Investing can be complicated, and if you haven’t done it before it can seem frightening. Don’t let that fear prevent you from taking advantage of an opportunity to grow your money. This guide to investing for beginners can help you get started.
📚 In this post:
- How Investing is Different from Saving
- When Should You Consider Investing?
- The Risk-Reward Relationship
- Asset Allocation
- Asset Diversification
- Active vs. Passive Investing
- Income vs. Value vs. Growth Investing
- Investment Instruments
- Alternative Investments
- What is a Broker and Why Do You Need One?
- Start with Education
How Investing is Different from Saving
Investing involves committing a sum of money (usually for the long haul) with the aim of earning an attractive return. The objectives of investing are increasing your income, building wealth, and securing your financial future.
Saving, on the other hand, is setting aside a part of your income consistently to create a financial cushion. People typically like to save money to make a larger purchase, such as a car, a home improvement project, a vacation with family, or to cover unforeseen expenses, such as surgery or repairing a damaged roof.
Saving is usually done by placing funds in a bank savings account, money market account, or Certificate of Deposit (CD). The Federal Deposit Insurance Corporation (FDIC) insures these products, making them highly secure.
Investing is riskier than saving. There’s no insurance. Investments do not produce guaranteed returns. However, while saving is secure, the interest you earn may not even be enough to compensate for inflation. You could actually be losing money over the long haul. Investing offers the possibility of significant long-term growth.
When Should You Consider Investing?
Any beginner should ideally start investing only after the following two crucial items have been taken care of:
Clear Your Credit Card Debt
The interest rate on your credit card debt is almost always going to be higher than the return you might consistently earn on an investment. If you’re carrying significant credit card debt, the smartest investment would be to pay that debt off first.
☝️ Clear your high-interest debts before committing money to investments.
Build an Adequate Emergency Fund
Shakespeare said that sorrows do not come like a single soldier, they come in battalions. Illness, natural disasters, layoffs, and other financial emergencies can arise without any forewarning. You should have an emergency fund that will cover your living expenses for at least six months.
💡 Investing works best when you have a significant time horizon. A good rule of thumb is to invest money that you won’t need to use for at least five years. If you keep this money in a savings account inflation will chew away its value. Invest it prudently and there’s a good chance that your money will grow.
The Risk-Reward Relationship
Risk is an inherent part of investing. You will have to assess the degree of risk you are willing to undertake. You’ll need to decide whether the expected rewards are worth that risk. A clear understanding of the risk-reward relationship is indispensable to building a successful and sustainable investing strategy.
Higher potential rewards usually come with higher risks. Volatile stocks can rise quickly and fall just as fast. High-risk bonds pay higher interest rates. If the potential reward of an investment is high, you can expect that the risk is also high.
☝️ Different asset classes, such as stocks, mutual funds and ETFs, bonds, and alternative investments have their risk-reward profile. You need to clearly understand the distinctions between them.
Risk Tolerance and How to Assess It
One of the key evaluations in investing for beginners is to discover your risk tolerance level. High-risk portfolios are often tempting because they can produce large returns. They can also produce large losses. It is critically important to consider the downside risks. Are you prepared for your investment to go to zero if things go wrong?
In simple words, your risk tolerance level is one that allows you to sleep soundly at night. If your investment exposure is causing you a persistent worry, it is not worth it. At the end of the day, investing is a highly personal and lonely journey for an investor. An extremely aggressive approach could make you rich very fast, but it could also wipe out your life’s savings.
On the other hand, an excessively risk-averse approach will limit your growth potential. Striking the right balance between risk and reward is one of the key challenges of investing for beginners.
An investment portfolio should preferably have allocations for multiple asset classes. Asset classes include stocks and mutual funds, bonds, and cash. Your risk tolerance levels and your investing time horizon are two major factors that will influence your asset allocation.
Why Does Asset Allocation Matter?
Allocating your funds to different asset classes within your investment portfolio gives you additional protection against market fluctuations. In general, when one class of assets is doing very well, the other asset classes may only deliver ordinary or even negative returns because most investors are going after the asset class, which is in high demand.
💡 If you encounter poor returns in one asset class, you can often make up for it in another asset class.
Diversification of your investment portfolio should occur at two levels: within each asset class and between or among asset classes. In other words, apart from asset allocation (which itself is a form of diversification), you can also spread your risk by investing in diverse items within a particular asset class.
👉 For example:
Your stock portfolio should have a mix of companies and a mix of sectors in which those companies operate.
If your holdings are concentrated in one company you are vulnerable to high losses if unexpected events hit that company or sector.
Achieving the right diversification and keeping a track of each item in the portfolio can be complicated and time-consuming. Investing for beginners is often easiest when you diversify through ownership of ETFs, mutual funds, or index funds rather than individual stocks. Each fund owns a large number of stocks. That allows you to build a diverse portfolio without committing a large sum of money.
Active vs. Passive Investing
Active investing is for hands-on investors who manage their own portfolios the way a professional portfolio manager would. As an active investor, your objective would be to earn returns that are on par with or better than the average market returns. Your goal is to maximize your advantage from short-term volatility in the markets.
Active investing demands astute market knowledge, dispassionate analysis, and the temperament to enter and exit specific investments with discipline. Active investing requires expertise and discipline. It also requires a significant commitment of time and energy. You will have to monitor your portfolio on a daily basis. Studying potential new investments and keeping up with market conditions affecting your existing investments requires time, effort, and knowledge.
Passive investing, on the other hand, requires a long-term approach. This is often an ideal investment strategy for beginners. You will have to make fewer decisions (not buying and selling frequently). That means you reduce your chances of being wrong. It is also cost-effective because fewer transactions mean lower transaction costs.
Passive investing works when you are willing to adopt a buy-and-hold strategy. Patience is the strength of a passive investor. A popular example of passive investing is buying an index fund, which follows the S&P 500 or another major index such as Dow Jones Industrial Average. The prize in passive investing usually goes to investors who can stay calm and focus on their long-term goals.
Income vs. Value vs. Growth Investing
There are several distinct approaches to selecting stock investments.
- Income investing requires you to focus on stocks that have historically been high dividend payers. Companies that generate a lot of cash, but do not have many new avenues to invest that cash (for growth) may want to distribute higher dividends among the shareholders. Many well-established companies that don’t have a lot of room to grow rely on dividends to attract investors. Dividend-bearing stocks often hold their value when markets decline, because investors look to the security of that income.
- Value investing involves identifying companies with stock values that are lower than their fundamental indicators would suggest that they should be. This often involves finding strong companies in sectors that have been beaten down by events like the recent pandemic. These stocks can grow in value as the market recognizes their fundamental strength.
- Growth investing involves choosing stocks of companies with high growth potential. These companies may not have strong current cash flows and profits. Their appeal is that they are expected to grow exponentially in the foreseeable future and deliver exceptional returns on capital.
☝️ You need to be careful about highly publicized growth stocks: the expected growth may already be reflected in the price.
None of these methods is inherently better than the others. You have to balance them is a way that suits your needs.
Which Approach Is the Best One for You?
You can achieve your financial objectives through any of these investment types, or a mix of all three.
👉 If your risk tolerance is higher, you are relatively young, and you have a significant personal income, you could increase your exposure to growth companies.
👉 As your portfolio matures you might want to add value stocks.
👉 If you are more conservative or nearing your retirement, or have a limited income, you may prefer dividend investing to boost your income.
Growth, value, and income mutual funds and ETFs (exchanged-traded funds) may also be a good choice if you want a blend of both types of stocks in your portfolio. This can provide you with some short-term income while also generating long-term growth from a part of your portfolio.
You will need to understand the investment instruments that are available to you. The three basic types are stocks, bonds, and mutual funds. The risk profile of each instrument can vary. Understanding each instrument will help you build a blend that suits you best.
A stock is a security that represents proportionate ownership of the company that has issued the stock. Stocks are a part of most investment portfolios because historically investors have earned superior returns over time in stocks compared to most other asset classes.
☝️ It’s important to understand the risk-reward ratio and be judicious about stocks. These investments are inherently volatile.
📘 Our complete guide to stock investing basics: Stock Investing For Beginners
A bond is an instrument of debt, which represents a loan that an investor has issued to a borrower. When you invest in bonds, you are basically lending your funds to a government entity (such as a municipality) or a private corporation, depending on the type of bonds you purchase.
Rating agencies such as Standard & Poors and Moody’s assign ratings to bonds. Risky bonds have to pay higher interest rates to attract investors: the higher the bond rating, the lower the interest rate.
☝️ Bonds are usually considered a safer investment compared to stocks, but yields may be low, especially when prevailing interest rates are as low as they are in early 2021.
📘 Our complete guide to bond investing basics: Bond Investing For Beginners
Mutual funds and Exchange-Traded funds (ETFs) are diversified baskets of stocks or bonds, each managed by a professional portfolio management firm for a fee.
Many beginner investors choose funds because they do not have to use individual investing skills or track their stock portfolio. When you invest in a fund, your money is put to work without you having to engage directly in the everyday investing process.
☝️ Many funds have management fees, and you’ll need to compare those when selecting funds.
📘 Our complete guide to mutual fund investing basics: Mutual Fund Investing For Beginners
As the name suggests, alternative investments are non-mainstream asset categories that usually entail significant risk but may also deliver exceptional returns. The universe of alternative investments is expanding and now also includes complex assets such as cryptocurrencies. Some prominent alternative investments include:
- Real Estate: You do not necessarily have to invest in big-ticket residential or commercial investment properties. You may buy shares in REITs (real estate investment trusts), which work like mutual funds, and are traded like stocks.
- Hedge Funds and PE Funds: These alternative investment vehicles are usually available only to high net worth or accredited investors, who are willing to make large investments. These investments may deliver “alpha” returns but the downside risks are also huge.
- Commodities: Tangible assets, such as gold, silver, oil, and agro products are called commodities, which may be considered for portfolio diversification.
☝️ Alternative investments can be profitable, but they often require a high degree of expertise. They may also require substantial amounts of capital. They are usually not suitable for beginning investors.
What is a Broker and Why do You Need One?
When you want to invest, you will usually require a broker. Brokers are professionals who have been licensed to engage in stock trading with a securities exchange. Depending on your investing needs, you may decide whether you want to work with a discount broker or a full-service broker.
Full-service brokers usually represent licensed brokerage firms that can offer you personalized investment advice based on your investment goals.
A discount broker, on the other hand, will not provide you portfolio advice, but simply execute your stock trades. Numerous online discount brokers are available, offering various levels of service.
Many discount brokers offer “robo-advisor” services, which use algorithms to select investments according to your designated risk tolerance or other specifications. These can be excellent choices for beginning investors who are not yet confident in their own ability to select appropriate investments.
👉 Investing for beginners often starts with a retirement plan. If you have a 401(k) or IRA your plan provider also serves as your broker.
Start with Education
Investing for beginners starts with acquiring a basic understanding of the principles of investing. While you need to know what you are doing as an investor, it is often more important to know what not to do. You need to stay away from investments that you do not understand. Remember the words of the legendary investor Charlie Munger, who famously said: “If I know where I’m going to die, I will not go there.”
Start with simple investments, and rely on genuine advice from accomplished investment professionals, while staying away from “hot tips” and “get rich quick” ideas from sources with vested interests. There are many investment scams out there but with common sense, they are easily avoided. If it sounds too good to be true, it’s not true!
Investing for beginners is not about getting rich quickly. A conservative approach and a long-term time horizon are generally more profitable and less risky than a “get rich quick” approach. As with baseball, playing good defense and hitting a lot of singles will win more games than swinging for a home run every time you step up to the plate!