Investing for Beginners in Plain English
Learning to invest, or at least understanding how your money is invested, is a key component in personal finance. If you want to learn more about investing for beginners in plain English, you’ve come to the right place!
Before we get started, investing does have an element of risk associated with it. xUSD is a personal finance blog and articles are published for informational and educational purposes only. Nothing mentioned in this article should be seen as financial advice.
Investing vs Saving
The terms investing and saving are often used interchangeably as if they mean the same thing. The main difference is the risk involved.
Savings, such as putting money on a savings account is normally risk free but offers a very low return.
The intention behind saving money isn’t really to make money. It’s rather to put money away for a rainy day, or to save up to buy something.
Investing, such as buying stocks and bonds are more risky than saving but can offer higher returns.
The intention behind investing is to make money. This can be to generate a passive cash flow, such with dividends, or a rental income from real estate. It can also be for capital gains, such as when the value of assets increase.
Risk vs Reward
The general rule of investing is the higher the risk, the higher the potential return should be.
Notice I am saying “should be.” In reality, it can happen that lower risk investments can outperform higher risk investments, especially over the short term.
Investing for Beginners - Key Considerations
Take the following factors into consideration in your investment decisions:
- Start investing as soon as you can – The sooner you start investing the better. Investments often require a long-term approach. If you wait too long before you start investing you may not be able reap the full benefits.
- Passive vs Acting Investing – Passive investing has a long-term horizon and follows a buy and hold strategy. Active investing has a short-term horizon and follows a buy and sell strategy. For more information, see the article on passive vs acting investing.
- Remember to save as well – Investing is not an alternative or replacement for saving money. You should still put money aside to save for a rainy day or for something you want. If you need money urgently, you can’t always cash-in your investments at short notice. And, even if you can, it may not be a good time to do so.
- View investments as a long-term plan – Don’t invest money you’ll be needing over the short term. If you need your investment back within the next couple of months, rather put the money on a savings account.
- There are no guarantees – Accept the fact there are no guarantees you’ll make money from your investments. The best you can do is to make informed decisions. Feel free to get professional advice but do your own homework as well.
- Know your appetite for risk – Don’t invest in high risk investments if you can’t afford to lose money, especially over the short term.
- Diversify – Don’t put all your eggs in one basket. If you have exposure to several different investments you’ll be able to spread your risk.
- Stocks and bonds are not the only investments – Many people automatically think of the stock exchange when they think of investments. You do have some other options as well, as you’ll see later in this article.
- Never borrow money to invest in paper assets – Don’t borrow money to invest stocks, bonds, currencies, and derivatives (futures & options).
- Never stop learning – This doesn’t only apply to investing for beginners but also to experienced investors. There’s always something new to learn that can benefit your wealth creation efforts.
- Taxation – Taxation is an important topic to consider before making any investment. Familiarize yourself on how you’ll be taxed before you invest. Remember, even if you invest in something that has tax advantages, this may be offset due to historically lower returns.
- Fees and costs – Don’t forget the importance of fees as costs. As you’ll see in the below example, it should be one of your main considerations.
The following charts are courtesy of the U.S. Securities and Exchange Commission.
It shows a $100,000 investment portfolio with a 4% annual return over 20 years. Notice the impact ongoing fees of 0.25%, 0.50%, or 1.00% have on the portfolio over 20 years.
In 20 years, 0.50% annual fees reduce the portfolio (red line) by $10,000 compared with a 0.25% annual fee (blue line).
In 20 years, 1.00% annual fees reduce the portfolio (green line) by nearly $30,000 compared to a portfolio with a 0.25% annual fee (blue line).
In 20 years, the total amount paid for a 1% annual fee adds up to almost $28,000. If you were able to invest that $28,000 you would have earned an additional $12,000.
Investing 101: Investments for Beginners
Here are 10 of the most popular investments for beginners. I’m calling it Investing 101 but that doesn’t mean it’s only meant for beginners. Many experienced investors invest in exactly the same things.
1. Investing in Mutual Funds
Mutual funds are very popular with new investors. There are thousands of mutual funds in the United States. According to statistics, well over 40% of all American households have mutual funds.
What are mutual funds?
A mutual fund is a managed fund that receives money from many different investors. It invests money in securities such as stocks, government bonds, and corporate bonds. This gives investors that buy shares in mutual funds exposure to a large range of securities.
Mutual funds offer you the opportunity to diversify your investments, and risk. This way you don’t “put all your eggs in one basket” like when you invest directly in one stock.
Note: Investors don’t own shares of the fund’s holdings or underlying investments. They own shares of the fund itself.
How to buy & sell mutual funds
Investors buy shares in a mutual fund directly from the fund or through an approved broker. Shares are not bought from other investors. The sales price is calculated based on the net asset value of the fund plus any applicable fees.
Shares can be sold back to the fund at any time. Payment is usually made within seven days.
Note on taxes: Interest, dividends, and capital gains are taxable. Income from government bonds and municipal bonds are generally tax-exempt.
The largest mutual fund companies in the United States, based on assets under management (AUM), are:
– BlackRock Funds
– Charles Schwab
– Fidelity Investments
Types of mutual funds
The most common types of mutual funds are:
Fixed income funds
The fund mainly invests in bonds, which is generally less risky than stocks.
The fund mainly invests in stocks, which is normally more risky than bonds but offer higher potential returns.
Balanced / multi-asset funds
The fund mainly invests in stocks and bonds.
Note: A high stock vs bond ratio such as 70 / 30 can potentially offer better returns than a low ratio. However, the higher the ratio in favor of stocks, the higher the risk.
Mutual fund returns
A common question is: “How much can I expect to make by investing in mutual funds?”
Since there are thousands of mutual funds it’s not really possible for anyone to answer this question. There are simply too many variables.
Most mutual funds will be willing to share their returns with you over a 1-year, 5-year, and longer period. However, this doesn’t mean the fund will continue to deliver the same or better results in the future.
Let’s look at a practical example:
Vanguard Balanced Index Fund (VBIAX)
As of 06/30/2020 this fund had net assets of $44.3 billion.
Asset allocation: 58.65% in stocks, 38.50% in bonds, and 2.85% in short-term reserves.
Since its inception in 2000, this fund has had an average annual return of 6.42% (before tax).
In you look at the long-term pattern over a 20-year period, this mutual fund has delivered good results. However, you’ll also notice many short-term fluctuations. For example, it took the fund about 3,5 years to return to it’s high reached in October 2007. It only reached that level again in April 2011.
Mutual funds can deliver great returns over the long-term. However, based on the above example, it’s very difficult for anyone to tell you how any mutual fund will perform in the future. The best they can do is show you the historical performance of the fund.
2. Investing in Exchange-Traded Funds (ETFs)
ETFs or exchange-traded funds are one of the most popular investments for beginners.
They combine the trading flexibility of a stock with the diversification benefits of a mutual fund. ETFs, like mutual funds, pool money from investors to invest in stocks, bonds, or other assets.
The best way to understand ETFs is to know how they are different from mutual funds.
Mutual Funds vs ETFs
- Buying & Selling – Mutual funds are bought directly from the fund or an approved broker. ETFs are traded on a stock exchange and are bought & sold the same way you would buy or sell shares.
- Trading Hours – Mutual funds only trade once a day after the markets close. ETFs prices fluctuate during the day as they are bought and sold throughout the trading day.
- Share Price – Mutual funds are traded based on the net asset value (NAV) of the assets in the fund plus any fees. ETFs are traded at market prices that aren’t necessarily the same as the net asset value (“NAV”) of the shares.
- Taxation – ETFs are normally more tax efficient than mutual funds as it has fewer capital gains distributions. However, the structure of the ETF and what it invests in will play a role in how tax efficient a fund is. With the exception of most government and municipal bonds, interest, dividends, and capital gains are taxable.
Types of ETFs
There are generally two types of ETFs, namely:
The vast majority of ETFs are index-based ETFs. They invest primarily in the securities of an index, such as the S&P 500.
Actively Managed ETFs
Actively managed ETFs invest in stocks, bonds, and other assets.
3. Investing in Index Funds
Investing in index funds is one of the best investments for beginners.
Index funds are available as mutual funds and ETFs. They invest in stocks listed on an index such as the S&P 500. Their goal is to try to match the index’s return.
There are very few managed funds that are able to outperform index funds. Index funds also have very low fees compared to other funds.
Here’s a short video from Tony Robbins who’s a strong advocate of index funds.
Earlier in this article we used Vanguard’s Balanced Index Fund (VBIAX) as an example.
This is how it has performed compared to the S&P 500:
$10,000 invested in Vanguard’s Balanced Index Fund in July 2010 would have grown to $25,665.63 by July 2020. However, $10,000 invested in the S&P 500 over the same period would have grown to $36,557.64. That’s a massive difference!
Vanguard, like other companies, do have index funds in their range of mutual funds and ETFs. Let’s have a look at how well Vanguard’s S&P 500 ETF (VOO) performed compared to the S&P 500.
As you can see from the above graph, Vanguard’s S&P 500 ETF has been very successful in following the performance of the S&P 500. The difference is only $101.01 based on $10,000 invested over a 10 year period. Quite impressive!
4. REIT (Real Estate Investment Trust)
No discussion on investing for beginners can be complete without covering REITs or Real Estate Investment Trusts. It’s estimated about 87 million Americans own REITs through retirement savings or other funds, such as mutual funds and ETFs.
What is a REIT?
Congress established REITs in 1960. Through a REIT individual investors can invest in income-producing real estate, without the hassle of buying property.
The majority of REITs are traded on a stock exchange. However, there are also public REITs that are not traded on a stock exchange, and private REITs.
REITs fall under two broad categories, namely:
1. Equity REIT – Generates income from rent and from the sale of properties.
2. Mortgage REIT – Generates income from mortgages or mortgage securities.
Here is a short video that explains how REITs work:
- Pay out at least 90% of its taxable income annually as dividends.
- Invest at least 75% of its total assets in real estate assets and cash.
- Derive at least 75% of its gross income from real estate related sources. This includes rental income, and interest on mortgages.
- Derive at least 95% of its gross income from real estate sources, and dividends or interest from any source.
- Have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.
Pros and Cons of REITs
The main advantages of a REIT include high-yield dividends, hedge against inflation, and good diversification. It can reduce the volatility often associated with a traditional stocks & bonds portfolio.
With REITs your focus should be on earning dividends and not really on capital growth. A REIT pays out between 90% and 100% of its annual taxable income as dividends. This means most REITs don’t have sufficient retained earnings they can reinvest for future growth.
A REIT has to raise equity or issue debt in order to expand. Equity is normally raised by issuing new shares. This can have a negative impact on its share price.
For example, it’s common for a company with large cash reserves and limited investment opportunities to buy back its own shares. As a result, the value of the remaining shares will increase. In the case of a REIT, issuing new shares can lead to a drop in the share price.
Note: REITs require a long-term investment horizon.
REITs and Taxes
The majority of pass-through income, such as REIT dividends are taxed as ordinary income. The Tax Cuts and Jobs Act of 2018 added a 20% deduction for Section 199A dividends, which includes REITs.
The current maximum rate for ordinary income is 37%. After the 20% deduction, the highest effective tax rate on REIT dividends is 29.6%.
Investing for beginners shouldn’t be hard or complicated. Robo-advisors have become increasingly popular in recent years. They make it easy for beginners to start investing in securities with little money. And, they generally have a low fee structure.
Most robo-advisors invest in exchange-traded funds (ETFs).
What is a Robo-Advisor?
Robo-advisors collect information from clients using an online questionnaire or survey. They use this information to offer advice on how a client should invest their funds. It’s based on the financial position of the client as well as their investment goals and risk profile.
Their recommendations are mostly automated based on the algorithm of the robo-advisor’s platform, with little to no human interaction.
Some of the best, most popular robo-advisors, include:
6. Peer-to-Peer Lending
I had some doubts whether or not to include peer-to-peer lending for investors in this article about investing 101. Peer-to-peer lending isn’t suited for all beginners. In the end I decided to briefly cover it, even if just for educational purposes.
Peer-to-peer platforms connect people who want to borrow money with investors who are prepared to lend them money. Many of these platforms only accept accredited investors.
Even those that don’t only accept accredited investors have limitations imposed on them. These limitations, at mostly state level, cover who may invest, and how much they can invest.
One of the best peer-to-peer platforms that welcome non-accredited investors is Prosper.
Note: I previously mentioned Prosper and LendingClub. However, the LendingClub Notes platform retired on December 31, 2020.
Prosper requires a minimum investment of only $25 to get started. The investment horizon is between 36 months and 60 months. Historical returns average 5.1% per year.
You can explore available loans and select ones based on risk vs possible return. Loans are rated from AA (lower risk, lower return) to HR (higher risk, higher return).
Before you can become an investor on Prosper you need to comply with certain suitability requirements.
7. Gold as an Investment for Beginners
Investing in gold, especially during times of economic uncertainty, can be a good investment for beginners. It’s a way to diversity your investment portfolio. Gold has the reputation of being a safe haven in times of political & economic turmoil.
As can be seen from the below chart, the price of gold can be very volatile though. It can quickly shoot up, but can also drop just as fast. It should never be the main focus of your investment portfolio.
How much should you invest in gold?
There isn’t consensus among experts of how much of your investment portfolio should be invested in gold. Opinions vary between 2% and 20%. Most experts agree however you should have some exposure to precious metals, especially gold.
In my opinion, during times of relative economic stability, 2% to 5% of your investments should be in gold. In times of economic uncertainty, I would increase this to between 5% and 10%. As economic indicators start improving I would reduce my exposure back to between 2% and 5%.
If you’re interested in investing, GoldBroker offers you direct ownership of gold and silver. Below is a short video explaining how this works.
8. Investing in Real Estate
Is real estate investing for beginners? Absolutely! Real estate is one of the best investments for beginners, and experienced investors. Most real estate investments are done for only two reasons, namely:
1. Capital gains.
The typical business model for capital gains works like this:
Buy a property that needs work done to it in a good area, below its market value. Fix it up, and sell it for a profit.
2. Passive income.
The typical business model for passive income works like this:
Buy a property that may or may not need work done to it, below its market value. Rent it out.
Benefits of Investing in Real Estate
The main benefit of investing in real estate is you can use gearing (other people’s money) to increase your wealth. Let’s look at a practical example:
If you deposit $10,000 in a savings account, you’re only paid interest on $10,000. If it’s a high-yield savings account paying 1% interest per year, you’ll receive $100. You have no gearing. You only earn interest on the money you’ve deposited.
Now let’s assume you buy a house for $100,000 and put down a 10% or $10,000 deposit. It means you owe the bank $90,000. If you sell the property for $110,000 and pay the bank the $90,000 you owe them, you’re left with $20,000. (I’ve excluded fees to keep the example simple)
You have effectively increased your $10,000 investment by 100% to $20,000. This is despite the fact the value of the property only increased by 10% from $100,000 to $110,000.
This is an example of good debt where you can use gearing to increase your wealth!
If you buy and sell you can make money from capital gains, as per the above example.
If you buy and rent out the property you can earn passive income from rent. And, as the value of the property increase, you also benefit from capital gains.
Resources for Real Estate Investors
Here are some resources that can help you get started if you’re a beginner.
BirdDogBot.com is a search engine for real estate investors and wholesalers. It can save you a lot of time finding good deals.
Foreclosure.com gives you a head start in finding foreclosures you may be able to acquire at a good price.
Udemy has some great real estate courses. The above course on single family rental houses is a very good course for beginners. It covers buying a property for rental income.
9. Investing in a Franchise
Investing for beginners isn’t only limited to investing in paper assets, gold, and real estate. Buying a carefully selected franchise can give you a good return on your investment. And, you don’t always need to be actively involved so it can be a great passive investment.
Ever thought about investing in a laundromat?
According to Speed Queen, laundromats in the U.S. have an average cash-on-cash return on investment (ROI) of 20% to 35%. They have a success rate of nearly 94.8%. The best part is that the majority of laundromats only have 0 to 3 employees.
Note: I am not suggesting you should invest in a Speed Queen franchise. I am just using it as an example of what’s possible.
10. Invest in a Website
Investing for beginners can include investing in an online business, such as a website. In fact, buying a profitable website can be one of the best investments for beginners.
As a rule of thumb, a website can be bought for around 20 to 30 times of what it makes every month. For example, a website that makes $100 per month can be bought for between $2,000 and $3,000.
This will give you a gross annual return on your investment of between 40% and 60%!
One of the best platforms to buy a website is Flippa.
Flippa.com is one of the largest, most popular platforms for buying & selling websites.
Investing in a website can be risky if you don’t know anything about managing a website.
Here are a couple of things to look out for:
- Monthly running costs – At the very least, a website has to pay for hosting. Find out how much hosting the site will cost and if there are any other monthly expenses. You want full control over hosting, and the domain name should be transferred to you.
- How is the site monetized? How does the site earn money? Is this something you’ll be able to take over and manage?
- Where does the site traffic come from? The best answer is free organic traffic from Google. You don’t want to post on social media every day to get visitors to your site. Ask for a Google Analytics traffic report to view the sources that send traffic to the site.
- How much traffic does the site get? Be careful of sites that get little to no traffic and then have a sudden traffic spike. You want to get a regular stream of monthly visitors.
- How much time do you need to spend on the site every week? You don’t want to invest in a site that requires a lot of your time. You’re looking for passive income.
- What’s the income history of the site? You want a website with a successful track record. You want to see consistent earnings and not only the earnings for one or two months.
Investing for beginners involves some risk and will require a learning curve. However, it can be very satisfying knowing you’re doing something your future self will thank you for!
If you have a lot of high-interest debt such as credit card debt, you should consider “investing” in yourself. For example, assume you owe $10,000 on credit cards and have to pay a minimum of 2% every month. That’s $200 per month, or $2,400 per year.
Clearing your $10,000 credit card debt and saving $2,400 per year is nearly like getting a 24% return on $10,000. I am not suggesting you shouldn’t invest until you’ve paid all your debts. Do take care though of high-interest debt such as credit card debt.
I really trust you’ve found this article on Investing 101 – Investing for Beginners informative and helpful. What investments appeal to you the most, and why? Let me know in the comments.