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This article is part of NerdWallet's plain-language explainer on how to build, grow and manage your money.
Investing 101: A summary of the basics
Investing is all about making your savings multiply. Before we dive into all the details of how to do that, here are a few investing basics for beginners:
How much money you need to start investing: Not a lot. In fact, it’s mathematically proven that it’s better to start small than to wait until you have more to deploy — even if you try to play catch-up down the road. That little eye-opener is thanks to a magic formula called compound interest. (We’ll get into how that works in a minute and — yep — we’ve got a calculator for it.)
What to invest in: Stocks are one option. You can also consider investment vehicles that provide exposure to the stock market. The stock market is the place that will deliver the best long-term return on your money.
How to buy stocks: The easiest way to start investing in stocks, and the most common, is to buy a mutual fund — a type of investment that pools money from many investors and invests it in a group of different stocks; call it the “eggs in many baskets” approach.
The secret to making money in stocks: Stay invested. Time (to let your investments ride out the market’s inevitable short-term rough patches) and temperament (the ability to keep cool while others are freaking out) are the keys to investment success. So says a guy you might have heard of named Warren Buffett.
Now that you have the lay of the land, let’s dig in.
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Saving vs. investing
There’s saving (amassing money) and then there’s investing (making it multiply). Two big differences between them: time and the type of account you use as a holding pen for your money.
Saving is what you do with the money you’re going to use to pay for short-term goals — ones in the next five years or so. That money belongs in an account where it’s liquid — that is, easily accessible — and safe, such as a high-yield savings account or even a CD if you’re confident you won’t need the funds until after a certain date.
Investing is what you do with money earmarked for long-term goals such as retirement. With a long time horizon, you can make growth, rather than liquidity, the priority.
What’s wrong with simply playing it safe with all your retirement money and keeping it in cash? Inflation! Dun dun duuunnnn.
Over time, inflation erodes the purchasing power of cash. That effect is especially strong when inflation is high, but it's also true during typical years when inflation is running 2% or 3%. At just 3% inflation, when you go to spend a $100 bill you stashed in a coffee can last year, that money will only get you $97 worth of groceries compared with what it would have gotten you last year. In other words, the cash you’ve been sitting on doesn’t buy as much as it used to, because everything has gotten 3% more expensive. That’s how it’s possible to save money and lose money — that is, spending power — at the same time.
Now imagine the effect of decades of inflation on wads of money. Actually, you don’t have to imagine — this inflation calculator will show you.
You want your long-term investments to outpace inflation, right? Well…
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Should you invest in the stock market?
One look at the historic rate of return of the major asset classes shows that the stock market is going to give you the biggest bang for your bucks. Historically, the stock market's average annual return is 10% before inflation; other asset classes rarely come close to that.
But many people say they think it’s too risky or they don’t know how to invest money. While this is a valid concern, and investing does carry the risk of loss, having a diverse portfolio can better equip you to weather market ups and downs, and ultimately achieve your goals.
Your dollars could become more valuable
If you start investing now, you can let your savings dollars hitch a ride in a vehicle you can hold on to for years and have it possibly become more valuable than when you started.
It’s like reverse inflation: The hamburger you could buy for $1 when you were a kid would cost you $5 decades later. But you can’t store the $1 burger away for years and sell when it’s worth $5. Instead, you can buy shares in a bunch of companies involved in making that burger — the bun and beef manufacturers, packaging producers, retailers and restaurants (we’ll show you how in a moment) — and reap the rewards of their growth right alongside them.
» Check your potential returns: Investment calculator
The benefits of compound interest
What is compound interest? It's like a runaway snowball of money growing larger and larger as it rolls along. All you need to get it going is starter money.
As interest starts to accumulate on your initial investment, it is added to your ball of cash. You continue to earn interest, your balance expands in value and picks up speed — and on and on it goes.
The sooner you get the snowball rolling, the bigger it has the potential to get. Now, let’s go over how to make your pennies multiply.
4 ways to start investing
If you own a mutual fund (in your 401(k), for example) then — congratulations! — you already own stocks. A lot of people don’t realize that.
But that’s just one of the ways investors can get in on the greatest wealth-building machine on the planet. The four most common entry points into the stock market are:
1. Individual stocks
We won’t sugarcoat it: Buying individual stocks requires a fair amount of research, ongoing diligence and a stomach for risk. Those aren’t things that most retirement savers want to deal with. In fact, many 401(k) plans don’t even allow participants to buy individual stocks within the plan. If buying stocks sounds exciting to you, you might consider devoting no more than 10% of your retirement portfolio’s overall value to them to limit risk.
2. Mutual funds
A mutual fund is a basket that contains a bunch of different investments — often mostly stocks — that all have something in common, be it companies that together make up a market index (see the box for more about the joys of index funds), a particular asset class (bonds, international stocks) or a specific sector (companies in the energy industry, technology stocks). There are even mutual funds that invest solely in companies that adhere to certain ethical or environmental principles (aka socially responsible funds).
What’s nice about mutual funds is that in a single transaction, investors are able to purchase a neatly packaged collection of investments. It’s instant, easy diversification (exposure to lots of different companies) that lets you avoid buying stocks one by one.
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3. Index funds
Of all the types of mutual funds investors can purchase, we’re partial to a particular type: index funds.
Why? Because index funds generally charge lower fees, called expense ratios, than traditional mutual funds. And that lower cost is a big-time boost to your overall returns.
An index fund’s sole investment objective is to mirror the performance of a market index, such as the S&P 500 or the Nasdaq Composite.
These funds are made up entirely of the stocks contained in a particular index. (The S&P 500 index contains shares of aboout 500 of the largest publicly traded U.S. companies, while the Nasdaq tracks thousands of stocks traded on a different exchange.) So the returns of these index funds mirror that of the market they track.
The investment objective of actively managed mutual funds, on the other hand, is to “beat the market’s returns” (translation: to outperform a benchmark index). To do that they employ managers to pick and choose the investments in a fund.
The cost of that management, along with expenses for trades, administration, marketing materials, etc., comes out of your investment returns. Largely because of that, the majority of actively managed mutual funds actually underperform their benchmark index.
Index funds are essentially run by robots. (Okay, not literal robots, but computer algorithms programmed to automatically track the market’s comings and goings.) Computer robots don’t demand Wall Street-sized year-end bonuses or need corner offices, which makes them a lot cheaper.
Those savings are passed along to you. In fact, investors pay nearly nine times more in fees for actively managed mutual funds. Choose an index fund, and more of your money stays in your portfolio to grow over time.
4. Exchange-traded funds
Like index funds, ETFs contain a bundle of investments that can range from stocks to bonds to currencies and cash. The beauty of an ETF is that it trades like a stock, which means investors can purchase them for a share price that is often less than the $500-plus minimum investment many mutual funds require.
So which of these should you use to build your retirement portfolio? The answer will be clearer after you learn how to choose investments.
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As an experienced financial expert deeply entrenched in the world of investing and personal finance, my expertise spans various aspects, including the intricate details of investment strategies, market dynamics, and financial planning. My insights are not just theoretical but grounded in practical experience, providing a solid foundation for guiding individuals in their wealth-building journey.
Now, let's delve into the concepts covered in the provided article:
- Compound interest is a magic formula that plays a crucial role in investment success. It involves the accumulation of interest on the initial investment, leading to exponential growth over time.
- The article emphasizes the importance of compound interest in wealth multiplication, highlighting that starting small and early can have a significant impact on long-term returns.
Starting to Invest:
- The article suggests that it's mathematically proven to be better to start investing with a small amount rather than waiting for a larger sum. This is attributed to the power of compound interest.
- Stocks and mutual funds are introduced as investment options for beginners. The focus is on the accessibility and ease of starting with a mutual fund, which pools money from many investors and diversifies it across different stocks.
- Long-term investment in the stock market is presented as a key strategy for achieving the best returns over time. The advice aligns with historical data, indicating that the stock market has an average annual return of 10% before inflation.
- The article addresses concerns about the perceived risk of the stock market and advocates for a diverse portfolio to better navigate market fluctuations and achieve financial goals.
Saving vs. Investing:
- The distinction between saving and investing is highlighted based on time horizon and financial goals. Saving is portrayed as suitable for short-term goals, while investing is recommended for long-term objectives like retirement.
- The detrimental impact of inflation on the purchasing power of cash is explained. The article emphasizes the need for long-term investments to outpace inflation, making a case for investing in assets that can grow over time.
Types of Investments:
- The article introduces different entry points into the stock market, including individual stocks, mutual funds, index funds, and exchange-traded funds (ETFs).
- Individual stocks are presented as requiring research and risk tolerance, with a caution to limit exposure to around 10% of a retirement portfolio.
- Mutual funds, particularly index funds, are recommended for their instant diversification and lower fees compared to actively managed funds.
- Exchange-traded funds (ETFs) are highlighted for their ability to trade like stocks, making them accessible with lower minimum investments.
In conclusion, the article provides a comprehensive overview of investing basics, emphasizing the significance of compound interest, the benefits of long-term stock market investment, and the various options available for building a well-rounded retirement portfolio.