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Investing 101: A summary of the basics
It’s time to make your savings multiply. First, a few investing basics for beginners:
How much money you need to start investing: Not a lot. In fact, it’s mathematically proven that it’s better to start small than to wait until you have more to deploy — even if you try to play catch-up down the road. That little eye-opener is thanks to a magic formula called compound interest. (We’ll get into how that works in a minute and — yep — we’ve got a calculator for it.)
What to invest in: Stocks. Or at least investment vehicles that provide exposure to the stock market. The stock market is the place that will deliver the best long-term return on your money.
How to buy stocks: The easiest way to start investing in stocks, and the most common, is to buy a mutual fund — a type of investment that pools money from many investors and invests it in a group of different stocks; call it the “eggs in many baskets” approach.
The secret to making money in stocks: Stay invested. Time (to let your investments ride out the market’s inevitable short-term rough patches) and temperament (the ability to keep cool while others are freaking out) are the keys to investment success. So says a guy you might have heard of named Warren Buffett.
Now that you have the lay of the land, let’s dig in.
Saving vs. investing
There’s saving (amassing money) and then there’s investing (making it multiply). Two big differences between them: time and the type of account you use as a holding pen for your money.
What’s wrong with simply playing it safe with all your retirement money and keeping it in cash? Inflation! Dun dun duuunnnn.
Over time, inflation erodes the purchasing power of cash. If the current inflation rate is 3%, when you go to spend the $100 bill you stashed in a coffee can last year, that money will only get you $97 worth of groceries compared to what it would have gotten you last year. In other words, the cash you’ve been sitting on doesn’t buy as much as it used to, because everything has gotten 3% more expensive.
Now imagine the effect of decades of inflation on wads of money. Actually, you don’t have to imagine. We’ll show you:
That’s how it’s possible to save money and lose money — that is, spending power — at the same time.
You want your long-term investments to outpace inflation, right? Well…
Why you should invest in the stock market
One look at the historic rate of return of the major asset classes shows that the stock market is going to give you the biggest bang for your bucks.
Historic returns on your investment
Despite the stock market’s far superior returns, a 2018 survey commissioned by NerdWallet and conducted by The Harris Poll found that 39% of Americans are not investing. And the Federal Reserve Board's most recent Survey of Consumer Finances showed that in 2019, only 15.2% of American families owned stocks.
Many people say they think it’s too risky or they don’t know how to invest money. While this is a valid concern, and investing does carry risk, having a diverse portfolio can better equip you to weather the market and ultimately achieve your goals.
Your dollars could become more valuable
Now’s the time to learn how to invest — to let your savings dollars hitch a ride in a vehicle you can hold on to for years and have it become more valuable than when you started.
It’s like reverse inflation: The hamburger you could buy for $1 when you were a kid would cost you $5 decades later. But you can’t store the $1 burger away for years and sell when it’s worth $5. Instead, you can buy shares in a bunch of companies involved in making that burger — the bun and beef manufacturers, packaging producers, retailers and restaurants (we’ll show you how in a moment) — and reap the rewards of their growth right alongside them.
» Check your potential returns: Investment calculator
Reap the benefits of compound interest
If you’re itching to get started investing, great! If you’re waiting until you have enough time or money, or for the stock market to cool down or heat up, stop that. Investing any amount of money is never a futile exercise, thanks to the magic of compound interest.
What is compound interest? It's like a runaway snowball of money growing larger and larger as it rolls along. All you need to get it going is starter money.
As interest starts to accumulate on your initial investment, it is added to your ball of cash. You continue to earn interest, your balance expands in value and picks up speed — and on and on it goes.
The sooner you get the snowball rolling, the better. Now let’s go over how to make your pennies multiply.
4 ways to start investing in stocks
If you own a mutual fund (in your 401(k), for example) then — congratulations! — you already own stocks. A lot of people don’t realize that.
But that’s just one of the ways investors can get in on the greatest wealth-building machine on the planet. The four most common entry points into the stock market are:
Individual stocks. We won’t sugarcoat it: Buying individual stocks requires a fair amount of research, ongoing diligence and a stomach for risk. Those aren’t things that most retirement savers want to deal with. In fact, many 401(k) plans don’t even allow participants to buy individual stocks within the plan. If buying stocks sounds exciting to you, we recommend devoting no more than 10% of your retirement portfolio’s overall value to them.
Mutual funds. A mutual fund is a basket that contains a bunch of different investments — often mostly stocks — that all have something in common, be it companies that together make up a market index (see the box for more about the joys of index funds), a particular asset class (bonds, international stocks) or a specific sector (companies in the energy industry, technology stocks). There are even mutual funds that invest solely in companies that adhere to certain ethical or environmental principles (aka socially responsible funds).
What’s nice about mutual funds is that in a single transaction, investors are able to purchase a neatly packaged collection of investments. It’s instant, easy diversification (exposure to lots of different companies) that lets you avoid buying stocks one by one.
Automated for the people: An ode to index mutual funds
Why? Because index funds generally charge lower fees, called expense ratios, than traditional mutual funds. And that lower cost is a big-time boost to your overall returns.
An index fund’s sole investment objective is to mirror the performance of a market index, such as the Standard & Poor’s 500 or the Nasdaq Composite.
These funds are made up entirely of the stocks contained in a particular index. (The S&P 500 index contains shares of 500 of the largest publicly traded U.S. companies, while the Nasdaq tracks a group of more than 3,000 stocks traded on a different exchange.) So the returns of these index funds mirror that of the market they track.
The investment objective of actively managed mutual funds, on the other hand, is to “beat the market’s returns” (translation: to outperform a benchmark index). To do that they employ managers to pick and choose the investments in a fund.
The cost of that management, along with expenses for trades, administration, marketing materials, etc., comes out of your investment returns. Largely because of that, the majority of actively managed mutual funds actually underperform their benchmark index.
Index funds are essentially run by robots. (Okay, not literal robots, but computer algorithms programmed to automatically track the market’s comings and goings.) Computer robots don’t demand Wall Street-sized year-end bonuses or need corner offices, which makes them a lot cheaper.
Those savings are passed along to you. In fact, investors pay nearly nine times more in fees for actively managed mutual funds, which charge an average of 0.78% per year, than they pay in fees for index mutual funds, where the average cost is 0.09% per year.
Choose an index fund, and more of your money stays in your portfolio to grow over time.
ETFs (exchange-traded funds). Like index funds, ETFs contain a bundle of investments that can range from stocks to bonds to currencies and cash. The beauty of an ETF is that it trades like a stock, which means investors can purchase them for a share price that is often less than the $500-plus minimum investment many mutual funds require.
So which of these should you use to build your retirement portfolio? The answer will be clearer after you learn how to choose investments.
Sitting on cash that could be invested? Find out what it’s costing you.