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Fundamentals of Investing


Fundamentals of Investing

Investing your money wisely is one of the most important things you can do to secure your future financial independence.

Investment: What it is -- and how it can help you achieve financial independence 

Virtually everyone has heard stories like this -- if you would have invested a small amount of money in "Company X" years before its stock price took off, you'd be a virtual millionaire today. Apple is one of the most famous examples of this. An investment of just $1,000 in Apple stock in 1980 would have been worth $300,000 in 2015.

While these stock market fairy tales aren't going to be experienced by the average investor, the numbers don't lie -- investing can be very profitable, and it's a cornerstone strategy of most retirement plans. It can also be quite daunting for beginners and younger investors. If you aren't confident in what you're doing, the odds are good you'll make poor decisions -- or perhaps forego investing at all, costing yourself considerable money in the process.

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

Basics for New Investors

The basic idea behind investing is simple -- to make your money earn more money for you. You can do this in a variety of ways, but one of the most common methods is by 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, also 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 who aren't in a position to risk significant losses. The drawback, however, 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 a wide variety of individual stocks or bonds held within a single fund. This makes investment performance less risky and more predictable, typically.
  • 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 in value, or you can rent out the property you purchase with the goal of creating 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 Invest Your Money

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 offer 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, the fees they charge will lower your returns.

Generally speaking, new investors would do well to stick with low-cost funds that are tied to the performance of the S&P 500 (which is simply a listing of 500 widely-held stocks) or another market index. These are called index funds. Because they are comprised of the same stocks listed within the S&P 500 or another index, they 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 the basic outline listed above, you can begin investing with confidence.