It’s widely accepted that investing is the key to real financial security. But, for many people, the idea of investing their money is intimidating, often conjuring images of panicked stock traders screaming, “BUY!” “SELL!” into their phones while watching cryptic numbers and graphs dance wildly across computer screens. In reality, investing for beginners can be anything you want it to be, fitting its tempo, style, and level of risk to your temperament and tolerance for excitement.
Investing is about putting your money to work for you to achieve your goals on your timeline. It doesn’t matter what other people are doing with their money. All that matters is that you have your own goals and invest according to your individual needs, priorities, and tolerance for risk. When understood in that context, the idea of investing is much less daunting. However, it helps if you understand the basic principles and practices of investing, which is the purpose of this guide.
What Type of Investor are You?
There are several different types of investors based on their knowledge, temperament, available time and resources, and investment objectives. Understanding which type of investor you are will help you stay in your investing lane and keep you focused on the strategy that works for you. It will also help you understand the limitations and advantages of each and whether you should ever consider choosing another type at some point in time.
While investor types can be described in many ways, there are essentially two broad categories of investors.
- Passive Investor
- Active Investor
While there is no right or wrong answer in determining your investor type, there’s only one that currently reflects your profile.
Passive Investor
When people are ready to start investing, they are most likely to begin as passive investors. The concept of passive investing began to take hold with the introduction of index funds – funds that invest in companies assigned to a stock index like the S&P 500.[1] So, instead of trying to pick individual stocks or mutual funds with varying investment objectives, investors can simply invest in an index.
Passive funds have gained in popularity because of their low cost and the fact that they generally track the performance of the underlying index. If you had invested in an S&P 500 index fund from 2010 through the end of 2020, you would have earned an average annual return of about 13.6%.[2] Not bad for just setting it and forgetting it.
As a result, passive investing has gained prominence among many investors as a low-cost and low-maintenance way of investing in stocks for beginners. For people who lead busy lives or who otherwise don’t care to engage in the intricacies of investing, passive investing has proved to be a winner. And for more diversification and opportunities to generate returns, you can invest in several different indexes representing different industries or global regions.
On the other hand, passive index funds also mirror the volatility of the markets. When the stock market goes down, so do passive funds, and investors have little control over their performance. However, investors with the patience and discipline to ride out the inevitable market cycles are usually rewarded with positive returns over the long term.[3]
Active Investor
Whether investing in stocks or actively managed mutual funds, active investors believe they can make investment decisions that will enable them to outperform the market indexes. They believe they can identify opportunities in which the market has mispriced securities or profit by identifying when stocks become overvalued or undervalued and make trades accordingly.
Active investors are willing to expend more time and energy to track the market and utilize their knowledge and investing tools to make investing decisions. They expect their choices to generate returns over and above what passive investors can earn by merely tracking indexes.
Whether employed by an individual investor or an active mutual fund manager, active investment strategies are designed to generate higher returns while limiting downside risk. Because they are active investors, they adjust their portfolios in response to or in anticipation of changing market conditions. If they are correct, they can generate out-sized returns. If they are wrong, they can underperform the market.
Which Type of Investor Are You?
Unless you have the time, knowledge, and energy to dive headfirst into active investing, you will most likely start investing as a passive investor. You can remain a passive investor as most investors do, or you can eventually transition to active investing when you think you are ready.
Types of Investments
As you explore the world of investing, it’s essential to gain a broad understanding of the various types of investments and how each of them fits within your investment profile. Each investment vehicle has unique characteristics that may or may not be appropriate when applied to your particular situation. However, when combined with other types of investments, they can provide diversification, which can reduce your risk while improving your long-term investment performance.
The best way to consider the different types of investments is to view them in the context of different investment objectives.
Investments for Growth
Stocks: Investing in individual stocks allows you to own a piece of a company you think has growth potential. To raise capital, companies issue shares of stock to the public, which can be bought or sold on the stock exchanges. When investors believe a company has the potential to increase its earnings, they will bid up the price of its shares. Conversely, when investors believe a company will struggle to maintain strong earnings, they will sell the stock, driving the share price down.
Because it’s nearly impossible to know with certainty which stocks will perform well, it’s always advisable to own a broad mix of multiple stocks from different industries – between 30 and 50 at a minimum – to limit your risk exposure. By diversifying, you are lowering the risk for your portfolio because if one stock performs poorly it represents a smaller part of your overall portfolio.
Equity Mutual Funds: Picking individual stocks can be tricky, requiring a lot of time, knowledge, and access to potentially sophisticated tools/software. Mutual funds may be the best way to start investing in stocks for beginners. With mutual funds, you rely on professionals to pick stocks and manage a portfolio on your behalf. Mutual funds pool the assets of hundreds or thousands of investors to invest in dozens of individual stocks, providing you with instant diversification. For greater diversification, you can invest in multiple mutual funds covering different industries or global regions.
Index or Exchange-Traded Funds: Index funds and exchange-traded funds (ETFs) are similar to mutual funds. They pool the money of many investors to invest in a portfolio of securities. The difference is, an active mutual fund buys and sells securities in an attempt to maximize returns, while an index fund purchases only those securities that closely represent a particular index, such as the S&P 500 index, Russell 2000 Index, or Bloomberg Barclays Aggregate Bond Index. The objective of an index fund is to track the performance of its underlying index.
Investments for Income
Government Securities: When the U.S. government needs to borrow money, it issues Treasury securities to the public. When you purchase a T-Bond or T-Bill,[4] you are essentially loaning the federal government money, and it pays your back with a fixed rate of interest. Government securities are backed by the full faith and credit of the U.S. government, which makes them a very secure investment. However, because of that, the interest rate is lower than most fixed-income investments.
Corporate Bonds: Companies also borrow from investors in the form of corporate bonds. When you purchase a corporate bond, you become a bondholder who receives interest payments from the company. Bonds can be bought and sold on the open market, which means their prices can fluctuate (you can lose money). However, if you hold a bond to its maturity, the company is required to pay you the full-face amount of the bond, if they don’t default. A default is where a bond issuer does not make scheduled interest or principal payments within a specified period.
Bond mutual funds: Rather than trying to select one corporate bond, you can invest in a portfolio of bonds managed by a mutual fund manager. Bond funds attempt to maximize current income as well as generate capital appreciation for investors.
Short-Term vs. Long-Term Investment Strategies
One of your most important considerations when choosing an investment strategy is your investment time horizon – whether you are investing for short-term results or long-term performance.
Short-Term Investment Strategies
When investing for short-term results (less than five to eight years), you should be willing to assume much more risk for the possibility of higher returns. Choosing investments for their short-term growth potential is difficult because the economy and the markets can be unpredictable. Short-term investors tend to be active investors with the time and energy to research investment opportunities and proactively manage their investments. If they choose wrong, they risk losing a portion of their investment or getting stuck holding it longer than they anticipated.
Short-term investment strategies are most suited for investors with discretionary funds that, if they lost all of them, it wouldn’t impede their pursuit of financial security. Utilizing short-term strategies would be considered aggressive investing for beginners and is very risky.
Long-Term Investment Strategies
Most investors have a long-term time horizon, typically tied to their plans for retirement. That makes sense because most investors have neither the time nor energy to micro-manage their investments. But it also makes sense because studies have shown that investors who follow a long-term strategy tend to outperform those who don’t.
In investing, time can be your most valuable asset. The more time you have on your side, the less amount of money you need to invest and the less risk you need to take to achieve your long-term objectives. With less time, you may need to invest a more considerable amount of money or take more risks to achieve your goals.
Diversify and Reduce Risk
No doubt you’ve heard the old axiom, “Never put all your eggs in one basket.” That’s because if the basket breaks, you could lose all your eggs. Putting them in multiple baskets can reduce that risk through diversification.
Diversification is the recognition that we can’t know for sure which stocks, sectors, or asset classes will outperform another at any given time. So, rather than trying to guess how investments will perform, by investing in a range of investments, you can capture returns as they occur while reducing your portfolio’s volatility. Investing in an S&P 500 index fund is an easy way to achieve diversification.
The key to proper diversification is to select assets that don’t correlate with one another. For example, when stocks perform well, bonds tend to underperform and vice versa. Each type of non-correlating asset acts as a counterweight to the other.
The purpose of diversification is to minimize your losses during a market decline, which is the key to building wealth over time.
Frequently Asked Questions
How much should I invest?
There are many ways to look at this question. It’s generally a good idea to make sure you have built up an emergency fund first. The emergency fund should be anywhere from six months to a year of fixed expenses that is in a savings account. The amount you hold will depend on the stability of your job, your lifestyle, age, and many other factors.
After your emergency fund is build up, you could invest as much money as you have over and above what you need for living expenses. You should also separate your short-term goals and your long-term goals. For your short-term goals (three to eight years), you should save or invest in low-risk investment vehicles. The balance is available for investing in your long-term goals.
When determining how much money to put towards your long-term goals, let’s take an example. Say you are investing for retirement 25 years out. You can calculate how much you need to invest based on how much you need to accumulate over 25 years, assuming a specific rate of return. You can use our accumulation calculator and play with the return assumptions to arrive at a comfortable investment amount.
How much risk should I take?
One of the primary tenets of investing is that risk and return are related and that there can be no returns without risk. You should assume the amount of risk directly related to the return you expect to generate on your investments. So, your first consideration should be how much you need to earn on your investments to achieve your goals. For example, say you determine you will need to make 7% annually over 25 years to achieve your goal. You won’t have to take nearly as much risk as if you needed to earn 15% over ten years. However, the younger you are, the more risk you could assume because you will have more time for the markets to work through their cycles.
How do I choose my investments?
This is also a risk/return-related question that depends on your time horizon. For example, if you want to achieve an above-average rate of return, you would look first to growth investments, such as stocks and equity funds. Aggressive investing for beginners may mean focusing on high-quality growth stocks and funds. But you can temper the volatility of these investments by allocating a portion of your funds to safer stocks (i.e., dividend stocks)[5] or bond funds.
As a new investor, it may be difficult to start investing in stocks until you accumulate sufficient capital to invest in a diversified portfolio of individual stocks. Investing for beginners with little money may require you to focus on mutual funds and ETFs.[6] These allow you to gain exposure to any category of stocks you want while being diversified enough to minimize volatility. In choosing specific funds, you can narrow down your choices based on your criteria, such as your investment objective, risk profile, investment preferences, and fund costs – and then make side-by-side comparisons.
Who should I listen to for advice?
Working with a financial advisor who has your best interests in mind has its benefits, the biggest of which is to keep you from making costly investment mistakes. But not all advisors are required to put your interests first. Advisors who earn commissions for selling investment products may have conflicts of interest. Advisors who receive fees for their investment advice may be more objective. However, they may require a sum of money to open an account.
You could work with a robo-advisor, such as Wealthfront, Vanguard, and Betterment, who offer online asset allocation and fund selection advice. They help you track your investment performance and will recommend changes to your allocation when needed. In long history investing, robo-advisors are very new and they come with many risks you should be aware of before taking this approach.
Or, you could be a do-it-yourself investor, using the vast resources available on the internet to learn, plan, and manage your investments. Many fund companies, such as Vanguard and Fidelity, offer free tools and resources for managing your investments.
Conclusion
Achieving true financial independence might seem elusive to you if you have never invested before. However, short of inheriting a pot of money or winning the lottery, investing is the one of the best paths to financial independence. You should know that all successful investors started right where you are – learning the basics and developing the knowledge and confidence to broaden their horizons. More importantly, successful investors quickly develop the necessary patience and discipline to avoid costly mistakes.
Dechtman Wealth Management, LLC is a Registered Investment Adviser. This is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Dechtman Wealth Management, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Dechtman Wealth Management, LLC unless a client service agreement is in place.
1[1] The Standard and Poor’s 500, or simply the S&P 500, is a stock market index that tracks 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices.
2[2] Business Insider: The average stock market return over the past 10 years, https://www.businessinsider.com/personal-finance/average-stock-market-return#:~:text=Between%202010%20and%202020%2C%20however,in%20the%20past%2010%20years.
3[3] JP Morgan Principles for Successful Long-term investing, https://am.jpmorgan.com/sg/en/asset-management/per/insights/market-insights/principles-for-successful-long-term-investing/
4[4] T-Bond
Treasury bonds (T-bonds) are government debt securities issued by the U.S. Federal government that have maturities greater than 20 years. T-bonds earn periodic interest until maturity, at which point the owner is also paid a par amount equal to the principal. Treasury bonds are part of the larger category of U.S. sovereign debt known collectively as treasuries, which are typically regarded as virtually risk-free since they are backed by the U.S. government’s ability to tax its citizens. That said, they do not have high return rates.
T-Bill
A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. Treasury bills are usually sold in denominations of $1,000. However, some can reach a maximum denomination of $5 million in non-competitive bids. These securities are widely regarded as low-risk and secure investments. The Treasury Department sells T-Bills during auctions using a competitive and non-competitive bidding process. Noncompetitive bids—also known as non-competitive tenders—have a price based on the average of all the competitive bids received. T-Bills tend to have a high tangible net worth. T-Bills are normally held until the maturity date. However, some holders may wish to cash out before maturity and realize the short-term interest gains by reselling the investment in the secondary market. Treasury Bills are one of the safest investments available to the investor. But this safety can come at a cost. T-bills pay a fixed rate of interest, which can provide a stable income. However, if interest rates are rising, existing T-bills fall out of favor since their rates are less attractive compared to the overall market.
5[5] Dividend stocks are companies that pay out regular dividends. Dividend stocks are usually well-established companies with a track record of distributing earnings back to shareholders. A dividend is a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
6[6] ETF stands for Exchange Traded Fund. An exchange-traded fund is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold throughout the day on stock exchanges while mutual funds are bought and sold based on their price at day’s end.
