Investing, as simply defined by Warren Buffett is “…the process of laying out money now to receive more money in the future” (Forbes, 2019). This is done by contributing money to various funds, bonds, stocks, or accounts that support businesses or entities, and receiving dividends and changing market values of our investments. Many of us, especially those more risk averse, are concerned about the volatility of investing. However, not every investment carries the same risk, and with interest rates as low as they are, most bank accounts aren’t even matching inflation. This means that your money in the bank is not only not earning you more, it is actually losing value over the long term. To protect our own financial futures, it is important to have some form of investment. Below we talk about some of the most common investments, their risk level, and how to get started with them.
Passive Savings Accounts (High Yield Savings Accounts, Certificate of Deposit, Money Market Accounts, etc.)
This is likely the easiest and least risky investment that most of us are able to make. The principle is simple, you allow the bank to use your money and as such the bank pays you interest for keeping the money in that account. Most are relatively simple and have low barriers to entry such as High Yield Savings Account which can offer at times rates higher than 2% APY for no minimum and no penalty for withdrawing funds. Others can be more restrictive such as CDs which often require that you are not able to withdraw the funds (at least not without a penalty) for a set period of time and often corresponds to higher returns on deposits that are larger and for longer durations. These types of accounts are better than having nothing and also serve as a good place to park money that might be set aside for a rainy day or in between big investment moves.
401K or other Employee Retirement Plan
401K’s are usually one of the first places people begin investing. 401K’s are employee sponsored plans where money is taken directly from your paycheck, and they are usually pretax. You can contribute up to $19,500 as a single adult and there typically isn’t an investment minimum. Depending on your employer, they also may have a match program. Generally, to not leave money on the table we encourage contributing at least up to your match. However employees sometimes require investments well into twenty or more percent of your paycheck to get a 4 to 6% match . This level of paycheck contribution may not feasible or desirable for everyone.
Individual Retirement Account (IRA): IRA’s allow tax free or tax deferred savings. There are actually seven types of IRA, but here we breakdown the two most common and best for beginning investors.
Traditional: You make contributions pre-tax through investments that can grow tax deferred. The IRS doesn’t charge capital gains (taxes on assets you have had longer than a year that you sell) or dividend income taxes until you make a withdrawal. This means if you are in a lower income bracket in retirement then when you put the money in you will save money. While there are no income limits for a traditional IRA there are income limits for the tax-deductible contribution (although current tax loopholes do allow higher income earners to move funds from Traditional IRAs into a Roth IRA through a backdoor). Over the age of 70 and a half you may no longer contribute to a Traditional IRA.
Roth IRA: These are contributions on after tax money and your money grows potentially tax free with tax free retirement withdrawals. You can currently contribute up to $6000 in a Roth IRA and they are a good early career investment, especially if you don’t have an employee matched 401k or if you are likely to be a high earner down the line, as your Modified Adjusted Gross Income (MAGI) must be below $139,000 for a single person and $206,000 for a married couple filing jointly .
Beyond retirement accounts there are still multiple ways you can invest in the stock market and below we list the three most common. Even if you already have a robust retirement account investing in stocks can be a helpful way to expand your understanding of the movement patterns and risks of the stock market as individuals will likely see more fluctuation in stocks then their retirement account. As retirement accounts tend to already have good diversification of stocks you can be less conscientious of diversification if this is supplemental to retirement. If you don’t researching stocks and investing in different sectors and entities is very important to protect yourself against market risk.
Individual Stocks: individual stocks can be purchased through apps, online trading web sites, or with assistance of a financial advisor. They allow you to invest in a single company or entity and therefore generally are the highest risk version of investment.
Exchange trade funds or ETF’s: ETF’s trade like stocks but are a bundle of investments that include bonds, stocks, currencies, and cash. Prices change throughout the day and they are sold on an exchange. They can be bought the same place as individual stocks and mutual funds.
Mutual funds: Mutual funds, like ETF’s, contain a variety of stocks bonds and other securities but allow you to pool your money with other investors to purchase into entities you may not otherwise have access to.
Other important factors
Timing: even professionals have a very hard time timing the stock market. In 2013, Forbes reported an article about an Orlando cat that was pitted against a group of schoolchildren and a group of actual professional investors with decades of investment knowledge. At the end of the year the cat who had selected stocks by throwing his favorite toy mouse on a grid for different companies, had earned approximately three times the return that their professionals did (although both beat the children). Clearly consistent timing of the stock market is difficult. Therefore, many investors choose dollar cost averaging which involves investing a fixed amount of money regularly over a long period of time. For young investors, who have more time to wait out investments, the ups and downs of the stock market will even out and waiting for the perfect time maybe unrealistic.
Dividend: A dividend is a distribution of the company’s revenue to its stockholders or shareholders. Dividends can be considered payouts from the company, although many applications or trading sites such as Acorns or Scott Trades Flexible Reinvestment Program (FRIP) allow you to reinvest your stocks for free and gain additional stock holdings. Importantly, how much a stock is worth does not necessarily correlate to the dividend. Amazon, a high trading stock, that has seen great growth this year pays no dividends, while Delta, like many airline stocks has been extremely volatile this year and trades at around 10% of Amazon, is a high dividend stock. Your dividend is dependent on the value of the stock but varies by the individual company.
Simply, this means having stocks in different places. This is a risk management strategy to limit exposure to any single asset or risk. By investing in a variety of outlets including 401k’s and mutual funds which are already diversified for you, or being conscientious of the stocks you choose, such as not having all tech stocks or investing only in gold, you naturally will have some level of diversification. If you have more limited funds or last time to invest it is even more important to spread your investment in a variety of entities.
Where To Buy: Stocks, ETF’s and mutual funds can be bought through a variety of websites for stock trading such as TD Ameritrade, Etrade, Fidelity, and Schwab. Be careful to read the fine print and be aware of what trades will cost you. Mobile apps such as Robin Hood and acorn often offer free trades, but have less tools and are newer with less support .
Taxes: if you sell any asset for more than cost you have to pay capital gains taxes which will be taxed along with your ordinary income taxes. Dividends are also taxed, as either long term capital gain rates or ordinary income tax rates depending on the type. While day trading or frequent heavy buying and selling of stocks can seem appealing, it can complicate your taxes, especially as a new investor, so make sure you are aware of this when filing. Most companies will send you a 1099 tax document that you can use for filing which does simplify the process.