The premise of investing is that you put money into a product, company, or business now with the hope that the product, company, or business will continue to grow and create wealth.
You get a share of that wealth later when you sell your investment or cash it out.
If it were truly that simple, investment bankers and stockbrokers wouldn’t be some of the wealthiest people around.
No, unfortunately to the uninitiated, investing money is a daunting and confusing prospect.
Luckily for you, we’re here to demystify and explain the process. This guide will cover the different stocks, bonds, and funds, and options. It will also talk you through the risks and opportunities surrounding investing.
What is Investing?
By definition, investing is the act of allocating money with the expectation of generating a profit later on.
Investing isn’t limited to stocks and bonds. You can invest money in a business you start, or in a home you buy to later sell on.
When most people think of investing they think of stocks and shares. These kinds of investments are bought and sold at stock exchanges and on trading floors. This is the kind of investment we are going to focus on in this article.
However, it is always helpful to remember that you have other options too.
The key point is that you expect your money to be returned with profit over time. If you break even or make a loss, then your investment hasn’t been successful.
The problem is that there is no such thing as no-risk investing. Whatever you choose to invest in, there will always be a chance that you lose money.
For sure there are low-risk options but even these carry the threat of loss. If you want to get into investing you need to be comfortable with taking risks.
Glossary of Terms
Before we go further, I think it’s a good idea to clear up some of the terms used in the investing world. It will make things a lot easier to understand as we progress.
Asset – a resource that is of economic value to the owner.
Bond – corporate debt offered by a company.
Broker – Someone who sells financial products like stocks and bonds.
Capital – this is an asset that allows you to take part in economic activity. Usually, this is money or stocks.
Coupon Rate – The amount of interest paid yearly to a bondholder.
Dividend – A quarterly amount of money paid to stockholders from the revenue of a company.
Diversification – Spreading your investment across different assets.
Face Value – The amount of money invested in a bond that will be returned at the maturity date.
Market Index – A hypothetical portfolio that contains a representation of the best stocks on the market. It is used to sample and predict how a similar portfolio would perform.
Maturity Date – The date on which the face value of the bond will be repaid to the bondholder.
Mutual Fund – A pool of investors who provide capital for a fund manager to invest on their behalf.
NAV – Net asset value per share. This is how much a share in a mutual fund is worth based on the investments the fund holds.
Portfolio – Your collection of investments.
Return on Investment – Any profit that is made by your investment.
Risk – The potential for loss.
Stock – Used interchangeably with share, means a stake in the ownership of a company.
Stockholder – A person who owns shares in a company or corporation.
Volatility – The amount by which a stock changes price. The more often the price changes the more volatile the stock.
Types of Investments
As we’ve mentioned, there are lots of different ways to invest your money. Each type of investment has its own risks and opportunities and some are more reliable than others.
In this section, we are going to talk you through some of the different investment opportunities available to you.
In simple terms, a stock is a share of a company. You pay money to own a little bit of the company.
The more stocks you own in a company the bigger your stake of ownership.
Stocks and shares mean the same thing and the words are used interchangeably in the US.
Most of the time stockholders have very little say in the running of a company. This is especially true of big corporations.
They have hundreds and thousands of stockholders who aren’t invited to sit in on board meetings.
In some cases, stockholders are given a vote in company meetings but the vast majority of stockholders do not exercise their vote.
The main reason for owning stocks in a company is to make money. When you buy stocks you are giving the company money with the understanding that they will use the money to develop and grow.
When a company grows you earn a return on your investment. A profit, in other words. Your return can be given in one of two ways.
Most commonly, you earn money when the price of your stock appreciates. This happens because others notice the company is doing well and they want in.
In our near future report review we explore this appreciation.
When demand outstrips the supply, the price of the stock increases. You can then sell your stock for more than you paid in the first place.
The other way to see a return on your investment is for the stock to pay dividends. Not all stocks pay dividends by many do. These dividends are usually quarterly payments that are made from the company’s revenue.
Most of the time, you won’t buy stocks directly from the company. You will buy them from another investor who is looking to sell their shares.
Most stocks are common stock that comes with voting rights. This kind of stock is more volatile than preferred stock which is the other common kind.
If you own common stock in a company and that company goes bankrupt you are more likely to lose your investment.
Preferred stock is a more stable option. It usually pays a fixed dividend every quarter and if the company makes a loss or goes bankrupt, these stocks are paid off first. This means you are less likely to lose your investment.
Preferred stocks are less likely to drop in value but it also means that they are less likely to increase in value. These are a good option for people who are more concerned with a stable income than long term growth.
Whichever option you choose, you’ll want to diversify your stock. Holding shares in one company means that you are open to big losses if that company goes bankrupt.
If you hold a portfolio of stock with shares in several companies, you have a safety barrier that can cushion the blow of one of your investments failing.
Bonds are often confused with preferred stocks because they pay a fixed interest rate to the holder.
However, bonds do not entitle you to any ownership in a company.
In essence, bonds are a loan to the company, government, state, or other issuing entity.
The idea is that you lend the issuer money and they give you a bond which details the terms of the loan, the interest to be paid, and the maturity date.
Governments and companies issue bonds when they need to scare up money for new projects or to pay off existing loans. These entities usually need more money than can be borrowed from a bank which is why they turn to the public.
Bonds are usually issued in increments of $100 or $1000. The initial cost of the bond is called the face value and this is also known as the par value.
The face value is what is paid back to the bondholder at the maturity date. In the meantime, interest is paid to the bondholder every year.
Bonds can be sold on to other investors or even the issuer if they have improved their credit rating. Depending on the interest rate environment at the time, the value of the bond may be above or below the face value.
Bond values are inversely linked to interest rates. When the interest rate is high, bond values drop. However, when interest rates are low they increase in value.
When you buy a ‘second-hand’ bond from a bondholder, you may end up paying less than the face value if the interest rate is high and the bond has dropped in value. At the maturity date, you will still be paid the face value of the bond.
It’s a bit confusing so let’s look at an example.
Andy buys a bond from a company. He pays $1000 which is what he will receive back at the maturity date. In the meantime, he is paid 5% of the face value in interest each year. This means he gets $50 a year.
After a few years, the interest rate goes up and Andy sells his bonds because he is worried that the company might go bankrupt. If they do, he will probably lose his $1000.
Because the interest rate is high, the bond is worth less than its face value. He sells it to Brad for $900.
The company stays afloat and Brad gets $50 a year in interest. After a few more years the maturity date comes around. Brad redeems his bond and gets $1000 because that is the face value of the bond.
The fact that Brad paid $900 to take the bond off Andy’s hands is irrelevant. Brad took a chance on the company and it paid off.
The interest paid on your investment is called the coupon rate. This rate is determined by the issuer’s credit quality and the length of the bond.
If the issuer has a poorer credit quality, then the interest payments will be higher. This is to compensate you for the risk of investing in a company or agency with poor credit. The risk of them going bankrupt is higher and so the risk of you losing your investment is higher.
The length of the bond also affects the coupon rate. Longer maturity dates usually mean higher coupon rates. Again, this is a form of compensation. As your money is locked in for longer it is exposed to more interest rate changes and risks.
Now, this is where things can get confusing. Bonds come in different qualities, categories, and varieties. We will take a look at each of these things and then an example.
- Investment Grade Bonds – These are the highest quality bonds. They are usually issued by the US Government or very well rated companies like utility companies. These bonds are at low risk of defaulting.
- High-Yield Bonds – These are also known as junk bonds. They are at a higher risk of defaulting because the issuer’s credit rating is not as high. To compensate you for this risk, the coupon rates tend to be higher.
- Corporate Bonds – Issued by companies.
- Municipal Bonds – Issued by states or municipalities.
- Government Bonds- Issued by the US Government. Usually, these come from the US Treasury.
Government bonds tend to be called bills if they have a maturity date of less than a year.
If the maturity date is 1-10 years they are called notes. Only bonds with maturity dates of over ten years are called bonds. They all work the same way in principle.
- Agency Bonds – Issued by government-backed agencies like the Federal National Mortgage Association.
- Zero-Coupon Bonds – These are bonds issued without a coupon rate. This means that you don’t get yearly interest.
However, they are sold at a discounted price to the face value. You get a return on your investment when the bond matures because you get your investment plus the difference between the cost and the face value of the bond.
Generally, bills and bonds issued by the US Treasury are zero-coupon bonds.
- Convertible Bonds – These bonds have a clause that allows you to turn your bond into stock when the conditions are right.
These bonds are of great use to companies as they can reduce the amount of interest they pay by making their bondholders into stockholders.
It’s a fairly good deal for the investor too as stocks can produce higher returns than bonds.
- Callable Bonds – These are similar to convertible bonds in that they can be returned to the issuer before the maturity date.
However, these bonds remove the choice from the bondholder. They also don’t give the bondholder stocks when they are recalled.
Essentially, a company can recall bonds when they are doing well enough to afford to pay the face value.
This is usually done when a company’s credit rating increases or the general interest rate drops. Buying back the bonds allows the company to reissue them at a lower interest rate and therefore reduce the amount of interest they pay overall.
For investors, these are a risky choice. Callable bonds are usually recalled when they are increasing in value. This means that they won’t be able to make a profit by selling them on.
- Puttable Bonds – These tend to be worth more than other bonds with the same credit rating, coupon rate, and maturity date.
This is because these bonds allow investors to sell the bonds back to the company before the maturity date. When returned to the issuer, the bondholder receives the face value of the bond.
Issuers may include a puttable clause if they are trying to entice buyers for the initial loan amount. They may also offer a puttable clause as compensation for a lower coupon rate.
As you can imagine, there are lots of different combinations available when it comes to bonds. If you want to invest in bonds you’ll need to check what quality, category, and variety you are buying which is something we discuss in our Motley Fool Rule Breakers Review.
Mutual funds are companies that make it their business to invest in stocks, bonds, and other financial products.
When you invest in a mutual fund, you are not buying stocks directly. Instead, you are essentially pooling your money with everyone else in the fund.
This pool of money is used by the company to invest in the stock market.
Because you invested in the mutual fund, you own a portion of everything the fund owns. This means if they invest wisely you get a portion of the profits.
What you are not entitled to are stockholder privileges like voting rights. This is because you didn’t purchase the stock yourself.
The major benefit of a mutual fund is that it allows you to diversify your portfolio for a fraction of the cost if you were doing it as an individual.
For example, let’s say you have $1000 to invest, you could use that money to purchase stocks in a big company like Apple. This is great when the company is doing well, however, if the company has a bad quarter or year, your stocks plummet in value.
You don’t have any other stocks because the Apple stocks soaked up all your capital. Therefore you feel this loss quite heavily.
On the other hand, if you put that $1000 into a mutual fund you own a portion of all the stocks owned by that fund. The fund has your capital plus the capital of everyone else in the room so they can have a wider investment portfolio.
Now, that mutual fund might hold some Apple stocks, so when Apple has a bad quarter they do make a bit of a loss. However, the other assets in the portfolio even out the loss from the Apple stock.
In a way, you can think of mutual funds as like a lottery syndicate. You could buy your own ticket but you have a better chance of winning if you all pool your money and buy more tickets.
In terms of seeing a return on your investment, mutual funds payout in three different ways.
Firstly, there are dividends. Any dividends accrued by stock held by the mutual fund is divided between the investors. The more you invest in the fund the bigger the share of the fund you own. Therefore you will get a larger part of the dividends.
The second way you’ll see a return on your investment is if the fund manager sells shares at a profit like what we discuss in this Joel Litman review. This profit is called a capital gain and is usually shared between the fund’s investors.
Finally, if the fund’s investments increase in value but are not sold by the fund manager, then the fund’s value increases. At this point, you might want to sell your shares in the fund for a profit.
Most mutual funds are part of a larger company that own hundreds if not thousands of mutual funds. Each fund will have a fund manager but this manager could be working on several different funds at the same time.
Other than fund managers, there are very few employees in a mutual fund. There will be an accountant who is responsible for valuing each fund.
The accountant works out the net asset value per share (NAV.) This figure is used to determine how much shares in the fund should cost to buy. If the fund’s investments are doing well, the NAV goes up.
One thing to remember is that you will need to pay an annual fee which is often called the ratio. This is a mix between a membership fee and an administration fee.
The fund may also take a commission which will cut into your return. When choosing a mutual fund you want to pay close attention to the fee and commission prices.
There are several different kinds of mutual funds. They differ from each other based on what kind of investments they make and the type of returns they generate.
Types of Mutual Funds
- Equity Funds – These are named equity funds because they primarily invest in stocks. Equity is another term used to refer to stocks.
Equity funds are further categorized by the size of the companies they invest in, the investment approach, and whether they invest in US stock or foreign stock.
- Fixed Income Funds – These funds are often referred to as bond funds because they prioritize investing in fixed income assets like bonds.
Returns on investment are paid by the insurance that is paid on the bonds. Return can also be generated when the fund manager sells bonds for profit.
The many and varied types of bonds can make investing in a fixed income fund riskier. You need to keep an eye on these types of investments.
- Index Funds – Index funds are mutual funds that invest based on market indexes.
A market index is essentially an estimation of the value of a portfolio. The portfolio used for an index has specific characteristics depending on the index provider.
Common indexes include the Dow Jones Index, the S&P 500, and the Nasdaq exchange index. Each index has its own parameters. The Dow Jones index, for example, uses the 30 largest stocks.
Index funds essentially try to mimic those hypothetical portfolios. They are a passive form of investing as the fund manager doesn’t actively try to buy and sell. They build the portfolio and let it run with the market.
The advantage of index funds is that they have lower running costs because there is less involvement and less overhead costs. You don’t need an analyst to choose stocks and the manager doesn’t need to act every day as we explain in our Dr. Steve Sjuggerud review.
The downside to these funds is that they tend to have lower returns. The stock they purchase tends to be pretty stable meaning they are fairly low risk but low return too.
Index funds are also vulnerable to market collapses. While such events are relatively rare, they will cause a massive amount of damage to an index fund.
Index funds are recommended for retirement plans because they shine when it comes to long term performance. Index funds are the low and slow investment method.
- Balanced Funds – These funds are essentially hybrid funds. They split the investors’ capital across stocks, bonds, and other investments. The idea is that your money is less likely to be lost if the stock market drops.
In most cases, the fund manager has the freedom to allocate the money as they see fit, though some balanced funds have fixed allocations.
- Exchange-Traded Funds – Similar to index fins, ETFs are a package of stocks based on a market index. Unlike other mutual funds, ETFs can be traded throughout the day.
All other mutual funds can only be traded at the end of the day. This means if you decide to sell your shares in a mutual fund you can only do this at the next trading point. This is usually the end of the day.
This restriction on mutual funds means that you only get to sell under the conditions at the end of the day.
With ETFs, you can sell throughout the day to get the most profitable sale. The downside to this is that you may need to pay a stockbroker to do this trading for you.
The great thing about ETFs is the lower cost compared to other funds. Even with the stockbroker fee, these kinds of funds are still cheaper than other funds.
ETFs are great for diversifying your portfolio because like other mutual funds they contain a wide range of stocks or bonds.
ETFs are usually passive investments though some are actively managed. These types of ETFs are usually more expensive than the passive kind.
Principles of Investing
Risk V Return
This is the crux of investing. You need to decide what level of risk is acceptable and manageable to you for the chance of return.
The two aspects are interrelated. The higher the risk the bigger the return, in general. You can’t always go for the riskiest options because more often than not, you will fail. Success on a high-risk investment is a 1 in a 1000 chance.
To have the best chance of success you will need to balance your investment portfolio with low, medium, and high-risk investments.
The major risk when buying stock is that the company won’t perform well and your stocks will depreciate.
With bonds, the major risk is that the issuer will default or go bankrupt before they can pay back your investment.
Different investment options offer their own returns but, as ever, you need to balance the return with the risk.
Analyzing Potential Investments
Unless you are investing in a mutual fund you will need to analyze any potential investments you make.
If you do want to go for a mutual fund, you still need to do your research but the fund will have an analyst who will examine the individual stock options.
Analyzing stock is not an easy feat.
There are several different approaches to analyzing investment opportunities. Often these strategies seem to be at odds with each other.
We will take a look at some of the more common analysis approaches, but remember, if you’re not comfortable analyzing stock, use a financial analyst or advisor.
This kind of analysis focuses on individual stock, bond, or fund options. The idea is to identify the individual merits of each asset. This involves looking at the value and other characteristics.
Bottom-up analysis is a form of microeconomics. It tends to ignore or disregard overarching trends in favor of the individual potential of each asset.
Essentially, this form of analysis is the opposite of bottom-up analysis. The idea is to look at the global markets, then the specific market trends. You are essentially trying to predict how the market as a whole is going to fare rather than individual stock options.
It is a macroeconomic approach that places more value on trends and patterns than individual stock assessments.
This is similar to a bottom down analysis in that it is a microeconomic approach and it focuses on individual options.
The difference between fundamental analysis and bottom-up analysis is that fundamentalists focus on the intrinsic value of the company or corporation. They try to establish how much the stock from that company should be worth based on the company’s value and potential.
The main idea with fundamental analysis is to identify stock options that have been undervalued by the market. You buy these undervalued stocks and then sell them for profit when the price catches up to the intrinsic value.
This form of analysis relies on computers. The computer analysis patterns and statistics to create graphs and charts.
This form of analysis uses trends, patterns, and signals to decide how strong or weak a particular asset is.
This technique is mostly used by day traders who are on the trading floor.
The idea behind investing regularly is that you are less prone to loss thanks to market fluctuations. If you invest your money all in one go, you have to sit and wait out bad times in the hope that it will get better.
If, however, you invest a few times across the year you can take advantage of highs that will offset any low return investments.
It might be tempting to stick all of your capital into some stocks but you have to be very careful about when you choose to invest and what company you invest in.
When it comes to investing, it pays to have your finger in a lot of pies. Diverse assets and regular investing are key.
When we talk about investing regularly, we don’t suggest jumping in and out of stocks. Investing is a long-term game and you want to avoid selling and buying too frequently.
What we mean by investing regularly is that you have a few times throughout the year where you buy more stock. Whether this is in a company that you already own stock in or a new asset completely, it doesn’t matter.
Regular investment is also an excellent method of increasing your assets if you are low on capital. You can do it bit by bit across the year rather than needing to scare up a large amount of capital initially.
How to Begin
Factors to Consider Before Investing
Before you dive into the stock market, you need to have a good hard think about certain things.
- Your financial security – Ask yourself whether this is the best use of your money. If you have debts to pay, clear those before investing. You will likely be paying more interest on your debt than you can realistically expect to earn on your investments.
You should also make sure that you have a safety net. If your investments fail, will you be able to make ends meet? It’s dangerously naive to sink your capital into an investment in the hope that it will keep you afloat.
The investment markets are notoriously volatile. Even the most astute investor can lose. Having savings or income to fall back on can help you weather rough patches. If you have nothing to all back on you’re out of the game.
- Decide Your Aim – You need to establish what your investment aim is. Are you looking for long-term returns or are you more interested in fixed-income returns?
This will decide what kind of assets you invest in. If you want a fixed return then you’re better off going for bonds rather than stocks. If you’re hoping for a larger return at a later date, then you’ll want to invest in stocks.
Investing blindly without a clear goal is just going to cost you money. It is essentially like pissing into the wind.
- Your Age – Not to be morbid, but the older you are the less time you have to make a decent return.
If you invest when you’re young you can start with relatively little capital because you have the time to top up your investments. This means that by the time you hit retirement age, you’ll have significant assets to draw upon.
If you’re older and therefore closer to retirement, you’re going to want to put more in sooner to be in with a chance of having some return before you retire.
- How Soon Do You Need The Money? – Retirement isn’t always the withdrawal point. Sometimes people want to retrieve their capital before they stop working. This could be because they intend to make a big purchase or fund a lifestyle change.
If you are looking to remove your investment early, you probably want to choose low-risk options. This is because you don’t have the time to recover from a loss.
You should also check whether there will be any financial penalties for selling or removing your investment early. These fees can really eat into your return.
- Risk Tolerance – Your risk tolerance is how well you can manage risk-taking. If you are a worrier and know you’ll lose sleep over high-risk investments, do not take them.
You need to invest at a level you are comfortable with. If you can’t handle the risk of losing money then don’t play a high-risk game. It is not worth the health and wellbeing repercussions.
How to Get Started
The first thing you are going to need is capital to invest. In the past, you needed a large amount of cash to enter the stock market. Nowadays you can start investing with minimal amounts.
How much capital you need will depend on the broker you choose to use. Private individuals aren’t allowed to personally buy and sell stocks, bonds, and funds. It has to be done through a broker.
You can use a traditional, full-service broker if you have enough capital. It is usual for these kinds of brokers to have minimum starting balances of thousands of dollars. They also tend to take a cut of your assets and charge a yearly fee that covers the service they provide.
Full-service brokers are expensive but they have experience and offer a premium service. Everything is included like a financial advisor, analysis, and asset management.
If you have a smaller amount of capital, you might want to try a discount broker. These are actually the most common type of brokers nowadays. You can start investing with as little as $10 and fees and deductions are usually lower.
The disadvantage to these brokers is that you don’t always get the full range of support. Many offer educational tools but you are expected to select and manage your own assets.
Discount brokers tend to use robo-advisors. Just as the name suggests, these are computerized advisors. Essentially, it is software that analyzes the market and suggests securities you might want to invest in.
Robo-advisors are competent and reliable, but they lack the human touch. If you want a broker who has insight and experience, you will need to pay more.
Getting a broker is as simple as signing up online. You no longer need to visit a brokerage firm. This has helped more people access investment markets.
Once you have a brokerage account you can start trading. It is always a good idea to do your research before you purchase any assets. This leads us nicely onto our next section.
Consider Educational Courses
When it comes to learning about investing, it is as important to diversify your learning as it is to diversify your assets.
Make sure you read, watch, and listen to a wide range of resources. No one person has all the secrets even if they have been successful with investments.
Books, videos, and podcasts are wonderful ways to increase your knowledge. They can be accessed for free in a lot of places and even if you need to purchase them, they are fairly low cost.
Educational courses are a different ballgame. They tend to be more expensive than online or printed resources but they can offer a deeper level of understanding.
Often, courses are designed and delivered by industry experts. They benefit from teams of researchers and can offer you tips and advice from people who live and breathe investments.
If you do decide to take a course, make sure to research the course provider. Check their credentials and don’t get sucked in by marketing lines.
A good rule of thumb is that if someone claims they can make you money for nothing, then they are selling bullshit.
Investments are a good way to grow your money over time. You can try to limit risk but ultimately there is no such thing as risk-free investing.
If you arm yourself with knowledge, make some safe investments to start, and diversify your investments you can minimize your risk until you’re ready.