Investing is kind of like sex: everyone’s doing it, but no one’s talking about the basics. Instead, it’s the sensational aspects that get all the airplay. The result is an essential topic that’s often misunderstood and over-sensationalized.
Here we’ll look beyond the facade to tackle the nitty-gritty essentials of investing and provide some practical perspective on key questions. And if you run into any unfamiliar terms, scrolls down to our handy glossary at the end.
Wait, I’m supposed to be investing?
If you have an income, then ideally yes! There are some exceptions, however, so the answer for some will be “yes, but not yet.” If you have high-interest debt (like credit cards), this is a higher priority than investing. Also, if you don’t have any cash for an emergency savings fund, this also comes before investing. Yes, you can work on debt and emergency savings while still doing some investing (like contributing to a Roth IRA or 401k with matching), but this all depends on your situation. Having financial margin is a critical first step, as is learning how to prioritize your financial goals. But otherwise, if you’re earning an income you should start saving some of it for retirement and prudently investing those savings.
But I don’t have enough income left over after expenses to invest!
Expenses have a funny way of expanding into your life and snatching up available dollars. Regardless of how much you make, you should automate your savings so that your money is set aside as soon as (or even before) your paycheck hits your checking account. If you’re saving in a 401k, turn on steady contributions from your paycheck. For a IRA or Roth IRA or a taxable brokerage account, set up regular, automatic transfers to that investment account from your checking account for the day after your paycheck hits. This will force you to set aside money to save and invest.
There are some who truly cannot afford to set aside anything for saving or investing. Sometimes that’s just for a season until a promotion comes or family circumstances change, and sometimes that’s the hard reality. Look to see if you can make marginal improvements in the meantime by decreasing fixed expenses (such as rent or car payments) or increasing your income.
Shouldn’t I be saving for my kids’ college tuition instead of my retirement?
Generally, no. Compare both seasons of life, your child starting college versus your retirement. What happens if you reach retirement with insufficient savings, or 15 years into retirement you run out of money? Your options for increasing your income at that point are limited, and the burden of that shortfall may land on your children. By comparison, if by the time your child begins college you don’t have enough saved, you have several manageable and appropriate options: financial aid, loans, delaying retirement, increasing your income, trimming your lifestyle, a nonworking spouse returning to work. In short, it’s harder to respond to shortfalls in your income or savings at a later age, so don’t cut corners on retirement savings.
So what types of investment accounts should I use?
Start with retirement accounts, as those have some juicy tax advantages. First consider your employer's retirement plan (like a 401k, 403b, or 457), if one is offered. Contributions to these plans are tax-deductible and grow tax-free. If your employer's retirement plan offers any amount of matching, then take advantage of it—enroll as quickly as you can and contribute enough to max out the match. The maximum you can contribute to a 401k (or similar) plan in 2019 is $19,000.
Next, check and see if you are eligible for a Roth IRA. Contributions to a Roth IRA are taxable, but they grow tax free and will not be taxed upon withdrawal. In 2019, a single tax filer must have modified adjusted gross income (MAGI) less than $122k (though partial contributions can be made with MAGI of $122k-137k). If you're eligible, aim to max out your Roth contribution, which is $6,000 in 2019. (If you're not eligible to contribute to a Roth IRA, you can look into doing a "backdoor" Roth, but I don't recommend attempting one without the help of a tax accountant.)
I should also mention the Traditional IRA. For some taxpayers below a certain income threshold, these contributions are tax deductible. For everyone else, you can make a non-deductible (essentially an after-tax) contribution regardless of income. Traditional IRAs are different from Roths in that you always pay tax when you withdrawal the money in retirement. (If you make after-tax contributions, make sure you file Form 8606 which tracks your after-tax contributions so you don’t pay tax again on these previously taxed dollars.) Since an individual can only contribute $6,000 annually to a Roth IRA and traditional IRA combined, I recommend the Roth IRA for as long as your income makes you eligible.
In short, every person’s situation is different, but in general here is a sound order of priority for contributing to investment accounts each year. Keep in mind that with any tax-advantaged retirement account, there are restrictions on when you can take money out of the account, so view all contributions to these accounts as long-term, not-to-be-touched-until-retirement dollars.
Contribute to your 401k (or similar employer-sponsored plan), up to the amount of your employer’s match.
Max out your Roth IRA if you’re eligible, up to $6k in 2019.
Finish maxing out 401k contributions, up to $19k in 2019.
Make non-deductible traditional IRA contributions (up to $6k in 2019). (This is where some will use the backdoor Roth strategy.)
Invest through a taxable brokerage account.
Where should I keep my investments?
For an employer-sponsored plan like a 401k, this is pretty easy. You must use the company your employer has chosen to administer the plan. HR can give you instructions on how to enroll, how to log into your account online and how to select investments from a short list of options the 401k allows.
For your Roth IRA, Traditional IRA, or taxable brokerage accounts, the cheapest option is to open an account at a low-cost brokerage firm such as Fidelity, Schwab or Vanguard. If you’re inclined to manage your accounts on your own (including picking funds, making trades, and rebalancing your portfolio), this may be for you. You will be responsible for investing the money in your account. Sites like NerdWallet offer reviews and comparisons of each brokerage firm.
However, for most young investors, robo-advisors are my preferred platform. Betterment and Wealthfront are two of the largest in this fast-growing space. For a small fee (0.25% annually for both Betterment and Wealthfront), the robo-advisor automatically invests your money and rebalances your portfolio periodically — a time-efficient and cost-efficient solution for investing, especially when you’re just starting out.
Can you remind me of that apocryphal quote by Albert Einstein that you personal finance people always mention?
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t ... pays it.”
Whether or not Einstein said it, the point is returns on your investments compound over time, resulting in surprising gains over long periods. For example, suppose you save $50k by age 25 and invest it in the stock market. By the time you’re 65, assuming annual returns of 8%, that will have grown to over $1 million. But if you save and invest that same $50k at age 35 (instead of 25), what will it grow to by the time you’re 65? Only $500k. Big difference!
The moral of the story is to invest early and stay invested. What if it’s too late to invest early? Then heed the Chinese proverb: “The best time to plant a tree was 20 years ago. The second best time is now.” Do the next best thing and start investing now.
So what hot stocks should I buy? Apple, right?
I generally recommend investing broadly in the market through low-cost index funds, a strategy known as passive management. This diversification reduces the risk and volatility that comes with picking and owning individual stocks. Furthermore, the numbers show passive investing outperforms stock-picking over the long term, even by professional investment managers. Ignoring fees, the S&P 500 outperformed 83% of actively-managed mutual funds over the last 15 years.
If I’m only supposed to buy index funds, then why is Jim Cramer always on TV? And why are my co-workers always talking about the latest killing they made on Netflix stock?
The stories people don’t share are about how their stock picks tanked or how they’ve sacrificed precious time and energy fussing over their stock portfolio for meh returns.
Stock-picking is a big industry, and there will always be people allured by the possibility of making it big in the market. Some people even succeed. But for the majority of people, prudent investing means holding index funds for the long term.
What’s that stuff about fees everyone was saying when Jack Bogle died?
Jack Bogle (the founder of Vanguard and the creator of the index fund) preached the importance of avoiding investment fees, primarily through low-cost index funds that track the market. Beyond the fact that passive investing generally outperforms stock-picking, the substantial fees associated with active management eat into your investment returns. Accounting for fees, the S&P 500 outperformed 95% of actively-managed mutual funds over the last 15 years.
As Warren Buffett put it, “Performance comes, performance goes. Fees never falter.”
So how do I know how much I’m paying in fees?
If you’re investing in mutual funds or ETFs, look for the expense ratio, which is the amount of annual fees you pay as a percentage of your investment. You might see it reported on your statements or online portal, or otherwise you can look it up at Morningstar.
Let’s look at an ETF index fund. For example, the Vanguard Total Stock Market ETF (VTI), an index fund that seeks to track the entire stock market, has an expense ratio of 0.04%. So if you owned $10k of VTI, then you’d pay $4 in fees that year (through an automatic reduction in your investment, as opposed to a separately charged fee). That’s an incredibly low expense ratio. I typically see expense ratios around .15% or less with index funds.
Now let’s look at an actively managed mutual fund for comparison. The JPMorgan Global Allocation Fund (GAOAX) is an actively-managed fund that invests in a broad range of asset classes throughout the world, with an expense ratio of 1.07%. So if you owned $10k of GAOAX, then you’d pay $107 in fees that year. That’s a relatively high expense ratio, but you’re getting a team of investment professionals who are leveraging their expertise to try and beat the market. This is a pretty typical expense ratio for an actively managed fund, though the range is much wider with active funds.
Beyond expense ratios, also keep an eye out for other fees you may be paying, like annual account fees, trading fees, and administrative fees. There are also advisor fees or commissions if you’re working with an advisor or broker. (We’ll come back to this in a minute.) In short, look over your statements to find these (though you may have to look quite closely), and if you don’t understand something or can’t find any fee information, start asking questions until you find answers. Many fees can be avoided or minimized by investing in different funds or with a different institution.
Okay, you’ve convinced me. So what index funds should I hold?
The first thing to determine is your desired allocation of equity (i.e., stocks) and fixed income (i.e., bonds) within your investment portfolio. Stocks have higher returns but are more volatile — the stock market lost over half its value during the Great Recession, for example (though it’s up roughly 300% since then) — while bonds have more modest returns but are less volatile.
If we’re talking long-term investing (10+ years), the old school rule of thumb is that your percentage of bonds making up your portfolio should roughly equal your age, with the rest in stocks — so, if you’re 40, hold 60% stocks and 40% bonds. As you get older, you’ll shift your allocation away from stocks and toward bonds, decreasing volatility as retirement approaches. A more modern version of this rule, which is where most of my client recommendations tend to land, is taking your age and subtracting 10 or 20 to arrive at the percentage of bonds to hold. Ultimately it depends on your risk tolerance and ability to stomach large stock market drops.
Thanks, now please just tell me which funds to buy!
If you’re investing in low-cost index funds, as I recommend, you can find model portfolios online. For example, here are some straightforward portfolios at the Bogleheads website (which is generally a good resource), and some similar simple portfolios here at Forbes.
If you use a robo-advisor, the platform will select and rebalance the portfolio for you.
As the market goes up and down, your portfolio will naturally drift away from your target allocation. For example, if you’re holding 60% stock and 40% bonds and then the stock market drops, the value of your stocks might dip to 40% of your portfolio. It’s good practice to occasionally rebalance your portfolio (such as by selling bonds and buying stocks, in this example) to stay on track with your investment strategy. However, for taxable accounts, you’ll need to be cognizant of potential capital gains tax consequences when doing so. As noted, robo-advisors will automatically rebalance for you, as will responsible investment advisors.
Remind me about capital gains?
When you trade in your holdings in a retirement account, there’s no tax consequence today because it’s a tax-deferred (or tax-free in case of the Roth) account. But for a taxable account, any time you sell an investment, any growth in the investment from the time of purchase is called a gain. The IRS likens that to a form of income and they want a piece of it.
Let’s look at an example. You bought $1,000 of ABC stock 5 years ago, and now it’s grown to be worth $5,000. You sell the stock and now have $5,000 in cash. Your gain (and the amount on which you owe capital gains tax) is $4,000, which is simply the difference between the price at which you purchased and sold the stock.
How do I know if I need an investment advisor?
This largely comes down to three things: your preferences, size of accounts, and complexity in your financial life. The closer you are to retirement, the more complex your investing needs become, and an advisor can add a lot of value. The larger your accounts get, the more burdensome the weight of self-managing and the bigger potential gains from any tax efficiencies an advisor can realize.
While just about everyone could benefit from an expert helping them allocate their 401k and make smart investment decisions, not everyone needs a dedicated person managing their investments in an ongoing capacity. If you have less than $500k of investable assets outside of your retirement plans through work, you’ll likely have a hard time finding an advisor to help you manage your money, though some smaller advisors will manage smaller accounts. You’re most likely to find advisors with lower minimums (or no minimums) through XY Planning Network. It’s a fantastic organization of younger, fee-only advisors serving younger clients.
How much does an investment advisor cost?
It depends and it’s complicated. An advisor may charge a fee (such as a flat monthly or annual fee or a percentage of assets under management) or earn a commission on the investments they sell you, or a combination of both. The industry is trending towards fees, as there are more conflicts of interest in the world of commissions.
The average fee for an advisor charging a percentage of assets under management is about 1%, and sometimes this will include comprehensive financial planning. Make sure you understand what’s included in the fee and only work with advisors who are independent and not incentivized to sell a certain company’s products. XY Planning Network and NAPFA are good places to start if you’re looking for an investment advisor. Both organizations will also have advisors who provide investment advice but do not require asset management, which means they have no asset minimums. (This is how Ford Financial Solutions operates.)
Good-to-Know Investment Terms
Types of Investments
Asset class: Asset classes are defined categories of investments. At the most basic level, we distinguish between equity versus fixed income investments. From there, you can further distinguish investments by size of the company (such as large-cap, mid-cap, and small-cap stocks), sector of industry (e.g., tech, financial services), and location (US, Europe, emerging markets), among other categories. As you research mutual funds and ETFs, you’ll see that each fund is categorized in an asset class, which helps you identify what that particular fund invests in.
Equities: Equity refers to ownership. In the investing world, equities refer to stocks or any other investment where you hold an ownership interest. Equities fluctuate in value based on the appreciation or depreciation of the underlying asset owned.
Fixed income: Like equities, this is broad asset class. With fixed income, you invest in the role of a lender rather than owner. As a lender, you receive fixed payments (or income). The most common type of fixed income investment is a bond. Fixed income investments are less risky than equities.
Stocks: A stock represents a piece of ownership in a company. They are sold in shares.
Bonds: This is a form of lending money to a borrower (such as a company or government), in exchange for payments for a fixed amount of time at an agreed-upon interest rate.
Index: An index tracks the collective performance of a group of stocks or bonds. One of the most common indexes you’ll hear about is the S&P 500, which is a group of 500 large US companies. The rise and fall of the S&P 500 often serves as a proxy for how the broader US economy is doing.
Mutual funds: This is a type of investment that pools together money from lots of investors to then collectively invest in a variety of stocks or bonds. A money manager controls the pool of money and selects the underlying investments. Mutual funds allow investors to diversity much more easily and often to a greater degree than would be possible on their own.
ETF: Short for “exchange traded fund,” these investments are similar to mutual funds but often less expensive. ETFs typically mimic an index, providing diversification. Key differences between mutual funds and ETFs are their organizational structure and the way they are traded and priced in the market.
Target Date Fund: A target date fund exposes you to both stocks and bonds and is a one-stop shop for creating a diversified portfolio. The allocation between stocks and bonds will slowly shift (moving more towards bonds and away from stocks, decreasing risk) as you approach the “target date.” You may see target date funds as an investment option in your 401k or 403b plan. An example of a target date fund is the Vanguard Target Retirement 2035 Fund, which is for investors targeting retirement around year 2035.
Expense ratio: This refers to the internal operating expenses of an investment, such as a mutual fund or ETF. It is expressed as a percentage, such as 0.40%. This means that $4 of every $1,000 invested will go towards the investment’s internal expenses. This is an important metric to look at before choosing an investment—the lower the expense ratio the better, generally.
Portfolio: Your portfolio is the group of investments that you own inside an investment account or across all accounts.
Investment Principles & Techniques
Diversification: This refers to owning many different types of investments in your portfolio. By holding a diverse mix of investments, you can lower your risk while increasing your potential returns. A diversified portfolio will likely see less volatility than one that is undiversified.
Passive management: Passive management (also called index investing) seeks to keep pace with an index. It is characterized by low portfolio expenses (i.e., the funds inside the portfolio have low expense ratios), minimal trading costs (due to infrequent trading activity), and relative tax efficiency (because the funds inside the portfolio are tax efficient and turnover inside the portfolio is minimal).
Active management: Active management involves an investment manager that implements a strategy to build a portfolio intended to outperform the market or a given index. Active management is more expensive, and studies indicate most active managers underperform the market.
Rebalancing: This refers to the process of selling one security and buying another inside your portfolio to maintain the ideal balance between asset classes. For example, suppose you decide on a portfolio of 80% equities and 20% fixed income. As the market changes and the value of your securities fluctuates, your allocation might slowly change to 90% equities and 10% fixed income, which is riskier than you want. You sell some of your equities and buy more fixed income investments to bring the allocation back down to the desired 80% equities and 20% fixed income.
Allocation: At a high level, this refers to the balance between stocks and bonds in your portfolio. The allocation in your account should appropriately reflect the amount of risk you’re willing to take.
Risk tolerance: The extent to which you’re willing to lose some or all of your investment in exchange for the potential for larger gains. Someone who is very risk tolerant will allocate a larger portion of their investments to equities (which carry more risk and more upside) than fixed income. Conversely, someone who is very risk averse will keep a larger portion of their account in low-risk investments such as cash and fixed income.
Types of Investment Accounts
Brokerage firm: This is a financial institution that allows you to open an account and buy and sell investments. Examples of low-cost brokerage firms are Fidelity, Vanguard, and Schwab.
Robo advisor: This is a relatively new term in our industry. A robo-advisor is a technology tool to help you outsource and automate investing. Two of the largest robo-advisors are Betterment and Wealthfront. You open up an investment account like a Roth IRA or taxable brokerage account, and then based on the information you provide the platform creates a portfolio for you and handles the trading and rebalancing at a low cost to you.
Investment account: This refers to any type of account where you purchase investments such as stocks, bonds, mutual funds, and ETFs. It’s broad term that might refer to a retirement account or non-retirement account.
Taxable account: This refers to non-retirement accounts that have no tax advantages to them. Each year you’ll pay taxes on any income received in this account, and you’ll pay taxes on gains any time you sell an investment.
Retirement account: These are accounts that have tax benefits to encourage people to save for retirement. There are certain restrictions on how much you can add to these accounts each year and when you can withdraw the money in retirement. These accounts include employer retirement plans (such as a 401k, 403b and SEP IRA) and non-employer based accounts (such as a Traditional IRA and Roth IRA).
529 account: This is tax-advantaged savings account for college. It’s most often used by parents to save for a child’s future college expenses. Money goes in after-tax, and you don’t pay taxes on the gains so long as the money is used for qualified education expenses.
Roth IRA: This is a special retirement account that I really love. Your income must be below a certain threshold to qualify to make contributions into this account. You put after-tax dollars into the Roth IRA, and then you don’t pay tax on either the growth or the withdrawals in retirement.
Traditional IRA: This retirement account lets you make contributions each year with pre-tax or after-tax dollars (depending on your taxable income). You don’t pay taxes on these accounts until you take the money out in retirement. This is called tax-deferred savings.