Monday, May 12, 2008

Basic Investing

So I'm thinking I should actually write a post on investment strategy, since that's what I set out to do in the first place. But, I'm not sure where to start. If you're an "experienced" (defined as your mastery of knowledge and practice, not time) investor, then you could probably skip this post. I'm a little anxious because there are actually some very attractive opportunities out there that people should be taking advantage of (and it doesn't involve recruiting others and making $8million dollars a month without getting out of bed). I'll start with some vocab, and then, in a few days (I promise), I will follow up with some of those interesting opportunities. Then I'll conclude the 3-part series with some basic behavioral finance.

Basic terms.

  1. Stock- Stock represents ownership in a company. If the company does well, you do well. Likewise, if it performs poorly, the value of your stock decreases.
  2. Bond- A Bond represents a loan that YOU make to the company. In other words, a company may need $10million dollars for a new venture and they want to raise money for that venture. They issue bonds which means they will pay you for lending them money every year, and, at the end of whatever time frame (1,3,5,10 years), you get all your money back. So you get your money back and you get all the interest payments in the meantime. Whereas a stock is OWNERSHIP in a company, a bond represents LONERSHIP. What's the downside? Bonds are backed by the full faith and credit of the issuing institution. The more risky the institution, the more interest they pay you in the meantime (thus government bonds are considered to be the safest and pay the least amount of interest).
  3. Mutual Funds- Sometimes the cost of one share of stock or the purchase of one bond is prohibitive. For example, a share of Google may cost you a few hundred dollars. Or one bond might have a minimum face value of $1,000 dollars. Additionally, you may not like the fact that all your wealth is tied up in a few companies be it as a stock or bond. Mutual Funds are the answer. Nevermind the name, here is what they are. They basically pool everyone's money and buy in bulk. So, you may only have $1,000 dollars to invest. Well, you could own a few shares of Google, or, maybe, one share of Google, and maybe a few shares of something else. You could also buy one bond (maybe). Or, you could buy a Mutual Fund. Here, they combine your $1,000 dollars with everyone else and come up millions of dollars. Then they go out and buy shares, or bonds (usually one or the other, but not both), in several different companies (typically 100 or so) and you participate proportionately. Now, instead of only being diversified over a few companies, your spread across one hundred. Much more diversification. Which is an important term.
Where do you put money? How do you start? Here are my basic rules.

  1. Take the free money
  2. Short term savings. First things first, if you don't have 3 months worth of living expenses in a savings account you should do that first.
  3. Employee Retirment Plans. Some of you may have a 401(k) where you contribute 6% and your employer will match it (remember, you should do this. See rule number one). If you can't contribute the max, then start with whatever you can, because your employer matches.
  4. Roth IRA. This is a personal retirement plan. The IRS allows you to put a certain amount of money away each year that grows (without taxes) until you take it out (can't touch it until you're 60 without penalty). When you get to distributions, you don't have to pay taxes on them. This is a nice compliment to your 401(k), which you do have to pay taxes on when you take distributions.
  5. Brokerage account. This is where you open up that Fidelity, E-Trade, Scottrade, Schwab, T Rowe Price, account. You can buy and sell stocks or bonds whenever you like (but beware of extra costs).
As a note, 401(k)'s, IRA, and brokerage accounts are only shells--you still have to choose what to invest in (stocks, bonds, U.S., International, etc.)

Anyway, I'll get more detailed but I wanted someone with no experience to be able to read this and get a general idea.


Tacy said...

sorry, whats a distribution again?

Jenga said...

When your money comes back.

Jenga said...

I mean, when you decide to tap into your money (in the case of retirement accounts)

KVB said...

These terms I am familiar with, but I look forward to the series.

(by the way, if you are wondering who the heck I am, I am Nates classmate that came to AZ for the conference.)

Nate said...

I want to see a post comparing 30-yr fixed mortgages to ARMs.

Jenga said...

All in good time