Investing 101: The Basics
As someone who has been investing for decades, I often assume every reader has a similar background to mine.
But in reality, that’s not the case.
This is a good thing, because if every potential reader had the same experiences, knowledge, and perspective as I, there would be no reason for anyone to read anything I write!
In the first couple months of Retiring On My Terms, we’ve discussed a wide variety of topics:
Today I’m beginning a series of posts that will hopefully help build a foundation of knowledge around personal finance and investing for those who are newer to these topics.
As a reminder, we are not financial advisors, and Retiring On My Terms is for informational purposes only. Before making any investment decisions, you should consider your own financial circumstances, and consult with a professional advisor.
We’ll start with investing, a simple word that causes great consternation for many Americans, who assume investing is too complex, too rigged, too risky, or too expensive for them to consider participating.
According to Investopedia, investing is the act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.
The first (of seven!) definitions for invest at dictionary.com is to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
Quite simply, investing is using money you have today to purchase something you believe will provide you with more value in the future.
One thing I don’t think Investopedia or dictionary.com do a good enough job explaining, however, is that investing involves risk.
Investopedia alludes to risk when it mentions “the expectation of obtaining an additional income or profit,” while dictionary.com alludes to risk when it mentions “potential profitable returns.”
“Expectation” and “potential” are nice ways of saying that when you are investing, there are no guarantees that what you think will happen to your money will actually occur in the future.
There is the risk that some – or all – of the money you are investing will be lost.
I’m not explaining things this way to scare people, but to make sure readers understand exactly what investing is. Investing is using $1,000 today, with the belief it might grow into $1,001, or $1,100, or $2,000 at some point in the future, or generate a certain amount of income for a certain period of time, but with the knowledge the investment could be worth less tomorrow.
To be clear, this doesn’t mean investing is a bad thing. On the contrary, investing can be a great thing! But if anyone tries to explain an investment to you without mentioning the potential risks involved, you should be suspicious.
FINRA, the Financial Industry Regulatory Authority, identifies a dozen types of investments: bank products, bonds, stocks, investment funds, annuities, saving for college, retirement, options, commodity futures, security futures, alternative and complex products, and insurance. While the FINRA list is comprehensive, some of its categories are a bit esoteric for our discussion, and it doesn’t explicitly mention real estate, which is one of the most popular investments out there.
For our purposes today, we’re going to focus on a handful of key investment types: bank products, bonds, stocks, mutual funds, and real estate.
We’ll provide a brief summary of each of those five types of investments today, followed by a more comprehensive discussion of each of those investments in the coming weeks. If something is not crystal clear today, hopefully it will be once we publish the more detailed posts on each investment type down the road. In the future, we’ll also dig into some of the more exotic types of investments identified by FINRA.
Bank Products are probably the most familiar type of investment to many readers, and include products provided by your local bank or credit union, such as savings accounts, checking accounts, money market accounts, and certificates of deposit. Some might quibble with the definition of all of these accounts as investments, but for our purposes, if you expect an account to generate interest income, we’re going to call it an investment.
Interest income, by the way, is what you expect the bank to pay you when you lend it money by putting your savings into one of the bank products described above.
That money doesn’t just sit in a vault somewhere. The bank tries to lend it to other people when they need funds to purchase a home, buy a new car, or finance expansion of their business. Of course, the bank charges those borrowers interest, most likely at a higher rate than they are paying you in your bank account. The difference between the lower interest rate the bank pays you on your bank account, and the higher interest rate the bank charges to lend, is one of the primary ways banks make money.
Let’s look at a simple example. Say you have $1,000 you don’t plan on spending any time soon. You decide to put that money into a savings account paying an annual interest rate of 1%. After a year, you will have received $10 in interest ($1,000 times 1%), and your savings account will have a total value of $1,010.
You’ll remember that earlier we mentioned risk as something to consider when making an investment. Many bank products are relatively low risk compared to other investment options, and some bank deposits are backed by the Federal Deposit Insurance Corporation (FDIC), which insures certain accounts for up to $250,000.
Because bank products are generally lower risk, that of course means your potential returns are likely to be lower as well. Many people today are receiving just a fraction of the 1% interest rate we used in our example in their actual savings accounts.
Bonds come in a variety of shapes and sizes, but at their essence are fairly simple investments (at least before the investment bankers start making them more complicated!). You lend money to an organization today, with the expectation they will pay you periodic interest payments over the term of the investment, and then return the money you invested (called the principal) back to you at an agreed upon date in the future.
For example, let’s say Apple Inc. decides to issue a bond to raise money to manufacture more iSomethings. The company offers a 10-year bond with an interest rate of, say, 2.5%. If you invest $1,000 in this new Apple bond today, the company promises to pay you $25 a year in interest ($1,000 times 2.5%) for the next ten years, and then to give you back your $1,000 a decade from now.
Bonds can be issued by a variety of entities, such as the federal government, state governments, municipalities, and corporations. Bonds that are viewed as higher quality, such as those issued by the U.S. government or large multinational companies like Apple, will generally offer lower interest rates to investors than high yield (or junk) bonds, which are riskier investments. With any bond there is a risk that the borrower will not make the scheduled interest payments, and that your principal will not be returned at maturity. If you have to sell your bond before its scheduled maturity, it could be worth more, or less, than you paid for it. The majority of bonds are riskier than typical bank products, such as savings accounts and CDs.
When many people think of investing, they think of the stock market. Stocks represent an ownership interest in a company. When you own shares of stock in a company, you typically have the right to vote on key issues at shareholders’ meetings, and receive your proportional share of any dividends issued by the company. Dividends are periodic payments of a portion of the company’s assets to its owners, but unlike the scheduled interest payments on a bond, dividends are not contractually guaranteed.
You can make money from your investment in stocks in two key ways: by receiving income through dividends, and by capital appreciation, which means selling a stock for more than you paid for it.
For example, let’s assume we purchase 100 shares of XYZ stock at $10 per share, for a total investment of $1,000. When we buy XYZ stock it has a dividend yield of 1.5%, meaning that each $10 share of stock is expected to generate $0.15 in dividend income over the next year ($10 times 1.5%). Since we own 100 shares of XYZ, we expect $15 in total dividend income (100 times $0.15) over the next year. Many companies in the US pay dividends on a quarterly basis, so we’d expect $3.75 in dividend income from our 100 shares in XYZ every three months.
As you may be aware, stock prices change every day as the companies trade on the New York Stock Exchange, the NASDAQ, or other stock markets. If XYZ stock was priced at $12 per share a year from now and we decided to sell it, we’d receive $1,200 (minus any commissions and fees we paid to sell the stock) for the 100 shares we own. Given that we spent $1,000 to purchase XYZ, we would realize a capital gain of $200 when we sold the shares, and would owe taxes on our profits.
If the price of XYZ stock went down to $5, however, and we decided to sell our position, we would receive only $500 for our shares, meaning we would have realized a loss of $500 on our original purchase price of $1,000.
Stocks are generally considered to be riskier than bonds, because if the company you own falls on hard times and files for bankruptcy, bondholders normally get paid before stockholders receive anything. Although over the long-term investments in stocks have provided higher returns than investments in bank products or bonds, over the short-term prices can change dramatically. The price of any stock can head to $0. If you need to sell a stock you own when the price is low to pay for your mortgage, groceries, a car payment, or any other expenses, you could end up selling it for a lot less than you paid for it. Stock prices can be volatile!
A mutual fund is a type of investment in which a money manager aggregates funds from many investors, and invests them in a pool of assets, which can include bonds, stocks, and other asset classes. For investors who do not have the time, willingness, or experience to select individual bonds and stocks for their portfolio, mutual funds can provide a relatively simple way to construct a more diversified investment portfolio, and potentially benefit from professional money management.
Mutual funds come in many shapes and sizes. Some mutual funds invest solely in stocks, some invest only in bonds, and some invest only in money market securities. Some mutual funds focus on US securities, while others invest in assets from around the world. Some mutual funds invest only in specific market niches, such as growth stocks, high yield bonds, or real estate assets, while others attempt to build a diversified portfolio to meet the specific needs of certain investors, such as people who plan to retire in 2040.
Because of the variety of ways mutual funds invest money for their clients, the expenses involved can vary significantly. Fees for actively managed funds, in which the money managers attempt to generate better returns than their market, can cost a couple of percentage points – or more – of the assets you have under management, each and every year. Fees for passively managed funds, in which the money managers attempt to mimic the returns of a specific market segment, such as the S&P 500, can be as little as a few basis points (each basis point represents 1/100th of a percent).
Mutual funds can include an income component, with dividends and interest from the underlying securities held by the fund paid to investors via distributions, as well as potential capital gains similar to stocks. In a mutual fund, capital gains can be generated when the mutual fund sells shares of an investment it owned for you at a profit, as well as if you decide to sell the individual shares of the fund you own at a gain. In many cases, particularly in retirement accounts, distributions from mutual funds are reinvested automatically into additional shares of the fund. Similar to individual stocks, most mutual funds are priced daily. The riskiness of mutual funds can vary considerably, and is largely dependent on the types of underlying assets purchased by the money manager.
Real estate is an investment consisting of land and the buildings on it, as well as any crops, mineral rights, or other natural resources associated with that parcel of land. The most common type of real estate investment owned by Americans is residential real estate – often their own single family homes.
But single family homes are not the only types of investments in real estate that can be purchased. Other types of real estate investments include apartment buildings, office buildings, warehouses and distribution facilities, shopping centers and malls, timberland, farms, hotels and motels, and self-storage facilities – just to name a few!
The potential income component of real estate comes from the rent paid to the property owner by tenants. Real estate can also generate capital appreciation, if the property is sold for more than its original purchase price.
Unlike some of the other types of investments we have described, ownership of real estate can result in some very explicit ongoing costs, such as property taxes, maintenance and repairs, and insurance. An investor in real estate not only needs to be able to finance the purchase of the property, but also to pay for those ongoing expenses, even if the property is not rented out and generating cash flow to the owner. The risks involved in investing in real estate can vary significantly, depending upon the specific characteristics of the individual properties purchased.
In the coming weeks, I will discuss each of the investment types we outlined today in more detail, and share my own personal experiences – both successful and unsuccessful – with each type of investment.
What types of investments have you found to be the most useful on your journey towards financial independence and early retirement?