My goal for this article is to help you understand the core foundations of financial literacy in regards to investing. If you consider yourself a seasoned investor or perhaps you've never invested before, I guarantee you will get some amount of value from this. When I looked back and thought to myself, "What are the things I wish I knew about investing?" I thought of three broad topics:
1) What is investing?
2) Why invest?
3) What do I invest in?
A quick note before we get started. When I mention "investing" within the context of this platform I am primarily referring to the stock market and the various types of investments you can make within the overall market because the stock market is one of the most common places people invest in. With that being said, let's begin.
What is investing? I personally define it as distributing your money (or any type of asset) with the goal of generating a profitable return. What does that mean? It means using your money to work for you and make you more money in the future than what you started with. There are many different places to invest your money, including but not limited to, the stock market, startup businesses, cryptocurrency, bank CDs, real estate, gold, NFTs, farmland, etc. The list goes on and on.
The point of investing is to build wealth and make money. But why would I need to build wealth by investing when I already make money from working my job? The answer is time. In a typical W-2 job setting, you trade your time for money. For example, if you make $25 per hour and work 40 hours per week assuming no overtime, you will always earn $1,000 per week before taxes. If you want to earn more money, you have to either work more hours, earn higher wages, or a combination of both. This is commonly referred to as active income, because you are actively working the entire time to earn money. Active income has its limits because even if you get a higher paying job, there are only so many hours in the day to perform your duties.
Compared to active income, stock market investing takes a more passive approach, depending on your strategy. If you have a financial advisor that handles all of your investments, then you probably have the most hands-off strategy. However, if you are someone like myself who manages their own investments, although there is a little more upfront work to set things up, it can actually be very passive and low maintenance.
Another priceless advantage to investing is that you have time on your side. This is what I meant earlier when I said that your money will work for you and make you more money, which will make you more money and that money will generate more money over time. This is known as compound interest (basically the greatest concept ever invented) and will be explained in a later post.
Understanding the risk and reward involved in investing are crucial. Your risk tolerance depends on you in the same way that personal finance is personal. Higher risk-type investments carry the potential to earn higher rewards (greater returns/profits; whereas, a low-risk strategy will generally yield a lower return over time. You can use your current age in relation to the amount of years until you expect to retire as a factor in choosing your risk tolerance.
For example, if you're in your 20s-30s and plan to retire in your 60s, you have approximately 30 years to invest. With this long of a time period, you could afford to be on the riskier and more aggressive side of investing because you have decades to recovered from a short term loss and the potential to generate substantial returns. If you're in your 50s and plan to retire in the next 5-10 years, investing your money in lower risk stocks, bonds, or funds may help preserve your capital and lower the possibility of losing money in the short term.
But if you're more on the safe and conservative side in general, stick with that approach and enjoy safer profits and less volatility, but understand that your estimated annualized return will likely be lower than someone who invested in less conservative places. Keep in mind that the opposite also hold true.
Let's define some of the most common types of investments you can make in the stock market (this knowledge will especially help in Part 4).
Stocks
What is a stock? A stock can be thought of as a company that is traded on a stock exchange. Let's take Microsoft (Ticker symbol $MSFT) for example. If you own any amount of Microsoft stock, you are essentially owning a fraction of equity in that business. Owning a stock is referred to as owning "shares" of the underlying company. For example, if Microsoft is trading at $250 per share and you buy $500, you will own 2 shares. The ticker symbol is the unique letter combination that represents the company or fund traded on an exchange (i.e. MSFT (Microsoft), AAPL (Apple), TSLA (Tesla), TGT (Target), VTI (Vanguard Total Stock Market ETF), etc.).
Index Funds & Mutual Funds
An index fund is designed to track a specific index or sector in the stock market. These indexes are comprised of several dozens, hundreds, or even thousands of individual stocks. There are many different types of indexes/sectors, such as financials, utilities, consumer staples, technology, real estate, etc. There's also broad-based indexes that track the top 500 U.S. companies (S&P 500) or the entire U.S. stock market. Index funds are passively managed, meaning they're designed to identically match the returns of the associated index and are automated, unlike mutual funds.
Mutual funds are generally actively managed. This means there are professional portfolio managers and analysts that work to make the best investment decisions in the funds in an attempt to outperform the overall market. As a result, many mutual funds have high fees, which can impact the overall return compared to the extremely low fees that index funds have. Historically, broad-based index funds have outperformed mutual funds in the long-term.
Exchange-Traded Fund (ETF)
ETFs, or exchange traded funds, are very similar to index funds because they passively track an index, or large basket, of stocks. The primary difference between the two is how they're traded on an exchange. If you make an order to purchase an index fund during trading hours (the time the stock market is open), then your trade will automatically be executed at the end that trading day, regardless of what time you made the order. However, with ETFs, if you make a purchase at 10am, you will buy the ETF at whatever price it was at 10am. The same is true with selling. If you sell an index fund, then it will complete the order at the end of the trading day. Selling an ETF will execute the order immediately (assuming it's s standard market sell order).
Because broad-based index funds and ETFs have numerous individual stocks inside them, they are usually the best type of investment for diversification in a portfolio. Additionally, since they're passively managed, if one company underperforms or fails to meet the index funds' criteria, it'll be removed and replaced with one that better meets the expectations. This is a great pro to many passive investors because you don't have to manually remove a specific stock in your portfolio and then spend countless hours researching one that'll replace it.
I am not a financial advisor and this is not financial advice. This is simply for entertainment purposes only where I share my personal insights regarding personal finance and investing. Keep in mind that investing carries risk and make sure to do your due diligence before you place any trades.
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