CHAPTER
14

Your Investing Options

In This Chapter

  • Knowing when it’s time to start investing
  • Why are you investing?
  • Assessing your risk tolerance
  • Mutual funds and exchange traded funds
  • Navigating the stock market
  • Lending your money by buying bonds

When you’re a little more established financially, you might start thinking about investing some of your money. Many millennials have expressed distrust in traditional investment opportunities, and many people in their 20s and 30s have an uneasy relationship with Wall Street. And yet, despite some traumatic ups and downs of the stock market during the past decade, most experts still insist that in the long term, investing in the market is the best way to ensure your money will grow. History has shown that markets are cyclical and conditions will improve.

Having money to invest means you have savings you want to put to work for you. Everybody should have some investments so their funds grow. Even with fluctuating markets, good investments grow over time, which helps you keep up with inflation and helps ensure your financial security when you retire.

In this chapter, we take a look at some of the basics of investing. We think the subject will seem less intimidating after you finish reading it.

When to Start Investing

Before you even think about investing money in stocks, mutual funds, or exchange traded funds (ETFs), take a close look at where you stand financially. How are you doing paying back your student loans? Are your credit cards under control? Do you have some money stashed in a safe place for your emergency fund? Are you making regular contributions to your 401(k) or another retirement savings plan? If all those things are taken care of and in good shape, you probably should think about putting some money in other investment vehicles.

You don’t need a ton of money to start investing, and you don’t necessarily need a financial adviser or a salesperson to tell you where to put your money. You can purchase many investments without a salesperson, and if you do your homework carefully, you’ll be able to figure out on your own the best places to put your money at this time in your life.

Almost everyone who begins investing starts small and builds up their investments over time. If you work carefully and patiently, you’ll do the same. It’s fun to watch the growth, particularly when you remember that you started small.

Money Pit

Don’t even think about investing yet if you still have credit card debt. Making 6 or 7 percent off an investment pales in comparison to paying out 18 or 22 percent or more on your Visa. Pay off the plastic first. You can’t get ahead while you’re carrying a load of debt.

Your Investment Goals Matter

Before you begin the investment process, sit down and identify just why you’re investing. Do you want to make money for a down payment on your first house? A beach house in 20 or 25 years? College money for your kids? Additional funds for your retirement years?

Each investor has different goals he or she needs to consider before beginning the investment process. If you’re investing in hopes of sending your child off to Princeton in 10 years, for example, you’ll invest differently than you would for your retirement 35 years down the road. What you’re investing for should largely determine the type of investments you make.

If you’re young and investing money you won’t need for a long time, you can afford to put your funds in higher-risk investments than you would if you were nearing retirement age and would soon need money from your investments.

If you’re investing so you’ll have money for a down payment on a house in 5 years, you’d be smart to consider an investment vehicle that’s more like a savings account—a certificate of deposit or money market account that pays you interest.

Pocket Change

If you’re investing money you’ll need within 2 years or less, you’re generally considered a short-term investor. Investing your money for 2 to 7 years puts you in the midterm range. If you won’t need your money for more than 7 years, you’re considered a long-range investor.

People invest for all kinds of reasons. They might want to build wealth to pass on to their children or to fund the trip of their dreams in 20 years. Many people invest for their kids’ educations, and everyone should be looking toward retirement funds.

As you learn more about investment vehicles, you’ll find out which ones are good for short-term investments and which ones to go with for the long haul. That’s important because you don’t want to tie up money for 20 years might need in 2. How you invest your money depends largely on how long it can remain out of your reach. It also depends on how much of it you can afford to lose.

Some investments are a lot riskier than others, and you need to know what you’re getting into before you throw your money into the pot.

What Kind of Risk Are You Willing to Take?

Some people are just naturally more risk averse or risk tolerant than others. You probably know people who like to play it safe in most everything they do and others who love the thrill of an adrenaline rush.

Those qualities extend to making investments. Everyone who invests money hopes the value of his or her investment will increase, of course. But some investors are willing to take a lot more risk than others to make that happen.

High-Risk Investors

People can be high-risk investors by choice, or they can be high-risk investors because they don’t know enough about what they’re doing. (The latter is more often the case.) A high-risk investor is generally classified as someone who can live with losing about a quarter of his or her investment portfolio in a year.

If you have $10,000 to invest, and the thought of losing $2,500 of it doesn’t give you chills, you might qualify as high risk. But even if you’re a high-risk investor, you still have to do your homework and find out where your money has the best chance of earning you more.

Suppose an investor chooses to be high risk. He jumps into the stock market and buys only investments with potential for very high returns. He got a hot tip from a buddy of his that a certain industry is about to take off, so he loads most of his money into that industry’s stock. Even if this guy knows what he’s doing, he’s a daredevil. But if he’s making high-risk investments because he hasn’t done his homework and doesn’t understand the importance of diversification or that his money should be spread around, he’s risking catastrophe—he’s speculating.

Speculating, like gambling, is taking chances and rolling the dice to try to make a killing in the market quickly. Getting a hot tip at a cocktail party and acting on it by putting down $5,000 is speculating. Investing, on the other hand, is buying 100 shares of IBM stock after you’ve investigated exactly what the company does, the fundamentals (explained later in the chapter), and the company’s outlook for the future.

Definition

Your investment portfolio is the listing and value of all your investments at a given point in time. Speculating is taking above-average risks to achieve above-average returns, generally during a relatively short period of time. Speculation involves buying something on the basis of its potential selling price rather than on the basis of its actual value.

Moderate-Risk Investors

If you’re a moderate-risk investor, you won’t bet the farm on a tip you overhear while you’re getting your hair cut or taking a yoga class. You’re generally classified as a moderate-risk investor if you determine you can stand to lose up to 15 percent of that $10,000 in your portfolio. The thought of being out $1,500 doesn’t make you jump up and down, but it won’t keep you up every night either.

Conservative Investors

Conservative investors are the meat-and-potatoes people of the investment world. Keep your fancy appetizers, your cream sauces, and your puff pastry desserts; just give these folks something they can depend on, something that won’t give them any surprises, and something they don’t have to worry about. They don’t want to take any chances with their investments and will gladly give up even the possibility of high returns to know their money will be there when they want it.

Conservative investors generally start having nightmares at the thought of losing even 5 or 6 percent of their portfolios over 1 year’s time. The thought of losing $600 of that $10,000 investment makes them very nervous.

Mutual Funds

Mutual funds are a very popular investment vehicle for individuals because they don’t require a lot of money to get started. They carry some other advantages as well.

Definition

Mutual funds are an aggregate of stocks, bonds, and assets purchased with money from many investors and typically managed by a portfolio manager and investment experts who research the market and recommend which investments to add to the fund.

Mutual funds are investments that pool many people’s money and place it into stocks, bonds, and/or other holdings according to the investment policy of the fund that’s stated in the fund’s prospectus, or plan. When you put your money into a mutual fund, you’re throwing it into a pot with another couple hundred million dollars or so. Most mutual funds contain more than $1 billion.

The money in the mutual fund is managed by a portfolio manager and a team of researchers who are responsible for finding the best places to invest the money. A portfolio is a group of investments selected and assembled to meet a financial goal. A portfolio manager is paid to supervise the investment decisions of others and handle the management of a portfolio, be it for individuals or for a mutual fund.

Types of Mutual Funds

Most mutual funds fall into one of five categories:

  • Money market funds
  • Stock funds
  • Bond funds
  • Balanced funds
  • Target date funds

Features of each type vary, as do the risks and rewards:

Money market funds These are low risk because your investment can only be placed in short-term, dependable investments issued by the U.S. government or corporations.

Stock funds These funds invest in corporate stock and come in different types. Your money might be invested in a growth fund, which aims for above-average gains, or an income fund that pays regular dividends. A sector fund concentrates on a particular area, such as health care, biotech, or technology. An index fund is concentrated on a particular market index, such as the Standard & Poor’s 500.

Bond funds As the name implies, these are invested in bonds. They usually pay periodic dividends to investors.

Balanced funds Often called hybrid funds, balanced funds own both stocks and bonds. They usually contain about 60 percent stocks and 40 percent bonds—a reasonably balanced mix of assets.

Target date funds These hold a variety of stocks, bonds, and other investments, selected depending on the age of the investor. If you invest in a target date fund when you’re 24, your mix will be more high risk than that of someone who invests when they’re 54. As you get nearer to retirement age, your investments will be shifted so they incur less risk. The mutual fund company manages your portfolio to minimize risk as you get older so you don’t have to.

Advantages of Mutual Funds

Mutual funds are popular because they can offer some great advantages. For example, money can be taken directly from your bank account each month and transferred into a mutual fund. This makes investing nearly painless.

Mutual funds also can offer diversification. If you are diversified and one or more of your investments hits a slump, you can rely on your other investments to boost your total portfolio. For instance, you could divide your money among three or four different types of stock funds so you’d always have some money invested in a profitable area of the market.

Definition

Diversification means investing your money in various securities in different industries, hoping to protect your investment against one or more companies undergoing financial disaster.

Part of diversification is investing in bonds or fixed income as well as different types of stocks. It can be difficult for you to plan that diversification on your own, which is why people look to mutual funds to diversify their portfolios. Diversification is very important, particularly in uncertain economic times such as those we’ve experienced in the past decade.

It doesn’t cost much out of pocket to buy mutual fund shares. You can purchase a no-load fund, which is a type of mutual fund in which shares are sold without a sales charge or commission. You do not pay a sales charge to buy the fund. If a sales charge or commission is charged, the mutual fund is called a load fund.

Brokerage for the investments within the mutual fund, or the cost of buying or selling shares of the stocks or bonds, are generally far lower than standard brokerage because the fund managers buy or sell so many shares of a security at one time and buy and sell frequently. Having this power enables them to negotiate trades for a lot less money than you could on your own.

You can direct almost any amount of money to where you want it. If you’re into a mutual fund for the long haul, you can direct your money to funds that invest more heavily in stocks instead of more-conservative bond funds. A balanced mutual fund is a good initial investment.

Plenty of information is available about reliable mutual funds, including funds that don’t require a lot of money to start and have the most reasonable fees. Check out the following to learn more:

One final advantage of mutual funds is that they carry almost no risk of going bankrupt. Due to diversification within a fund, a mutual fund is very unlikely to lose its entire value. You can invest $5,000 into XYZ Computer Company, for example, and within 5 years, the value could drop to $0, but if you invest $5,000 in a diversified general mutual fund, your money should follow the ups and downs of the stock market, not just one stock.

Look carefully at mutual funds as you begin to think about investing your money. They’re a great place to start investing and are an excellent vehicle in which your money can grow. Don’t just pick the fund by the name; read the information online about what the fund is actually invested in.

Exchange Traded Funds

ETFs are a more recent investment alternative. ETFs combine the diversification advantages of mutual funds with the trading flexibility and continual pricing of stocks and bonds. Mutual funds are sold only at the end of the day, but ETFs can be sold any time during the trading day. Index ETFs are available as well as managed ETFs.

ETFs were introduced in Canada in 1989 and started catching on in the United States soon thereafter. ETFs are as varied as mutual funds and have steadily increased in popularity, although Americans still have much more money invested in mutual funds than ETFs.

ETFs often have lower expenses and operating costs than mutual funds because they initially were mostly index funds, which do not require as much active management as some other types of funds; less active management results in lower costs. Many people like the idea of less active management and lower costs, while others prefer the active strategy work that goes into managing mutual funds.

Much debate and speculation surround mutual funds and ETFs and which is better. Most experts feel one is not better than the other and that both mutual funds and ETFs can be good fits in a portfolio. Be sure to read about whatever fund you’re considering before deciding where to put your money.

The Stock Market

For many reasons, the stock market is not a simple topic. Before you start investing your hard-earned money there, be sure to do some additional research and get a good understanding of how it works. For now, let’s have a look at what the stock market is and how you can get started.

Simply speaking, the stock market is the arena in which shares of publicly held companies, or securities, are released and traded. Trades occur within organized markets called exchanges.

The Major U.S. Stock Exchanges

The United States is home to three major stock exchanges:

  • New York Stock Exchange (NYSE)
  • American Stock Exchange (AMEX)
  • National Association of Securities Dealers Automated Quotation System (NASDAQ)

The NYSE, formed in 1792, is the largest organized stock exchange in the United States.

The AMEX was known as the American Curb Exchange prior to 1951 because trading was conducted on the curb of Wall and Broad Streets in New York City. The AMEX has less-stringent listing requirements than the NYSE, so it attracts many smaller companies, ETFs, and derivatives.

Unlike the NYSE, there’s no physical location for the NASDAQ; trading is done by computer. The AMEX and NASDAQ have merged but maintain their own names and identities.

The overall performance of the stock market is evaluated in many different ways. The Dow Jones Industrial Average (DJIA) is one measure of the stock market, and the standard we hear nearly every day. It consists of three indices that include averages for utilities, industrial, and transportation stocks as well as the composite averages. Each average reflects the simple mathematical average of the closing prices (the prices at the end of the day) and indicates the day-to-day changes in the market prices of stocks in the designated index.

Okay, what does that mean? The DJIA is a composite (group) of 30 stocks with a daily average. Tomorrow, if the stocks go up in price as an average, the DJIA goes up. If the average value of these selected stocks goes down, the DJIA goes down. If market trends are moving increasingly upward, it’s called a bull market. Market trends that are moving continuously downward are called a bear market.

Knowing What Stocks to Buy

The stock market can seem confusing, but the basic concept of investing isn’t all that complicated. When you buy a company’s stock, you’re really buying a little piece of the company represented by its stock. The more pieces, or shares, of stock in one company you have, the bigger a piece of the company you own. Owning stock makes you a shareholder in the company.

Stocks come in different kinds, such as blue-chip stock, which refers to stock of well-established companies like IBM and Exxon, and growth stock, which is that of companies on their way up.

Definition

Shares are what you own when you buy stock in a particular company. A shareholder is the person who owns the shares of stock. Blue-chip stock is the stock of established companies and considered less risky than growth stock, which is the stock of less-established companies.

Obviously, when you buy a company’s stock, you want that company to succeed and grow. For that reason, you should never buy stock—either on your own or with the help of a broker—without first thoroughly researching the company. You need to gain a good understanding of the goods or services the company provides, who its customers are, its market share, the size of the company, its history, the management team, and so forth. You also want to learn about the industry the company is in and check out financial aspects such as the company’s earnings, debt ratios, and trends.

You can use a variety of sources to learn all this information, but a good place to start is with market reports, available both in print and online. Compilations of news affecting either a particular market or the general stock market, market reports give you lots of information about the overall market and economy. This is valuable information when you’re trying to figure out what stocks to buy. After you’ve purchased some stock, market reports keep you up to date with information relating to your particular holdings.

Once you own stock, you can keep up with how it’s doing on a major financial site like the following:

Every publicly traded security has a ticker symbol that identifies and represents it. The ticket symbol for Microsoft, for instance, is MSFT. You simply enter the ticket symbol into the quote box on any of these sites to instantly learn how your stock is faring.

Money Pit

Some people are attracted to the stock market because they think it’s exciting, even glamorous. We’re not discouraging you from Wall Street, but remember to put your financial house in order first. If you don’t consider all the advantages—and disadvantages (including taxes)—before you invest, you could be putting your personal financial situation at risk.

Enlisting the Help of a Broker

Some people spend their days online buying and selling stocks. When you’re first starting out, however, it’s a good idea to work with a broker. Basically, there are four types of stockbrokers that range greatly in services and price:

Online discount brokers These brokers work with you on the phone or internet. You normally pay on a per-transaction or per-share basis, so you can open an account with an online broker with relatively little money and start buying and selling stock immediately. The downside is that discount online brokers don’t provide any kind of financial advice, although most provide links to information and resources for you to access.

Discount brokers with assistance Similar to online discount brokers, discount brokers with assistance provide some extra help by giving you tips on how to invest or directing you to reports and other information. They don’t, however, give you suggestions or advice about what to buy, and they generally charge a small fee for their assistance.

Full-service brokers These brokers charge between 1 and 2 percent of the value of your investment, but presumably they possess knowledge and information concerning your particular investment, and you would benefit from his or her expertise. A full-service broker should take time to get to know you and gain an understanding of your financial goals and factors that relate to you. A good full-service broker can be well worth the fees charged.

Money managers Finally, these brokers do what the title implies—they manage your investment account. People who hire money managers normally have hefty portfolios and are willing to pay someone to handle them while they’re doing other things. At this stage of life, it’s highly unlikely that you need a money manager.

Dollars and Sense

A broker can be your best friend when it comes to buying and selling stock. Remember, however, that ultimately you are responsible for what your money buys, meaning it’s important that you do your homework and don’t rely solely on your broker.

Some analysts say you can save 50 percent or more by buying stock from a big discount broker such as Charles Schwab or TD Waterhouse rather than from the traditional brokerage firms such as Merrill Lynch or Morgan Stanley. Full-service or discount broker? The choice is yours. If you feel you need advice and direction, look for a full-service broker. If you know what you want, or if you have another type of financial adviser, a discount broker should be fine.

Understanding the Risks of the Stock Market

Every investment you make, including buying stock, involves a certain level of investment risk, with the chance that you’ll lose the money you invest or the investment won’t perform as well as you thought. Investments with the chance for higher returns carry greater risk than those without the return potential.

Stocks can make money in two ways. As a shareholder, you may get annual dividends. Hopefully, the price of the stock also will increase so if you wanted to, you could sell your stock for more than what you bought it for and make a profit.

Definition

A dividend is a share of a company’s net profits, distributed by the company to a class of its stockholders, and paid in a fixed amount for each share of stock held. Dividends are usually fixed in preferred stock, which is a special class of securities; dividends from common stock vary as the company’s performance shifts.

The amount of dividends a corporation pays out is a reflection of the type of company it is. The stock of a growing company won’t pay out as many dividends as, say, an established utility company. It’s important to remember this difference if you’re planning to buy shares of a company. Will you receive a good annual income from your stocks, or are you banking on profits that will occur a few years or more down the road? At this stage of your life, it’s likely you’d buy stock with potential for growth, hang on to it for a while, and sell at a profit in the future.

What happens, though, if the stock you purchase takes a nosedive and loses much of its value? First, don’t panic. One thing you can count on it that the stock market will rise and fall, and rushing to sell stock that’s lost value is not a wise move.

The goal of investing in the stock market is to buy when the stock price is low—or at least relatively low—and sell when the price is high. If the value of your stock decreases, consider the state of the overall market. It may be that the whole market is down due to an event such as lower-than-expected job creation numbers. If that’s the case, it makes no sense to sell your stock.

If the value has declined due to a reason specific to the company in which you own stock, you need to take a close look at the underlying fundamentals of the company and try to figure out what’s happening. Has there been a change in management? A trade problem? Do some investigative work, and think carefully about whether it makes sense for you to hang on to the stock or to sell. A full-service broker can advise you.

Dollars and Sense

Check out your local newspaper’s business page for a “stocks of local interest” column. Read these stock reports daily for a week or two to get a feeling for how local companies are doing in the market. It’s sometimes easier to understand the stock market if you look at how it pertains to something you’re familiar with.

Bonds

When you buy a company’s stock, you’re buying a little piece of the company. That makes you an owner. Another way to invest is lend your money to an organization and have it agree to pay you back, with interest, over a specified time. When it comes to investing, you can own or you can loan.

When you loan money with the understanding that it will be repaid to you with interest, you’re participating in a lending investment. We most commonly think of bonds as lending investments, and they are the most widely used. Bonds come in many varieties, including municipal bonds, general obligation bonds, revenue bonds, corporate bonds, high-yield bonds, savings bonds, and government agency bonds. Other investments in which you lend money are certificates of deposit (CDs), Treasury bills, and Treasury notes.

All these are investments in which you give your money to a particular entity with the goal of getting it back at a certain time with an agreed-upon amount of interest added. The entity borrowing your money varies from a bank, which generally administers CDs; to a corporation such as AutoZone, for example; to the U.S. government, which offers bonds. Corporations also offer bonds; they borrow funds from you in the form of a bond and pay you back with interest, which generates income for you.

The conditions, such as the length of time the money will be invested, the amount of interest paid, and so forth, are different for each of these types of lending investments. In most cases, bonds offer a fixed interest rate. That is, the rate remains steady throughout the life of the loan. Some bonds offer variable interest rates, for which the changes are defined in the fine print. Be sure you know what you’re buying.

When interest rates go up, the value of your bond goes down. When interest rates go down, the value of your bond goes up. When your bond matures, you get your money back. Let’s look at an example: if you’re holding a bond that pays 5 percent interest and the interest rate jumps to 7 percent, you lose on the value of your bond if you sell it. But if you’re earning 7 percent interest on your bond and the interest rate drops to 5 percent, you’re still entitled to 7 percent, the agreed-upon rate. In that case, your bond would have increased in value (known as a premium bond) compared to new bonds being issued. Either way, you’ll get your initial investment back when the investment matures.

Always be sure the bonds you buy have a clear maturity date so you’ll know exactly when you can get your money back.

Definition

A premium bond is a bond for which the value has increased. The maturity date of a bond is the agreed-upon time at which you stop loaning your money to the government. You get back your investment and the specified interest when the bond reaches its maturity date.