Guide to Investing

There were two companies that were doing pretty well and they both wanted to grow. The first company, HomeAid, was a home goods manufacturer. The second company, Megasoft, was a software development company.

In order to grow, each company needed more capital so they could pay for things like buildings, equipment, advertising, etc. Each company decided to raise capital by issuing stock. When the day came for these two companies to sell their stock, HomeAid sold 10,000 shares of stock to the public for $50 per share, raising $500,000 in capital. Megasoft sold 10,000 shares of stock to the public for $100 per share, raising $1,000,000 in capital.

Chad and Jenny were two investors who wanted to invest their money in the stock market. They each had $500 to invest. Chad purchased 10 shares from HomeAid. Jenny purchased 5 shares from Megasoft. About 12 months later, tough economic times hit and both companies ran into some financial trouble.

Chad wanted to sell his shares and get out of the stock market. However, he found that investors were not willing to pay the same price that he had originally paid for his shares. HomeAid was now viewed as a less valuable company and its shares were now considered riskier investments. So in order to sell his shares, he would have to sell them at a discount of $40 per share for a total of $400.

So Chad decided to hold onto his shares in the hope that HomeAid would rebound and he would be able to recoup his initial investment. However, as time went on HomeAid was unable to recover and eventually went out of business. What did that mean for the money that Chad invested in HomeAid? He lost all of it.

Jenny also faced a similar issue with her Megasoft stock. She found that investors were only willing to pay $80 per share for Megasoft stock. She could have sold her shares and cut her losses, but she also decided to hold onto her Megasoft stock in the hope that it would recover. Well, not only did Jenny hold onto her shares, she actually bought more Megasoft shares. Since they were at a discount, she was able to purchase more shares for the same amount of money. She bought 6 more shares of Megasoft stock for $480. Now she had 11 shares, which cost her a total of $980.

Fortunately for Jenny, Megasoft was able to weather the economic storm and its stock price recovered. In fact, a few years later, it even exceeded its initial price by $10 for a total of $110 per share. So Jenny's total investment of $980 was now worth $1,210. That's a return of nearly 23.5% over the course of a few years.

Obviously, this is a fictitious example, but it illustrates the importance of understanding how the stock market works. Let's continue the lesson below.

Remember how Chad lost his entire investment in the stock market? Well, Chad learned the hard way that investing in individual stocks can be quite risky. Don't worry, though, because later Chad also learned about diversification and how it can help to reduce risk. You can diversify your investment portfolio by owning a variety of assets (e.g. stocks, bonds, cash equivalents, real estate) as opposed to owning stock from only a single company, for example. A diversified portfolio can help to reduce risk of losing money because if a few investments perform poorly, then the other investments in the portfolio may offset those losses and the overall portfolio may still perform well.

If you invest in mutual funds or ETFs, for example, then your investments will be diversified by default. Mutual funds and ETFs are made up of a collection of dozen, hundreds, or even thousands of stocks, bonds, or other assets. With a highly diversified portfolio, if one company goes out of business and you lose your entire investment in that company, the impact on the overall fund will be minimal.

For example, if Chad had invested in a mutual fund or ETF instead of individual stocks, he would have only lost a small portion of his investment. In fact, he might not have even noticed that a single company, among hundreds or thousands in his fund, went out of business.

So now when Chad invests in the stock market, he buys shares of mutual funds and ETFs.

If you have a 401(k) from work or a personal IRA, you might look at your investment statements at times and be alarmed at the amount of money you're losing. It's easy to panic and want to sell everything, but let's back up and get a little perspective.

Think of a share as an envelope with money in it. When the market is doing well (this is sometimes called a bull market), the amount of money in your envelope increases without you doing anything. When the market is doing poorly (this is sometimes called a bear market), the amount of money in your envelope decreases, also without you doing anything. But the envelope never disappears unless the company (that the share is from) goes out of business.

So the value of your shares will fluctuate over time and it is completely normal to have short-term losses and short-term gains. However, the stock market has been trending upward overall for a very long time. That means that long-term investing in the stock market generally leads to long-term gains. It is important to understand that there are go guarantees when investing in the stock market, but for long-term investors, the stock market has been a great way to build wealth.

As was illustrated in the example with Chad and Jenny, when the market dips and share values go down, then it might be helpful for long-term investors to think of it as a temporary sale or a discount on shares rather than a permanent loss of money.

OK. So if the market fluctuages and that is the expected behavior of the market, you might be wondering to yourself:

How can I ensure that the money in my investment portfolio is available when I retire, even if the market drops right before I retire?

Or you might wonder:

How can I ensure that I will be able to stay retired if I live for many decades in retirement?

These are great questions and they are related!

One way to achieve both of these goals is to make sure that you have a mix of investments. This is called asset allocation. Asset allocation is the process of dividing your investment portfolio among different asset classes, such as stocks, bonds, and other investments.

While you are relatively young and have a long investment horizon for retirement, it is okay to have most of your investments in higher growth investments, such as stocks. As you get closer to retirement, say 5 to 10 years away, then you should start to shift some of your investments toward assets like bonds, which are less risky and have less volatility than stocks. But you don't want to put all of your investments in bonds. While bonds may be safer than stocks, they also have lower potential returns. If you end up living for many decades in retirement, you will need some of your investments to continue to grow.

There are funds, such as target-date funds, that provide automatic asset allocation that shifts toward lower risk investments as you get closer to retirement. If you have a 401(k) plan through work, then it is likely a target-date fund. You can ask a financial advisor to help you determine an appropriate asset allocation for your circumstances.

We are going to show you how to start investing, but let's get a few concepts out of the way first.

Long-term Investing

There are two broad types of investors: Active Traders (aka day traders) and Passive Investors (aka long-term investors). Active traders try to time the market and make money by buying and selling assets frequently. Passive investors try to make money by buying and holding assets for the long term.

Our entire investment discussion focuses solely on passive, long-term investing. Active trading is beyond the scope of this article.

Market Indexes

You often hear about the economy and the health of the economy. But how is that measured? There are many ways, but one way that we will focus on is through market indexes.

You may have heard of the Dow Jones Industrial Average (the Dow) when someone said something like, "The DOW is down 100 points today." Or you may have heard that the S&P 500 (Standard and Poor's 500) is up or down today. What does that mean?

The Dow and the S&P 500 are just a couple of examples of what are called market indexes. A market index is a collection of stocks (or other assets) from various companies that are used as a gauge to measure the health of some part of the market (e.g. the stock market or a bond market). This collection of assets provides a statistical measurement that can be used to gauge market health. So when someone says the market is up or down, they are referring to how the market indexes are performing.

There are thousands of market indexes worldwide and they are used to track market trends and evaluate the performance of investment funds by comparing the performance of those investment funds to a particular market index.

Passively vs Actively Managed Funds

A passively managed fund, also called an index fund, is a mutual fund or ETF that is made up of assets that are chosen to mirror a market index. For example, an S&P 500 index fund will hold stocks that are similar to those in the S&P 500 index. This means that the value of the index fund will rise and fall in a way that is similar to the value of the S&P 500 index. Index funds usually have lower fees than actively managed funds.

An actively managed fund is a fund that has a manager who actively buys and sells assets in the fund in order to try to perform better than the market index.

Retirement Accounts

A retirement account is a special type of account that allows you to investment in various assets and receive tax benefits on those investments. For example, if you have an IRA, you can hold mutual funds and/or ETFs inside that IRA and receive tax benefits. Retirement accounts are considered "tax shelters" because they protect your investments from taxes.

There are many types of retirement accounts. Here are some of the more common ones:

• Traditional 401(k) and Roth 401(k)
• Traditional IRA and Roth IRA
• 403(b) and 457(b) plans
• Pensions
• SEP-IRAs and SIMPLE IRAs
• Solo 401(k) and Self-employed 401(k)
• Spousal IRAs
• Minor IRAs
• Health Savings Accounts (HSAs)

We will focus on 401(k)s and IRAs and then explain the differences between traditional and Roth accounts.

401(k)

A 401(k) is a retirement savings plan that is offered by an employer and allows employees to contribute funds directly from their paycheck. 401(k)s allow for higher contribution limits than IRAs and many employers offer to match employee contributions up to a certain amount.

If you leave your employer, then you have the option of keeping your 401(k) with your former employer or you can roll over your 401(k) into another retirement account, such as an IRA or your new employer's 401(k). Also, if you leave your employer, then you may forfeit any money that is not fully vested.

In order to use the funds from a 401(k) in retirement, you will have to roll it over into another type of retirement account, such as an IRA.

Investment Tip: An employer match is essentially free money, so try to contribute enough to get the full employer match and prioritize that investment over most other investment options, such as IRAs.

IRA

An Individual Retirement Account (IRA) is a retirement savings account that is setup and managed by an individual with earned income. IRAs have lower contribution limits than 401(k)s, but IRAs offer a broader range of investment options than 401(k)s, such as stocks, bonds, mutual funds, ETFs, etc.

Traditional vs Roth Accounts

Both traditional and Roth accounts (whether a 401(k) or an IRA) are tax-advantaged accounts that allow you to invest for retirement. The main difference between the two is when you pay taxes on your investments.

Traditional Accounts: You invest with money that you haven't paid taxes on yet (pre-tax dollars) and your investments grow tax-deferred (i.e. the taxes are deferred until you withdraw the funds in retirement). However, when you withdraw money from a traditional account in retirement, you will be taxed on those withdrawals as ordinary income, but only for the portions that have not already been taxed.

Roth Accounts: You invest with money that you have already paid taxes on (after-tax dollars) and your investments grow tax-free. The nice thing about Roth accounts is that when you withdraw money from your Roth account in retirement, you generally won't have to pay taxes on the money, including the earnings that have not been taxed. Be aware that there are some income limitations in order to be eligible to contribute to a Roth IRA (i.e. if you make too much money, you cannot contribute to a Roth IRA). But, at the time of this writing, those income limitations do not apply to Roth 401(k)s.

Summary of Traditional vs Roth Accounts:

Dollar Cost Averaging

In theory, you would want as many down markets as possible during your investing years, so you could buy as many shares as possible at a discount. And then when you pull money out in your retirement years, you would want the market to be up when you sell shares so you can get the highest return possible on your investments. However, we don't live in a theoretical world. We live in reality. And since we don't have a crystal ball to tell us when the market will be up or down, it is very difficult to time the market accurately. The next best thing might be dollar cost averaging.

Long-term investors don't worry about timing the market. Long-term investors often invest a consistent amount of money at regular intervals (e.g. every pay period or every month). Over time, this strategy causes you to buy more shares when prices are low and fewer shares when prices are high. This practice is called dollar cost averaging. In the end, you will have bought shares at an average price. If you have a 401(k) through your employer, you are already using this strategy!

Even though we don't have a crystal ball, if you feel like the market is down, then that might be a good time to buy more shares of an investment. This could allow you to take advantage of a potential discount you would be getting on shares.

Fear vs Greed

It has been said that these two emotions can drive the market.

Fear can trigger a sense of panic and cause investors to try to sell their shares when the market drops. This can lead investors to undervalue their assets and cause them to make poor decisions with their investments.

On the other hand, greed can drive overzealous buying of shares if investors feel like there is a potential boom and they are missing out on the profits. This can cause investors to buy assets at inflated prices, which would be another poor investment decision.

We caution you to avoid make investment decisions based solely on your emotions. To avoid these emotional pitfalls, it helps to have a plan and to stick with it. This could involve dollar cost averaging, as mentioned above.

Check back soon for step-by-step instructions on investing with specific investment brokers.