Investment Fundamentals

Investing means putting money into assets like stocks and bonds that can grow faster than a savings account over time, in exchange for accepting that their value will rise and fall along the way. For most people, the fundamentals come down to a few decisions: when you’re ready to start, how to split money between stocks, bonds and cash, how to spread it out, and how to keep costs low.

Are you ready to invest?

Before investing money you might need soon, get two things in place:

• An emergency fund in a savings account. If your car breaks down during a market drop, you don’t want to be forced to sell investments at a loss.
• No high-interest debt. Paying off a card charging 22% is a guaranteed 22% “return.” No investment reliably beats that. How to Get Out of Debt comes first.

The exception is an employer 401(k) match. Contribute at least enough to get the full match even while paying down debt, because it’s an instant return on your money.

The three main building blocks

Stocks are small ownership stakes in companies. They’ve historically offered the highest long-term growth, with the biggest swings: drops of 20% or more in a single year happen.

Bonds are loans to governments or companies that pay interest. They usually move less than stocks and grow more slowly.

Cash and cash equivalents, such as savings accounts, money market funds and Treasury bills, are the most stable, but over long periods they may barely keep up with inflation.

Asset allocation: your mix

How you divide your money among stocks, bonds and cash is called asset allocation, and it’s the biggest decision you’ll make. The SEC’s guide puts it simply: the right mix depends on your time horizon (when you’ll need the money) and your risk tolerance (how much decline you can stomach without selling).

• Money for retirement 30 years away can usually be mostly in stocks, because there’s time to recover from downturns.
• Money for a house down payment in three years probably shouldn’t be in stocks at all.

A useful test: imagine your investments dropped 30% next year. If you’d sell in a panic, your mix is too aggressive.

Diversification: don’t bet on one thing

Spreading money across many investments means one company’s collapse can’t sink you. The easiest way is through index funds or ETFs that hold hundreds or thousands of stocks or bonds in one purchase. Note that a fund focused on one industry or theme isn’t diversified, even though it holds many stocks.

Fees matter more than you’d think

Every fund charges an annual expense ratio. The differences look tiny, but they compound. Say you invest $10,000 and earn 6% a year for 30 years:

• at a 0.05% annual fee, you’d have about $56,600
• at a 1% annual fee, about $43,200

That’s more than $13,000 lost to a fee that sounded small. Check expense ratios before you buy, and ask any advisor what you’ll pay in total each year.

Keep it simple

• Target-date funds pick and adjust a diversified mix for you, gradually getting more conservative as the target year approaches. One fund can be a complete retirement portfolio.
• Invest automatically. Putting in the same amount every month, such as $200 from each paycheck, means you buy more shares when prices are low and avoids the temptation to time the market. At a 6% average return, $200 a month for 30 years would grow to about $190,000.
• Rebalance once a year or when your mix drifts well off target, selling a bit of what’s grown and buying what’s lagged.
• Don’t react to headlines. Selling after a big drop locks in the loss.

These return figures are for illustration only. Investments can lose value, and actual returns vary.

For where these accounts fit in a bigger plan, see Retirement Planning Essentials. If someone promises high returns with no risk, read Signs of Questionable Financial Advice.

Sources

• SEC Investor.gov: Beginners’ guide to asset allocation, diversification, and rebalancing
• SEC Investor.gov: Compound interest calculator
• SEC Investor.gov: Asset allocation and diversification

This article is for educational purposes and is not financial advice.