Friday, August 10, 2012

Investing 101 Part 2

Photo by Tax Credits
Here it is, as promised, Investing 101 Part Deux, I mean 2. In Investing 101 Part 1, we looked at what investing is and why you would want to do it. If you haven't read that yet and aren't sure whether you want to start investing, check it out. Then hopefully you'll want to continue on in the series and come back here. Otherwise, I'm horrible at blogging and should Command + Q (Alt+F4 for my non-Mac readers) right now.

So you're ready to put your money to work and start investing? Alright, before you jump in, it's probably time to go over what options are out there. There are two main types of investments, bonds and stocks, with millions of little baby choices underneath.

Bonds are basically a loan that you give to a company or even a government. By purchasing the bond, you are loaning the company/government money and they pay you interest and hopefully the full amount of the loan in return. Fingers crossed.

Of the two main investment types, bonds are usually the safer choice. Assuming you are purchasing bonds from a stable company or government (if there is such a thing), your money should be relatively safe. However, you pay a price for that safety. The returns are going to be lower for bonds than with a higher risk investment like stocks. The historical average annual return for bonds is somewhere around 5%.

Stocks allow you to buy a little piece (share) of an actual company. If the company decides to pay out some of its profits to shareholders you get a dividend, which is usually a certain dollar amount for each share you own. If the company doesn't pay a dividend, then you are relying solely on the stocks value to increase. Stocks are much riskier than bonds. With stocks you are guaranteed to get nothing, except crazy excitement every day. Because of the increased risk there is also potential for increased returns. The historical average annual return for stocks is somewhere around 10%.

There are your options. So now what, just start picking some? Thankfully, there's an easier answer than researching and selecting individual stocks and bonds. That answer is the mutual fund.

Mutual Funds
A mutual fund is a grouping of stocks and bonds. You buy into a mutual fund along with many, many other people. A professional mutual fund manager then takes all of that money and buys the individual stocks and bonds for everyone that owns the mutual fund. Of course he takes a little percentage of the money for himself which is called the expense ratio.

While there are thousands of mutual funds to choose from, there are two main types. Actively managed and index. Actively managed funds have an advisor that is constantly trying to beat the returns of the overall stock market or whatever specific area of the market his fund is targeting. Guess what, since he's actively trying to do that, he's also going to take a bigger percentage expense ratio out of your investment for his hard work. Index funds are the opposite. The manager just tries to mimic the market. This results in a lower percentage expense ratio used to pay the fund manager.

The more I read about mutual funds, the more I find that actively managed funds rarely outperform index funds. So as a rule, lower expense ratio index funds are going to perform better than higher expense ratio actively managed funds.

Now What?

Now that you know what is out there to invest in, what should you do? Well, come back for part 3 and we'll look at what goes into creating a portfolio that fits your specific needs.

I know, I know you're so excited to learn more. Let me tide you over by sharing what I do, just to give you some ideas. We basically use a three mutual fund approach with Vanguard as our brokerage firm. Why Vanguard? They have the lowest expense ratios around and are pretty much awesome.

So, our three fund approach. We have our emergency money in the Vanguard GNMA fund. Basically like a bond mutual fund, only it's made of mortgages instead of bonds. The rest is split with 80% in the Total Stock Market fund (U.S. stocks index) and 20% in the Total International Stock Market fund (global index). In part 3 we'll look at why I created this portfolio and how it can be tweaked to accomodate your own personality and financial situation.

Where is your money currently invested? Do you have a portfolio strategy or do you just throw money at the market and hope it grows?


  1. We have a portfolio strategy and it includes some REITS as well as a 95/5 allocation for stocks/bonds. We stick with mutual funds and really avoid doing much with individual stocks or bonds.

    1. I've seen more and more about REITS in my financial reading lately but I haven't added them into my portfolio yet. My only stock picking is a little mad money account from my credit card rewards, sort of my pipe dream for a future career.