The Fundamentals of Investing

Investing - what is it, and how can it help you achieve financial independence?

Virtually everyone has heard stories like this - if you had invested a small amount of money in "Company X" years before its stock price took off, you'd be a millionaire today. Apple was one of the most famous examples: An investment of just $1,000 in 1980 is worth nearly $2,000,000 today.

While the average investor doesn't often experience this kind of stock market gain, the numbers don't lie - investing can be very profitable, and it's a cornerstone strategy of virtually all retirement plans. It can also be quite daunting for beginners and younger investors - sometimes so much so that it's challenging to get started. In that case, procrastination (or foregoing investing altogether) can cost you considerably over the long term.

With that in mind, let's talk about the fundamentals of investing.

Basics for New Investors

The basic idea behind investing is simple - making your money earn more for you. You can do this in various ways, but one of the most common methods is purchasing stocks, bonds, mutual funds, or real estate. In the investment world, these four things are called asset classes. Let's review the basics of each asset.

• Stocks, sometimes called equities, are simply a way to own a piece of a company and its assets and earnings. If the company does well, its stock price usually goes up, making your share of the company more valuable. If a company struggles, however, the value of your investment may decline.

• Bonds are an investment where you loan money to a business or governmental agency in exchange for interest payments. They are more predictable and less volatile than stocks, making them a better choice for those not in a position to risk significant losses. The drawback is that while bonds are generally safer, the returns are typically far lower.

• Mutual funds are collections of stocks and bonds, generally speaking. Rather than risking a large amount of money on a single investment, mutual fund investors diversify their holdings by owning pieces of various individual stocks or bonds held within a single fund. This difference typically makes investment performance less risky and more predictable.

• Real estate is as simple as it sounds. You purchase property as an investment rather than as housing. The goal is to buy property that appreciates, or you can rent out the property you purchase to create a passive income stream. There are also real estate investment vehicles called REITs (Real Estate Investment Trusts), which allow you to invest in property much in the same way as stocks.

How to Get Started

The most common investment method for most people is a standard employer-run 401k retirement plan. You determine how much of your salary you'd like diverted into your 401k investments, and the company typically matches that amount. If your employer doesn't offer a 401k, you can opt for an Individual Retirement Account (IRA) or Roth IRA. Both provide significant tax breaks from the federal government. 

If you'd like to be more hands-on with your investments or expand your holdings, you can hire a broker or open an account at one of the many self-service online brokerages. While brokers can offer critical advice for investing neophytes, their fees will lower your returns.

Generally speaking, most experts suggest that new investors consider low-cost mutual funds tied to the performance of broad stock indexes like the S&P 500 (the 500 largest publicly traded companies in the country) or a similar index. The index funds typically offer fairly reliable performance at a reasonable cost. The average annual return for the S&P 500 over the last 90 years is around seven percent, adjusted for inflation.

The Takeaway

Investing your money wisely is one of the most important things you can do to secure your future financial independence. By following some basic principles, you can confidently begin your investing journey. And like any decisions you may make about money, if you need help with how to proceed, seek the help of a qualified financial advisor.