If you have an adequate savings and have debt under control, your next move should be to start investing. The truth is, investing is the best way to build long term wealth and also outpace inflation. Two common investment markets are the stock market (owning equity) and the bond market (owning debt).
Table of Contents:
- Common Investing Markets
- The Stock Market
- What is a Stock Exchange?
- Stock Market Risk
- The Bond Market
- Types of Bonds
- The Stock Market
- Alternative Investing Markets
- Common Terms and Ideas
- Mutual Funds & ETFs
- Asset Allocation
- Active vs. Passive Investing
- Retirement & Tax Advantage Accounts
- Other Investment Vehicles
- Best Books on Investing
- Start Investing with a Brokerage Account
The Stock Market
The stock market (or equity market) is a market comprised of buyers and sellers of businesses that are publicly traded.
If you were to start your own business, you would own the whole company. It would be a privately owned company and you would be the sole proprietor. To put this in perspective, say you were to start a business and open a pizza shop. To start the business you will need to take out a loan and purchase a building for your shop. Say the building costs $250,000 and the equipment costs another $250,000. The total cost of opening the business is $500,000. So you take out a business loan for that amount to open your shop. In one year you make $150,000 in sales, but the cost of running the business (paying employees, electric bill, etc.) is $100,000. Your net profit is $50,000. Theoretically, it would take 10 years at this rate (not including interest) to pay your original loan of $500,000.
Say you were to offer up this company to the public. This is called an IPO (initial public offering). That initial $500,000 could be paid off rather quickly with funding from investors. Let’s say we divide the company into 10,000 pieces, called shares. If we take that original price tag of $500,000 and divide it by 10,000 we get $50. For as little at $50, an investor could own 1/10,000th of the pizza shop (they could own a larger stake if they bought 10 or 100 shares). Now, the total debt would be paid off right away and the pizza shop could grow faster; however, the investors did not spend $50 for nothing. Each share will get 1/10,000th of the profit that is produced by the pizza shop. The shareholders also get a say in any changes made to the business. If the company pulls in more profit, the shares now look more valueable and the shareholders can sell those shares to new investors at a higher price or continue to hold them for the long run.
What is a Stock Exchange?
A stock exchange is like a grocery store but rather than sell different foods, a stock exchange sells companies. Each company has a ticker symbol that uniquely identifies shares of the company’s stock. In the United States, there are 2 major stock exchanges: the New York Stock Exchange (NYSE) and the NASDAQ. The NYSE was founded on May 17, 1792, whereas the NASDAQ is much newer and was founded on February 4, 1971.
As of May 9th, 2020:
- The NYSE has approximately 2,400 listed publicly traded companies that can be bought or sold, including the NYSE exchange itself, which its parent company Intercontinental Exchange, Inc. ($ICE) is a publicly traded company.
- The NASDAQ has approximately 3,500 listed publicly traded companies that can be bought or sold, including the NASDAQ exchange itself, which is a publicly traded company ($NDAQ).
Stock Market Risk
I’m sure you’ve heard the horror stories of the stock market crash in 1929 leading to the great depression, the bursting of the Dotcom bubble in 2000, or the great recession in 2008. All of these due to excess greed. The stock market doesn’t have to be that scary if you understand it and know how to manage risk. To be successful, you must be able to hold through the ups and downs of the market. To do this, you cannot deplete your savings and invest everything in the stock market. That would end badly. Imagine this: The stock market drops 50% and something unexpected comes up and you are hit with a large bill. You have no savings since you put it all in the stock market. You sell your stock at 50% of what you paid for it and one year later the share price returns to the price it originally was when you bought it. You have just bought high, sold low and are now thinking about buying high again. You should have managed risk better by keeping an emergency savings of 6 to 12 months worth of expenses held in a separate account this whole time. Thus, proving the point that you should have a savings at all times.
To dive further into the stock market, visit our stocks page!
The Bond Market
Investing in the bond market is less risky than the stock market but also has less reward. A bond is part ownership of debt.
To dive further into the stock market, visit our bonds page!
Alternative Investing Markets
Some examples of other investment markets are:
- The Money Market
- Currency (Forex)
- Cryptocurrency
- Commodity
- Real Estate
- Derivatives
Mutual Funds & ETFs
A mutual fund is a fund that pools money from many investors and buys stocks, bonds, or keeps a cash balance (money market funds). These funds can either be actively managed by a fund manager or passively managed and track an index. The first mutual fund Massachusetts Investors Trust ($MITTX) was created in 1924 and is still traded today. Mutual funds are bought and sold in the after hours, once the stock market has closed for the day.
An ETF is pretty much the same concept as the mutual fund, except that it can be bought and sold during stock market trading hours.
Active vs. Passive Investing
In an actively managed fund, the fund manager or managers select which investments to buy and sell based on the objective of the fund (value, growth, etc.).
In a passively managed fund, there is no fund manager that is buying and selling the individual investments within the fund. The fund tracks a specific index or defined criteria, and automatically buys and sells the individual positions within the fund.
| Active | Passive | |
| Pros | 👍 Risk management can be better since the money manager of the fund can adjust the portfolio during certain market conditions. | 👍 Usually lower expense ratio (avg. 0.2% as of 2020) 👍 Tend to outperform active funds over the long term (92% beat over a 15 year period) |
| Cons | 👎 Usually higher expense ratio (avg. 0.5%-1.0%) 👎 Very few fund managers beat the indexes long term (8% beat over a 15 year period) | 👎 You can never outperform the index if you are tracking the index 👎 Sometimes these funds can lead to destruction of price discovery (buying rewards the good and poorly managed companies the same) |
Asset Allocation
The closer you are to retirement age, the less time you have to recover from a stock market crash. When you are younger, you have a much longer time horizon and can take on more risk. The rule of thumb is to use 110 minus your age to find and asset allocation that is right for you.
So, let’s say you are 30 years old. 110-30=80. Your retirement portfolio should contain 80% stocks and 20% bonds.
Someone who is 60 and only a few years away from retirement would have less time to recover from a major stock market selloff. So for them, with their 50/50 mix, they will not feel as big of an impact and will not lose their nest egg that they have worked so long for.
There is a type of mutual fund called a target date fund. These funds usually have a maturity date. The fund starts off more aggressive with most of its holdings in stocks, and gets more conservative with most of its holdings in bonds and cash as it moves toward the target date.
Disclaimer: This is a widely popular way to invest over the years as one ages and Money Cat is not directing you to invest any specific way. It is up to you as an investor to determine what is right for you and fits into your financial picture. All investment come with risk and that should be taken into account before making any purchases.
Tax Advantage Accounts
If you are purchasing an investments for retirement, future healthcare benefit or for future educational needs, it may be a good idea to look into a tax advantage account for your situation. Tax advantage accounts offer an incentive to invest by either deferring taxes until a later point in time or being tax exempt all together.
It may be best to invest in a tax advantage account first before directly buying and selling shares of individual companies in a regular taxable brokerage account, which will lead to a taxable even. The tax advantages of holding positions within they accounts can add up over the long run. See our table below.
| Type of Tax Advantage Account | Description |
|---|---|
| Retirement Accounts | There is more than 1 kind of tax advantage account for this type of savings. Some examples are the 401(k), IRA, Roth, etc. Each account comes with a different set of rules and requirements. View our Retirement page HERE. |
| Healthcare Accounts | There is a specific type of account called an HSA that is tax efficient and is designated for healthcare. These types of accounts are only available to those with a high deductible healthcare plan. View more about HSA plans HERE or Learn about the types of health insurance HERE. |
| Educational Accounts | There is a type of tax advantage account that is designed specifically for educational expenses called a 529 account. The plan for these accounts vary by state. See more HERE. |
Other Investment Vehicles
If your company offers an ESPP for purchasing common stock of the company that you work for at a discount, it is often a wise choice to enroll. View are ESPP page for more info.
Start Investing with a Brokerage Account
Robinhood – This is a great app to get started with investing. This brokerage account is completely free and there are no commission fees when buying and selling stocks. There is also a bonus: Sign up, link your bank account & get a free stock!
For more investing insight, visit the folks over at valuenerds.com.