So you've decided to start investing. Congratulations! Whether you're just starting out on your own, in the middle of your career, approaching retirement age, or in the midst of your golden years, this means you've begun to think about your financial future, and how you might prudently manage your capital so that it can work for you.
Nobody starts out an expert, and even the best investors in the world were once sitting where you are.
Let's start with two basic questions:
- Where should you begin?
- How do you begin?
Those two inquiries might seem daunting, especially if you've encountered the array of intimidating investing terms — like price to earnings ratio (p/e ratio), market capitalization, and return on equity. But getting started with investing isn't as scary as it might seem.
The First Investing Step Is Figuring Out Which Types of Assets You Want to Own
Let's start with this basic truth: At its core, investing is about laying out money today with the expectation of getting more money back in the future — which, accounting for time, adjusting for risk, and factoring in inflation, results in a satisfactory compound annual growth rate, particularly as compared to standards considered a "good" investment.
That's really it; the heart of the matter. You lay out cash or assets now, in the hope of more cash or assets returning to you tomorrow, or next year, or next decade.
Most of the time, this is best achieved through the acquisition of productive assets.
Productive assets are investments that internally throw off sur money from some sort of activity. For example, if you buy a painting, it isn't a productive asset. One hundred years from now, you'll still only own the painting, which may or may not be worth more or less money. (You might, however, be able to convert it into a quasi-productive asset by opening a museum and charging admission to see it.) On the other hand, if you buy an apartment building, you'll not only have the building, but all of the cash it produces from rent and service income over that century. Even if the building were destroyed after a decade, you still have the cash flow from ten years of operation — which you could have used to support your lifestyle, given to charity, or reinvested into other opportunities.
Each type of productive asset has its own pros and cons, unique quirks, legal traditions, tax rules, and other relevant details. Broadly speaking, investments in productive assets can be divided into a handful of major categories. Let's walk through the three most common kinds of investments: Stocks, bonds, and real estate.
Investing in Stocks
When people talk about investing in stocks, they usually mean investing in common stock, which is another way to describe business ownership, or business equity. When you own equity in a business, you are entitled to a share of the profit or losses generated by that company's operating activity. On an aggregate basis, equities have historically been the most rewarding asset class for investors seeking to build wealth over time without using large amounts of leverage.
At the risk of oversimplifying, I like to think of business equity investments as coming in one of two flavors — privately held and publicly traded.
Investing in Privately Held Businesses: These are businesses that have no public market for their shares.
When started from scratch, they can be a high-risk, high-reward proposition for the entrepreneur. You come up with an idea, you establish a business, you run that business so your expenses are less than your revenues, and you grow it over time, making sure you are not only being well-compensated for your time but that your capital, too, is being fairly treated by enjoying a good return in excess of what you could earn from a passive investment. Though entrepreneurship is not easy, owning a good business can put food on your table, send your children to college, pay for your medical expenses, and allow you to retire in comfort.
Investing in Publicly Traded Businesses: Private businesses sometimes sell part of themselves to outside investors, in a process known as an Initial Public Offering, or IPO. When this happens, anyone can buy shares and become an owner.
The types of publicly traded stocks you own may differ based on a number of factors. For example, if you are the type of person that likes companies that are stable and gush cash flow for owners, you are probably going to be drawn to blue-chip stocks, and may even have an affinity for dividend investing, dividend growth investing, and value investing.
On the other hand, if you prefer a more aggressive portfolio allocation methodology, you might be drawn to investing in the stock of bad companies, because even a small increase in profitability could lead to a disproportionately large jump in the market price of the stock.
Investing in Fixed-Income Securities (Bonds)
When you buy a fixed income security, you are really lending money to the bond issuer in exchange for interest income. There are a myriad of ways you can do it, from buying certificates of deposit and money markets to investing in corporate bonds, tax-free municipal bonds, and U.S. savings bonds.
As with stocks, many fixed-income securities are purchased through a brokerage account. Selecting your broker will require you to choose between either a discount or full-service model. When opening a new brokerage account, the minimum investment can vary, usually ranging from $500 to $1,000; often even lower for IRAs, or education accounts. Alternatively, you can work with a registered investment advisor or asset management company that operates on a fiduciary basis.
Investing in Real Estate
Real estate investing is nearly as old as mankind itself. There are several ways to make money investing in real estate, but it typically comes down to either developing something and selling it for a profit, or owning something and letting others use it in exchange for rent or lease payments. For a lot of investors, real estate has been a path to wealth because it more easily lends itself to using leverage. This can be bad if the investment turns out to be a poor one, but, applied to the right investment, at the right price, and on the right terms, it can allow someone without a lot of net worth to rapidly accumulate resources, controlling a far larger asset base than he or she could otherwise afford.
Something that might be confusing for new investors is that real estate can also be traded like a stock. Usually, this happens through a corporation that qualifies as a real estate investment trust, or REIT. For example, you can invest in hotel REITs and collect your share of the revenue from guests checking into the hotels and resorts that make up the company's portfolio. There are many different kinds of REITs; apartment complex REITs, office building REITs, storage unit REITs, REITs that specialize in senior housing, and even parking garage REITs.
The Next Investing Step Is to Decide How You Want to Own Those Assets
Once you've settled on the asset class you want to own, your next step is to decide how you are going to own it. To better understand this point, let's look at business equity. If you decide you want a stake in a publicly traded business, do you want to own the shares outright, or through a pooled structure?
Outright Ownership: If you opt for outright ownership, you are going to be buying shares of individual companies directly. To do this right requires a certain level of knowledge.
To invest in stocks, think of them as you might your privately held businesses, and remember there are three ways you can make money investing in a stock. Plainly, this means focusing on the price you are paying relative to the risk-adjusted cash flows the asset is generating. Discover how to calculate enterprise value, calculate the gross profit margin and operating profit margin, and compare them to other business in the same sector or industry. Read the income statement and balance sheet. Look at the asset management companies, which hold large stakes, to figure out the types of co-owners with which you are dealing.
Pooled Ownership: An enormous percentage of ordinary investors do not invest in stocks directly but, instead, do it through a pooled mechanism, such as a mutual fund or an exchange-traded fund (ETF). You mix your money with other people and buy ownership in a number of companies through a shared structure or entity.
These pooled mechanisms can take many forms. Some wealthy investors invest in hedge funds, but most individual investors will opt for vehicles like exchange-traded funds and index funds, which make it possible to buy diversified portfolios at much cheaper rates than they could have afforded on their own. The downside is a near total loss of control. If you invest in an ETF or mutual fund, you are along for the ride, outsourcing your decisions to a small group of people with the power to change your allocation.
The Third Investing Step Is Deciding Where You Want to Hold Those Assets
After you've decided the way you want to acquire your investment assets, your next decision regards where those investments will be held. This decision can have a major impact on how your investments are taxed, so it's not a decision to be made lightly. Your choices include taxable brokerage accounts, Traditional IRAs, Roth IRAs, Simple IRAs, SEP-IRA, and maybe even family limited partnerships (which can have some estate tax and gift tax planning benefits if implemented correctly).
Let's briefly look at some of the broad categories.
Taxable Accounts: If you opt for a taxable account, such as a brokerage account, you will pay taxes along the way, but your money is not nearly as restricted. You can spend it however you want, at any time. You can cash it all in and buy a beach house. You can add as much as you desire to it each year, without limit. It is the ultimate in flexibility but you have to give Uncle Sam his cut.
Tax Shelters: Retirement plans like 401(k)s or Roth IRAs offer numerous tax benefits. Some are tax-deferred, which (usually) means you get a tax deduction at the time you deposit the capital into the account, and then pay taxes in the future, allowing you year after year of tax-deferred growth. Others are tax-free, meaning you fund them with after-tax dollars (read: you don't get a tax deduction), but you'll never pay taxes on either the investment profits generated within the account nor on the money once you withdraw it later in life. Good tax planning, especially early in your career, can mean a lot of extra wealth down the road as the benefits compound upon themselves.
Some retirement plans and accounts also have asset protection benefits. For instance, some have unlimited bankruptcy protection, meaning that if you suffer a medical disaster or some other event that wipes out your personal balance sheet and forces you to declare bankruptcy, your retirement savings will be out of the reach of creditors. Others have limitations on the asset protection afforded to them, but still reach into the seven-figures.
Trusts or Other Asset Protection Mechanisms: Another way to hold your investments is through entities or structures such as trust funds. There are some major planning and asset protection benefits of using these special ownership methods, especially if you want to restrict how your capital is used in some way. And if you have a lot of operating assets or real estate investments, you may want to speak to your attorney about setting up a holding company.
An Example of How a New Investor Might Start Investing
With the framework out of the way, let's look at how a new investor might actually start investing.
First, assuming you're not self-employed, the best course of action is probably going to be to sign up for a 401(k), 403(b), or other employer-sponsored retirement plans as quickly as possible. Most employers offer some sort of matching money up to a certain limit. For example, if your employer offers a 100 percent match on the first 3 percent of salary, and you earn $50,000 per year, that means on the first $1,500 you have withheld from your paycheck and put into your retirement account, your employer will deposit into your retirement account an additional $1,500 in tax-free money.
Whether or not your employer offers matching, though, you'll need to invest the money you put in the account. Your 401(k) will probably have a default option, but choose the mutual funds or other investment vehicles that make the most sense for your future needs. As money gets automatically added to your account with each paycheck, it will be put toward that investment.
Next, assuming you fall under the income limit eligibility requirements, you'll probably want to fund a Roth IRA up to the maximum contribution limits permissible. That is $5,500 for someone who is younger than 50 years old, and $6,500 for someone who is older than 50 years old ($5,500 base contribution + $1,000 catch-up contribution). If you are married, in most cases, you can each fund your own Roth IRA. Just make sure you invest the money you put in there — by default, IRA providers will park your money in a safe, low-return vehicle like a money market fund until you direct them otherwise, so decide on which mutual funds, ETFs, or other investments you want to put your money toward.
Once you've taken care of such personal finance essentials as funding an emergency fund and paying off debt, you'd want to return to your 401(k) and fund the remainder (beyond the matching limit you already funded) to whatever overall limit you are allowed to take advantage of that year. With that done, you might begin to add taxable investments to your brokerage accounts, perhaps participate in direct stock purchase plans, acquire real estate, and fund other opportunities.
Done correctly over a long career and with the investments managed prudently, it could increase your odds of retiring comfortably drastically.