Investing 101

Alden Wicker
Posted

How Investing Works

Before we get into the nitty-gritty of how to invest, you should understand a few fundamental principles underlying all investing:

Risk Tolerance

The first step to investing is to determine for yourself how much risk you are willing to take on. When it comes to investing, risk is the possibility that your investments will perform worse than you were hoping or expected. As a general rule, the younger you are, the more risks you can take, because if something goes wrong at age 30, you have time to start building up your money again. Plus you can ride out dips in the market and be confident it will eventually go back up. But as you get closer to retirement, you’ll be more cautious with your money. (Find out your risk tolerance with our quiz.)

Return

So why would people want to invest in anything high risk at all? It has to do with your return, or the profit you hope to make. As a general rule, the higher the risk, the higher the potential return. So investing in a tiny startup is very risky, but if that startup succeeds, it could grow ten times. (On the flip side, it could disappear and take your money with it.) Investing in Coca-Cola is much less risky, but it will probably only grow a fraction of that each year. And bonds are the safest, but you pay for that safety by making less money than you would in stocks during boom times.

Diversification

So, how do you avoid undue risk? Diversification, which means putting your money in more than one type of investment so that bad performance in some of them will be offset by good performance in others. Investing all your money in one company is never a good idea because if it goes south, so does all your money. You want to spread your investments out across a wide variety of companies, industries and even countries.  This doesn’t only distribute risk; it also means you have a variety of growth opportunities that you might not have if everything is in one stock.

Common Investments

Stocks
When you buy a stock for $10, you are actually buying a tiny piece of a company and becoming a type of owner, called a shareholder. The company will use your money to expand—by hiring more employees or opening new locations, for example—and increase profits. As the company grows, it becomes more valuable, and your little piece of it becomes more valuable too. If all goes well, you can eventually sell that little piece for $12, $20, or $50, depending on the circumstances. Of course, it’s also possible that the company will lose value or go out of business, and then your little piece isn’t worth much or anything at all. That’s the risk you take.

Bonds
You can also invest in bonds. When you buy a bond, you are essentially loaning the government or a company money in order to finance their business. For example, when you buy a U.S. Treasury bond, you are loaning the federal government $1,000 for a certain time period—say, 10 years. They will pay you back the interest every year, and then at the end of the 10 years, you’ll also get your $1,000 back. Bonds are the safest type of investment, since it is safe to assume the U.S. government will pay you back. (If it can’t, we all have much larger worries.)

Mutual Funds and ETFs
We talked above about the importance of diversification. Mutual funds and ETFs do a lot of the work of diversification for you. They are collections of stocks, bonds and other types of investment vehicles. Some hold a variety of stocks from a certain country or region. Some hold stock from a certain industry. Some just mimic the makeup of indexes like the Dow Jones or Nasdaq.

The difference between ETFs and mutual funds lie in how they are managed and how often they are traded. ETFs can be traded like a stock, while mutual funds can only be sold and bought in certain intervals. Mutual funds are also often managed by a person and have different fee structures as well. But both can serve almost the same purpose in your portfolio.

What to Keep in Mind When You Invest

Before you jump into investing, you’ll want to keep some general principles in mind:

1. Remember that there are ups and downs, not just ups.

Historically, over the long term, the stock market has tended to go up, but it will have days, months and even years where it will go down. The key to dealing with the inevitable swings in the stock market is to keep a cool head and think about the long term. Don’t follow day-to-day market news or try to “play” the market. Instead, check in just a few times a year and rebalance according to your needs.

2. Choose a strategy and stick with it.

From time to time, you might hear about a hot new investment strategy or tip. An IPO everyone is buzzing about (Netscape), a fabulous investment firm run by a friend of a friend (Heard of him? His name is Madoff) or a complicated investment vehicle that is giving unheard of returns (collateralized debt obligations backed by subprime mortgages!). It’s best to not get caught up in a bubble or hype, and instead stick to your original strategy.

3. A down market isn’t the time to pull out, it’s the time to buy.

People normally feel confident enough to invest when the market is going up, and then they get scared and pull out when the market goes down. Unfortunately, this is the exact opposite of what they should be doing–not only because they’ve forgotten that there are natural ups and downs (point #1), but because they are then buying investments at their most expensive and selling them at the moment they are least likely to get much for them. You should do the opposite and view a down market as an opportunity to buy at a discount. Like a sale at Kate Spade, the temporary dips in the market help you get your hands on investment shares you want for the future at a better price.

Remember …

Investing over the long term is the best way to grow your money and outpace inflation. And you don’t have to be a business school graduate to do it well. You just need to know the basics and keep your eye on the prize: a comfortable retirement that includes lots of travel and a beach house.

*This is if your parents had invested in a broad basket of stocks tied to the Dow Jones Index. In 1982 it was at 776. Today it stands at 12,217. That’s an increase of 1,400%.