Smart Money Podcast: Nerdy Deep Dives: Investing, Part 2

Sean Pyles: Welcome to NerdWallet’s Smart Money Podcast, where we typically answer your personal finance questions, except for this episode, where we are continuing our three-part series about how to get started investing. I'm Sean Pyles.

Last week, we talked about how to get into investing in the right way, and this week we're going to dig into different investment strategies. If you have any questions, thoughts, comments, etc. about investing, share them with us on the Nerd hotline by calling or texting 901-730-6373. That's 901-730-NERD. Or you can email us [email protected].

Hearing from all of you is one of the best parts of the show, so please keep your comments coming. And as always, be sure to download, rate and subscribe. Alrighty, on with the show. This week, I am joined yet again by my partner for the series, investing Nerd Alana Benson. Hey, Alana.

Alana Benson: Hey, Sean.

Sean: So what is on the agenda for today?

Alana: I'm really excited for today, because this is when we just get into the real body of investing, like what people really think about — and I think a common stumbling block for would-be investors — which is what investments do people actually pick? And how do you know if they're any good before you buy them?

Sean: And this is where we wade into the alphabet soup of ETFs, S&Ps and IRAs, and a lot of people begin to think that this world isn't for them. And while the jargon can take some getting used to, familiarizing yourself with these terms doesn't take a lot of work. And from there, it's actually much easier to figure out how to take these disparate letters and use them to write your own path toward building wealth.

Alana: Exactly. And you're totally right, there are way too many acronyms in the financial world.

Sean: Yep.

Alana: But before we get into this week's episode, here's a quick recap of what we talked about last week. We started off by discussing attitudes about investing, and how they can hold people back. Then we did a bit of myth-busting about investing. And finally, we discussed different approaches to investing, including why some people prefer to choose their own investments, and why others want help, and whether that's in the form of a robo-advisor or financial advisor, and that the most important thing is finding the path that's right for you.

Sean: And also just getting started, diving into it. That's a really important part. So if folks have not listened to that episode already, maybe go back and listen to it before getting further into this one.

And as always, I've got to give you this quick reminder from the NerdWallet legal team, which is that we are not financial or investment advisors. The nerdy info we're discussing in this series is provided for general educational and entertainment purposes, and may not apply to your specific circumstances.

Alana: All right, let's get into it. Once you have an investing account, whether that's a regular brokerage account or a Roth IRA or what have you, you need to put some money in your account so that you can start buying investments. But keep in mind, just because you're funding your account, that doesn't mean that you've invested in anything yet.

Sean: Right. And also one point of clarification, here we are talking about long-term investment strategies, i.e., investments that will grow an account for five years or longer. If you're looking for info about how to day trade or speculate on specific stocks or investments, the Reddit forums might be more of what you're looking for. I say this as someone who is a proud member of the dogecoin subreddit, but anyway, continuing through the investment process: So you have your investment account, like a brokerage or a Roth IRA, now you gotta put some fuel in this baby to get it going. And the fuel in this case is going to be your money, so you can actually buy investments.

Alana: Exactly.

Sean: And this is a point where people can run into analysis paralysis. There are a seemingly infinite amount of investments that people can buy. Do you pick a reasonable target date fund, or shovel all of your savings into crypto? I don't really recommend doing that, but some people have done that in the past year, as we've seen.

Alana: Yeah, Sean, you make a really good point. So what do you buy? There's so many types of investments out there that it can feel really overwhelming. So to make this easier to understand, we're just going to break down a few of the common types of investments that people have likely heard of. Then we'll get into how to build something we in the business like to call a diversified portfolio, and we'll figure out how you can make your portfolio resilient based on your risk tolerance and your investment timeline.

Sean: Sounds like a plan. I also think now might be a good time to explain one of the driving forces behind investing, and why it's so appealing to those who want to build wealth.

Alana: So the whole reason we are investing is to make more money off of our existing money, and compound interest is the interest that you earn on both your original money and on the interest you keep accumulating.

So just bear with me, there's going to be a lot of numbers here. So for instance, if you put $10,000 into a high-yield savings account with a 1% annual yield, you'd earn about $100 in interest the first year. So that earned interest would then start accumulating interest. So after 10 years of compounding, you would have earned over $1,000 in interest. But high-yield savings accounts, like the one in this example, just don't offer nearly as high of a return as most investments do over the long term.

Sean: And we do have some great calculators at NerdWallet that can show you how even a small amount invested today can grow over time. And just for you, our dear listeners, we have included this calculator in our show notes post for this episode. Play around with it, and see how much you could potentially earn. You can find a link to the show notes post at nerdwallet.com/podcast.

So, Alana, now let's talk about different kinds of investments. And let's start with one of the most obvious ones, which is stocks. This is a kind of an investment that a lot of people are really curious about. So what is up with stocks, and why do people care so much about them?

Alana: I am so glad you asked, Sean. So first, stocks are a slice of ownership in a company. So let's make up a company, we'll call it Nerd Zone, and Nerd Zone makes, I don't know, socks. OK? So Nerd Zone is a company that makes lots of different kinds of socks with nerdy patterns for nerds like us. So if you're buying Nerd Zone stock, you are buying a small slice of ownership in Nerd Zone the company.

Sean: Got it. So when you buy the stock, you're saying that you support all of these nerdy patterned socks so much that you want to give them money to keep making new patterns on new socks, and then some. And that's great, but what's in it for the investors? Where does the making money part come in?

Alana: When you buy a share of Nerd Zone for let's say $100, over the course of the year, the stock price goes up to $120, so that you made that $20 just for being invested. Now, if you reinvest that $20, you'll start making money on the profit that you made from investing in the first place.

Sean: But stocks can also make money through dividends. Can you explain how that works?

Alana: Yeah, that's correct. So some stocks — and not all, just to be clear, not every stock will pay you a dividend — but some will pay dividends, which are just payments that the company gives its shareholders from its revenue.

Sean: OK. That makes sense. And now let's talk about cost. How much do stocks actually cost?

Alana: So stocks can really range. For instance, Amazon, on the day that we recorded this episode, costs $3,489 per share. So that's really expensive, but Amazon has performed really well over the last few years. And unfortunately, I make them more money than I would like to admit.

But not every stock is so crazy expensive. So take Airbnb for example. At the time of the taping, the share price for Airbnb was $168. So if you had $1,000 to invest, you could buy several shares of Airbnb but you couldn't even buy a single share of Amazon.

Sean: Right. But buying either one of those can be a pretty significant investment into stocks. What do people stand to gain from investing in those stocks?

Alana: If you bought one share of Amazon stock on January 1 of 2000, you would have paid about $64 for that share. If all you did was hold on to that single share, you would have made $3,425 just from investing it. Now, that's a pretty extreme example, since Amazon has done incredibly well over the last 20 years. What if instead of Amazon, you had bought Blockbuster stock? You probably would not be very happy with your stock's performance right now.

Sean: Yeah, that's a great example, because it touches on something that is really important when investing in stocks or any kind of investment, which is risk. Stocks in particular are pretty high risk, because we never know what the future holds. If you went back to the year 2000, for example, and told someone that in a couple of decades Blockbuster was about to go bust and the little online bookstore Amazon was going to rule the world, they probably wouldn't have believed you.

Alana: I know. No one really expected that. And that just goes to say, you never know what's going to happen to any single stock. You can make an educated guess and read the news, but there's lots of risk involved in buying single stocks.

Sean: Yeah. And beyond the risk of potentially losing the money that you invest, there are also fees associated with buying stocks, right?

Alana: Mm-hmm. There's what's called a commission fee, which is charged by the broker every time you trade a stock, but a lot of brokers have dropped that fee, making trading essentially free.

One thing you do have to be careful about, though, is your taxes. Because if you buy a stock or another investment, and then sell it for a profit, you may have to pay capital gains tax on it.

Sean: OK. So that's good to know. And what I find really interesting about stocks is that they can be a really splashy way to invest. There is a certain cachet to saying that you own stock in X trendy company, which is part of why they get a lot of attention, but it's not exactly a well-rounded way to invest. Funds, on the other hand, can be a little bit more well-balanced, right?

Alana: Yeah. I personally — and this is my own opinion — I think funds are awesome. There are just a bunch of different types of funds, like mutual funds and index funds and ETFs, but we're just going to boil it down to funds in general first. And funds are basically just baskets made up of a bunch of investments like stocks, bonds and other things. So instead of just buying Amazon or Airbnb or Blockbuster, you'd buy all three of those plus a bunch of other investments all at the same time.

Sean: So instead of buying one egg in the basket, you have a number of different eggs from different chickens or quails or whatever in that basket. That way if one of them doesn't develop how you'd hoped they would have, the idea is that another egg is going to, and it'll hatch and give you a beautiful newborn dollar bill to call your own.

Alana: Yeah. That's a definitely a new take on the eggs and basket analogy, but you're totally right. And because you have so many stocks, if one like Blockbuster goes out of business, you're still invested in a whole ton of other stocks. And this principle is called diversification, and it's a great way to make your investments less risky.

Sean: Yeah. And less risk sounds great. And you mentioned index funds, mutual funds and ETFs, so let's talk about what each of these are, and how they're similar and different.

Alana: So with most of the different types of funds, the difference can come down to management. For example, mutual funds are often actively managed; that means that there is a person somewhere who is picking exactly what stocks and bonds and other investments should go into that fund. Because there is a person doing that work, those funds charge more. Index funds follow a particular index, like the S&P 500. That way no one really needs to sit around and pick the investments.

So generally, all the companies in the S&P 500 are included in an S&P 500 index fund. And the cool thing about that is that pretty much however good or bad the index is performing, your fund is performing the same way. And a lot of investors talk about trying to beat the market; they're talking about trying to beat the performance of an index like the S&P 500.

So here is a very important not-so-secret secret: It is very, very, very difficult to beat the market. In fact, most professional fund managers, the people who try to do this for a living, don't beat the market. And if even the professionals can't do it, it's kind of a hard sell to an individual to try and say, "OK, you can do this." But this is a great case for just investing in a low-cost index fund, because then you'll match the performance of an index and not underperform it.

Sean: OK. That makes sense. So what about ETFs?

Alana: ETFs are also typically passively managed, so they're less expensive than actively managed mutual funds. But ETFs are also cool because you can buy and sell them throughout the trading day, similar to stocks. They also tend to have lower fees than other types of funds.

Sean: And another thing that I like about ETFs, mutual funds and index funds is that they can allow you to invest in an industry you're interested in with a single purchase. There are funds for real estate, information technology, and there are even cannabis funds.

As far as investing in an index fund or an ETF, can you give me an idea about how much that would cost?

Alana: So as of this taping, a Schwab S&P 500 index fund, and that's just a fund that happens to be managed by Schwab, is trading for $69.20 per share. And an iShares S&P 500 ETF is trading for just over $450. So they can really range.

Sean: Like with stocks, the price of ETFs and index funds can vary greatly. And I do want to circle back to the topic of fees, though. These types of investments have a sneaky little fee known as expense ratios that people should be aware of. Can you explain what these are?

Alana: Sure. Expense ratios are a charge shareholders cover that pays the fund's operating costs, like administrative costs, compliance and marketing. They're just charged on top of your annual fee, and they're taken out of your investment, so they're easy to miss, but if you look through your fund's prospectus, then you'll likely be able to find it.

Sean: This is a good reminder of what can be lurking in the fine print. How much do expense ratios actually cost, though?

Alana: Fortunately, index funds and ETFs often have really low expense ratios, generally under 0.2% or even under 0.1%. So if you have an actively managed fund, that will be more expensive, maybe running as close to 0.5% or higher. That's because you have to pay the fund managers to do the work of actually running the fund.

Sean: My thinking on expense ratios is that while it's annoying to have to be charged another fee, it's a fairly marginal cost, but it's good to know exactly what you're being charged for. Now, let's talk about one more common investment. Tell us about bonds.

Alana: So bonds are a little bit different. You're not buying shares in any company, you're loaning out your money. So if you buy a government bond, you're loaning the government money for a certain number of years at a set interest rate. So say that you buy a 10-year bond, in this case the government will pay you interest over those years for the privilege of borrowing your money, and then it will pay you back on a certain date 10 years later.

Sean: And why would someone choose bonds over, say, buying a company stock, or investing in an ETF or index fund, something like that?

Alana: The good thing about certain bonds is that they're very, very reliable. If you're super nervous about investing and potentially losing all your money, there is a very high chance that a bond backed by the government will pay you back. Unfortunately, you pay for that reliability in a lower interest rate. So you likely won't get the impressive returns from bonds that you will from stocks.

Sean: Gotcha. All right, now that we know a little bit about the common types of investments that are out there that people will run into, how do we use that knowledge to build a portfolio? Folks may want a diversified portfolio, but I'm guessing they might not want to buy 400 individual stocks and one ETF.

Alana: Yeah, 400 stocks would be a lot to keep track of, but that's a really good question, and one that a lot of people are often curious about. So how you divide up your portfolio will really depend on your risk tolerance and your investment timeline. In your case, Sean, you probably have, I think, a little ways to go until retirement, right?

Sean: Yeah, 30-something years. Yeah.

Alana: Yeah, you got time. But the great news about that is that because you have such a long timeline, you have lots of time to ride out the highs and the lows of the stock market. The general trend of the stock market is up.

So if you only bought stocks the week before the crash in 2020, and then sold them the next week, sure, your portfolio would just look like a straight line down. But if you held onto those stocks for 30 years, when you zoom out, that big crash will start looking like a small blip in an otherwise upward trajectory. And the idea is that when you have more time between you and retirement, you can take more risk in your portfolio. And then as you get closer to retirement, you want to start reallocating your portfolio to less-risky investments.

Sean: OK. Jargon alert. You just said the word reallocating, which is something I think people may have heard of when it comes to investing, but may not be entirely familiar with. Can you explain this term?

Alana: Yeah. So basically, you adjust what you're investing in over time to reallocate for your own risk tolerance and financial goals. Since you have a while until retirement, you may want to have a higher allocation of risky investments, like stocks, than you do in bonds. Say you have 80% stocks or stock funds like an index fund, and then 20% bonds. If your stocks perform really well that year, your total portfolio may start to have 85% stocks. So at that point, you may want to reallocate or sell some of your stocks to keep your 80/20 allocation.

Sean: And we'd like to remind everyone that these are just hypothetical suggestions. This is not a portfolio allocation that is catered to anyone in particular, but if you are looking to figure out what kind of asset allocation is right for you, we do have some resources that we will list in the show notes.

Another jargony word that goes hand in hand with reallocation is diversification, which we've mentioned a couple of times already. Alana, can you give me an example of why diversification can be important?

Alana: Yeah. Remember last year when gas prices really tanked? Now, imagine if you only held oil companies in your portfolio.

Sean: So your portfolio would have tanked as well.

Alana: Exactly. So now imagine if you had some oil companies, but also some tech companies, some utilities, and a bunch of stock in Charmin and other toilet paper companies. Your portfolio would have felt the pressure from the drop in oil, but it would have been bolstered by the other investments that are in other industries. So it's always a good idea to diversify, so that you can withstand changing markets. And it's a good idea to diversify not just across industries, but geography and company size, too.

Sean: OK. That makes sense. And I think that we're at a good place to wrap up this episode. While we've covered a lot of ground today, we are not quite done. We have some nerdy homework for you, our listeners, to complete before next week's episode.

Alana: First, do some research about what kind of investments you're interested in. While investing in individual stocks might seem like a lucrative approach, investing in funds can be easier and offer a more balanced investment portfolio.

Sean: Next, consider your personal risk tolerance and retirement timeline, and use a calculator to explore how much you could make on your investments.

Alana: Last, think about your potential asset allocation. How much of your portfolio should be dedicated to each type of investment?

And that's it for this episode. For more information about how to get started investing, check out our show notes post at nerdwallet.com/podcast. We'll see you guys next week for the next installment of our nerdy deep dive into investing, with a discussion of different investing styles.

Sean: And before we go, here is our brief disclaimer thoughtfully crafted by NerdWallet's legal team. While Alana and I are knowledgeable and talented finance writers, we are not financial or investment advisors. This nerdy info is provided for general educational and entertainment purposes, and may not apply to your specific circumstance.