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Investing can seem like a complex and esoteric activity, where an individual must navigate a series of mysterious assets and potential obstacles to creating a balanced portfolio. Investing for beginners may seem daunting, but it’s worth keeping. If you focus on learning the basics and developing strong decision-making skills, you can realize solid long-term gains without excessive risk.
How is investing different from saving
Investing involves making a certain amount of money (usually long-term) with the aim of getting attractive returns. The purpose of investing is to increase your income, build wealth, and secure your financial future.
Save, on the other hand, is setting aside a portion of your income constantly to create a financial cushion. People generally like to save money to make larger purchases, such as cars, home improvement projects, vacations with family, or to cover unexpected costs, such as operating or repairing a damaged roof.
Saving is usually done by placing funds into a bank savings account, money market account, or certificate of deposit (CD). The Federal Deposit Insurance Corporation (FDIC) insures these products, making them very safe.
Investing is riskier than saving. There is no insurance. Investments do not generate guaranteed returns. However, even if saving is safe, the interest you earn may not even be enough to offset inflation. In reality, you can lose money in the long run. Investments offer the possibility of significant long-term growth.
When should you consider investing?
Ideally, every beginner should start investing only after the following two important elements have been resolved:
Pay off your credit card debt
The interest rate on your credit card debt is almost always higher than the returns you can consistently get from investing. If you have significant credit card debt, the smartest investment is to pay off that debt first.
☝️ Pay off your high-interest debt before making a money investment.
Create an adequate emergency fund
Shakespeare said that grief does not come as one soldier, they come in battalions. Illnesses, natural disasters, layoffs, and other financial emergencies can arise without warning. You must have an emergency fund that covers your living expenses for at least six months.
💡 Investing works best when you have a significant time horizon. A good rule of thumb is to invest money that you don’t need to use for at least five years. If you keep this money in a savings account, inflation will chew its value. Invest wisely and there is a high probability that your money will grow.
Risk is an inherent part of investing. You need to assess the level of risk you want to take. You have to decide if the expected reward is worth that risk. A clear understanding of the risk-reward ratio is indispensable for building a successful and sustainable investment strategy. Higher potential rewards generally carry greater risks. A volatile stock can quickly rise and fall as quickly as possible. Subprime bonds pay higher interest rates. If the potential rewards of an investment are high, you can expect the risk to be high as well.
☝️ Different asset classes, such as stocks, mutual funds and ETFs, bonds, and alternative investments have their own risk-reward profiles. You need to clearly understand the difference between them.
Risk tolerance and how to assess it
One of the key assessments in investing for beginners is to find your level of risk tolerance. High-risk portfolios are often tempting because they can generate substantial returns. They can also make huge losses. It is very important to consider the downside risks. Are you ready for your investment to go to zero if something goes wrong?
In simple words, your risk tolerance level is the one that allows you to sleep well at night. If your exposure to investment causes you constant worry, it’s not worth it. At the end of the day, investing is a very personal and lonely journey for an investor. A very aggressive approach can get you rich very quickly, but it can also wipe out your life savings.
On the other hand, an excessive risk-averse approach will limit its growth potential. Striking the right balance between risk and reward is one of the key investment challenges for beginners.
#Investing 101: Investing for Beginners 📈
An investment portfolio should have allocations for multiple asset classes. Asset classes include stocks and mutual funds, bonds and cash. Your risk tolerance level and investment time horizon are two main factors that will affect your asset allocation.
Why is asset allocation important?
Allocating your funds to different asset classes in your investment portfolio gives you additional protection against market fluctuations. In general, when one asset class performs very well, the other asset class can only offer regular or even negative returns because most investors pursue the asset class, which is in high demand.
💡 If you find low returns on one asset class, you can often offset it in another asset class.
Diversification of your investment portfolio should occur on two levels: within each asset class and between or between asset classes. In other words, in addition to asset allocation (which in itself is a form of diversification), you can also spread your risk by investing in various elements in a particular asset class.
👉 For example:
Your stock portfolio should have a mix of companies and a mix of sectors in which they operate.
If your holdings are concentrated in one company, you are vulnerable to heavy losses if an unexpected event hits the company or sector.
Achieving proper diversification and keeping track of every item in a portfolio can be complicated and time-consuming. Investing for beginners is often easier when diversifying through the ownership of ETFs, mutual funds, or index funds rather than individual stocks. Each fund has a large number of shares. That allows you to build a diversified portfolio without committing large sums of money.
Active vs. passive investing
Active investing is for practical investors who manage their own portfolios just like professional portfolio managers do. As an active investor, your goal is to get returns equivalent to or better than the average market return. It aims to maximize your profits from short-term volatility in the market.
Active investment demands ingenious market knowledge, impartial analysis, and a temperament to enter and exit certain investments with discipline. Active investment requires experience and discipline. It also requires a significant commitment of time and energy. You should monitor your portfolio on a daily basis. Learning about new investment potential and keeping up with market conditions that affect your existing investment takes time, effort, and knowledge.
Passive investing, on the other hand, requires a long-term approach. This is often an ideal investment strategy for beginners. You have to make fewer decisions (not buying and selling often). That means it reduces your chances of getting it wrong. It’s also cost-effective because fewer transactions means lower transaction fees.
Passive investing works when you are willing to adopt a buy and hold strategy. Patience is the strength of a passive investor. A popular example of passive investing is buying an index fund, which tracks the S&P 500 or other major indices such as the Dow Jones Industrial Average. Rewards in passive investing are usually given to investors who can stay calm and focus on their long-term goals.
Income vs. Value vs. Investment Value Growth
There are several different approaches to choosing a stock investment.
- Income investing requires you to focus on stocks that have historically been high dividend payers. Companies that make a lot of cash but don’t have many new avenues to invest that cash (for growth) may want to distribute higher dividends to shareholders. Many established companies that don’t have much room to grow rely on dividends to attract investors. Dividend-containing stocks often retain their value when the market falls, as investors seek safety from that income.
- Value investing involves identifying a company with a stock value that is lower than its fundamentals. This often involves finding strong companies in sectors that have been hit by events such as the recent pandemic. These stocks can grow in value as the market recognizes their fundamental strength.
- Growth investment involves the selection of shares of companies with high growth potential. These companies may not have strong cash flow and current revenues. Their appeal is that they are expected to grow exponentially in the future and offer an incredible return on capital.
☝️ You need to be careful with highly publicized growth stocks: the expected growth can already be reflected in the price.
None of these methods are inherently better than the other. You have to balance it is the way that suits your needs.
Which approach is best for you?
You can achieve your financial goals through one of these types of investments, or a combination of all three.
👉 If your risk tolerance is higher, you are relatively young, and you have a significant personal income, you can increase your exposure to a growing business.
👉 As your portfolio matures, you may want to add value to the stock.
👉 If you are more conservative or approaching retirement, or have limited income, you may prefer to invest dividends to increase your income.
The growth, value and income of mutual funds and ETFs (exchange-traded funds) can also be a good option if you want a combination of both types of stocks in your portfolio. This can bring you short-term earnings while also generating long-term growth of a portion of your portfolio.
You need to understand the investment instruments available to you. The three basic types are stocks, bonds, and mutual funds. The risk profile of each instrument may vary. Understanding each instrument will help you build the mix that works best for you.
Shares are securities that represent the proportional ownership of the company that has issued the shares. Stocks are part of most investment portfolios because historically investors have outperformed stocks over time compared to most other asset classes.
☝️ It is important to understand the risk-reward relationship and be prudent with action. These investments are inherently volatile.
A bond is a debt instrument, which represents a loan that an investor has issued to a borrower. When you invest in bonds, you basically lend your funds to a government entity (such as a municipality) or a private company, depending on the type of bond you are buying.
Rating agencies such as Standard & Poor’s and Moody’s assign ratings to bonds. Risky bonds will have to pay higher interest rates to attract investors: the higher the rating of the bond, the lower the interest rate.
☝️ Bonds are generally considered a safer investment compared to stocks, but yields can be low, especially when prevailing interest rates are as low as they were at the beginning of 2021.
Mutual funds and exchange-traded funds (ETFs) are diversified baskets of stocks or bonds, each managed by a professional portfolio management company for a fee.
Many novice investors choose funds because they don’t have to use individual investment skills or track their stock portfolios. When you invest in funds, your money is used for work without you having to participate directly in the day-to-day investment process.
☝️ Many funds have administrative costs, and you need to compare them when choosing funds.
As the name suggests, alternative investments are a category of unconventional assets that generally carry significant risks, but can also offer incredible returns. The alternative investment universe is expanding and now also includes complex assets such as cryptocurrencies. Some important alternative investments include:
- Real estate: You don’t have to invest in residential properties or high-cost commercial investments. You can buy shares in REITs (real estate investment trusts), which serve as mutual funds and are traded as stocks.
- Hedge Funds and PE Funds: These alternative investment vehicles are generally only available to accredited or high-value investors, who are willing to make large investments. These investments may offer “alpha” returns, but the downside risks are also enormous.
- Commodities: Tangible assets such as gold, silver, oil, and agricultural products are called commodities, which can be considered for portfolio diversification.
☝️ Alternative investments can be profitable, but often require a high level of expertise. They may also require large amounts of capital. They are usually not suitable for novice investors.
What is a broker and why do you need it?
When you want to invest, you will usually need a broker. The broker is a professional who is licensed to engage in stock trading with the stock exchange. Depending on your investment needs, you can decide whether you want to work with a discount broker or a full-service broker.
A full-service broker usually represents a licensed brokerage firm that can offer personalized investment advice based on your investment objectives.
A discount broker, on the other hand, will not give you portfolio advice, but will only execute your stock trades. Many online discount brokers are available, offering varying degrees of service.
Many discount brokers offer the services of “robo-advisors”, which use algorithms for selecting investments according to the specified risk tolerance or other specifications. It can be a great option for novice investors who are not yet confident in their own ability to choose the right investment.
👉 Investing for beginners often starts with a retirement plan. If you have a 401(k) or IRA, your plan provider also serves as your broker.
Start with education
Investing for beginners begins with acquiring a basic understanding of the principles of investment. While you need to know what you’re doing as an investor, it’s often more important to know what not to do. You should stay away from investments that you don’t understand. Remember the words of the legendary investor Charlie Munger, who said, “If I knew where I was going to die, I wouldn’t go there.”
Start with a simple investment and rely on genuine advice from accomplished investment professionals, while staying away from “hot advice” and “get rich quick” ideas from sources with vested interests. There are many investment scams out there, but with common sense, they are easy to avoid. If it sounds too good to be true, it’s not right!
Investing for beginners is not about getting rich quickly. Conservative approaches and long-term timelines are generally more cost-effective and less risky than “get rich quick” approaches. As with baseball, playing good defense and hitting multiple singles will win more games than swinging for a home run every time you get closer to the plate.