Here’s a riddle. What’s better than one dollar? If you said feline patty-cake, you’d technically be right. But the answer I was looking for was two dollars.
Growing your money is part of growing up. Appropriate investing is a powerful tool that can help you set goals and create the comfort and security necessary to hit those life milestones—buying a home, having a family, taking a kick-ass trip to Central America.
It’s natural to be a little reluctant to invest; just three years ago we saw the scariest market plunge in a generation. But since that time, the major stock indices have regained most, if not all, of that value. In no way am I predicting that things will continue to rise uninterrupted, but over the long term, the market’s general tendency is to rise, not fall.
Before I can set you loose on the markets, I need to be sure you’re secure for the short term. Build four to six months of living expenses into a run-of-the-mill savings account, the simplest, safest place you can keep your money. Even though today’s savings account interest rates are pretty low—in some places less than 1 percent—it’s still preferable to shoeboxing it. Why? Security. The Federal Deposit Insurance Corporation will protect your deposits (not to be confused with stocks and bonds that will be discussed later) up to $250,000 per person per institution.
Once you’re comfortable with your emergency fund, it’s time to start thinking about investing. The first step is to open a brokerage account. This should cost you absolutely nothing and can be done without ever interacting with a single human being, although I don’t suggest this approach. Virtually every person I’ve ever talked to on the phone about my money (banks, creditors, the IRS, etc.) has been attentive and helpful. Don’t be afraid of them.
Start with the financial institutions you already use. Chances are they have a brokerage arm. However, don’t be surprised if you hit some brick walls at smaller institutions: You may be forced to keep a minimum balance, restricted from investing in certain things, or you may have to pay a high price per trade—the actual buying and selling of an investment. If any of these are the case, look the many discount brokerages, such as TD AmeriTrade, Optionshouse or Scottrade. Frankly, they’re all pretty much the same, and you’re less likely to encounter the aforementioned walls.
With a brokerage account, you’ll be able to buy and sell various types of securities, a broad term referring to different financial instruments you can purchase. The two main categories are debt and equity. Both are issued to raise money from investors like you: Debt is exactly what it sounds like—you’ve lent somebody money, and they owe it back to you, with interest. Equity refers to actual ownership that you have in something. For example, if you were to have a mortgage on a house, you might be asked how much equity you have in it. Translation: how much of your house do you own versus the bank?
Debt securities are called “bonds.” Bond issuers find investors who pay them on the promise that over an agreed-upon time period, the issuer will pay back the face value of the bond and a set interest rate. Bond issuers are generally governments (national, state, and local) and companies. Their creditworthiness is ascertained through a rating agency such as Standard & Poor’s or Moody’s. The highest rating, AAA, indicates low default risk and comes with a lower interest rate.
Equity securities are called stock, which means ownership. When you own 100 shares of XYZ, Inc., you own a small piece of the company; at times, this ownership allows you to vote on the direction of the company. Each stock is listed on a stock exchange, and the price of any given stock—and thus your personal wealth—can change daily depending on what’s happening in the market: When a company’s prospects are bright, there’s an influx of people wanting to buy a piece of it, and thus the bid price increases. When things look hairier, a current stockholder may need to reduce their ask price to get someone else to buy it, and the price falls. When everything’s looking hairy and everybody’s reducing their ask price at the same time, that’s called a crash. It happens.
Bonds or stocks? It’s an age-old debate, but it depends on what you’re looking for. Bonds are more secure than stocks. If things go south at a company, they are legally required to pay their debts to bondholders before stockholders see any money—holders of common stock run the risk of being left with nothing if a company goes under. Bonds also offer a much steadier stream of income, which may be attractive for people who need cash flow, such as retirees. Stock values can be more volatile, but the potential return on stock, especially over the long term, can be very high—in 2004, one share of Apple Inc. cost about $10; today, it’s more than $600.
In reality, however, the answer to the question at the beginning of the previous paragraph is “neither.” It would be silly to think we could choose one or two securities that we believed would get anywhere close to maximizing our potential return. In other words, you want to own a variety of securities, what the fat cats up on Wall Street call “diversification.” By diversifying your portfolio, your average returns will be higher because your overall risk is alleviated, as capital gains on some securities will negate capital losses on others.
Up until the 21st century, the way you and I could most easily and cost-effectively spread out our investments was with a mutual fund, a basket of investments made up of many stocks and bonds. There’s generally a common thread to the investments in a given mutual fund: emerging markets companies, or maybe companies in the energy sector. Fund managers pool all the money from their investors, and trade the individual instruments inside the fund in order to increase the value of the basket. Unlike the stocks and bonds contained within, mutual funds aren’t traded on an exchange. Instead, their Net Asset Value is recalculated once a day, based on how the prices of the items in the basket changed. Many people think the only way to own mutual funds is in an IRA, but that’s not the case. In that brokerage account you just opened, you’re more than welcome to buy shares of a mutual fund.
Mutual funds are a nice diversification strategy, but they can be expensive. Unfortunately, there’s no way to avoid the cost of having someone sit in an office investing a big pool of your money. The expense ratio of a mutual fund is the main metric to assess its costs. Stay away from any fund with an expense ratio above 1 percent; I’d even like to see that closer to .7 percent.
There is, however, a cheaper solution: Fast forward to 2012 and the rise in popularity of the Exchange Traded Fund, or ETF. ETFs are similar to mutual funds in that they’re a basket of assets which may include stocks, bonds, currencies, commodities, etc. The main difference is that instead of their price being their NAV, they trade on exchanges like stocks. ETFs are attractive because they provide the same diversification as a mutual fund but are generally much cheaper. It’s not uncommon for EFTs to have expense ratios under .25 percent. You may not get as wide a variety of funds that exist in the mutual fund world, but I think that has more to do with their relative youth on the financial stage, as opposed to a structural limitation.
I personally don’t own any ETFs yet, just a few shares of stock in my current company and the mutual funds in my retirement account. But I’m certain that when I am in a position to expand my investment horizon, ETFs are the first place I’m going to look.
