’s $100/mo. If you’re fortunate enough to have a retirement plan through work, you should be able to set up automatic deductions from your paycheck. You won’t even notice it! Plus, your employer may match part of your contributions (like mentioned in example 1). If this is the case, this is simply free money. Don’t miss out! If you do not have a retirement plan through work, you can set up your own brokerage account with automatic contributions from your bank account. It all adds up and the sooner you start, the better you will be in the long run. Just do it!
What are the basic investing options?
Lastly, let’s discuss what your basic investing options are. The most common form of investing is buying stocks, bonds, and mutual funds. First, you must know the difference between the three. Stocks are shares of equity (ownership) in a company. If you buy 10 shares of Facebook, you now own a piece of Facebook. When Facebook grows in value as a company, your investment grows proportionately. You are part (a very teeny, tiny part) owner of this company. Congratulations! Next, there are bonds which are almost the opposite of stocks. Companies that need capital to grow and expand, issue bonds (debt securities). If you purchase a bond, you are loaning your money to the company that issued the bonds, and in return, they will pay you a fixed interest rate until the time they repay the principal. Bonds can also be issued by government agencies, such as municipalities, state, or federal government (because of course, the government always needs more money). You, as the investor, earn money from the interest the bonds pay. The riskier and longer-term the bond is, the better rate you should get and vice versa. Lastly, mutual funds: mutual funds are a pool of the two and sometimes cash. Rather than buying one stock with your first $1,000, you can diversify your investment by purchasing one mutual fund, which will get you maybe 20 different stocks in 10 different sectors. Plus, mutual funds are professionally managed behind the scenes so that you can sit back and relax. Of course, there is still risk associated with mutual funds, it’s just more spread out.
There’s still a lot to learn and many more concepts to grasp. Keep following along for more like this and soon you’ll feel comfortable enough to make these calls on your own or realize you might need an advisor to help you. Please share your questions and comments. We love hearing from you!