Investing can be a scary task for someone new to the world of finance. But despite what some Wall Street experts will tell you, many investment concepts are actually easy to grasp. With just a bit of study, it is possible for a newbie to understand the basics. In this article, we will examine some of the fundamental types of investments. We will also look at the more common account types.
Investing for Beginners: Basic Investment Types
There is a wide universe of investment products from which to choose. But beginners should probably focus on understanding the following:
- Common Stock. A common stock is an ownership share in a publicly traded company, like Apple or Wal-mart. Stocks are easy to buy and sell. And stock markets are transparent and well regulated. It is simple to research a stock investment thoroughly before you buy. Online brokers offer low commissions. Although stock gains can be unlimited, keep in mind that it is possible for your stock investment to go to zero.
- Bonds. You are lending money to the issuer when you buy a bond. In exchange, they pay you interest over a set period. You get your principal back once the bond matures. Bonds can be vary in maturity length, from 90 days to 30 years. Corporations, municipal governments, or federal governments issue bonds. You can buy bonds through your broker. It is possible to lose all your money in bonds if the issuer goes bankrupt, like Enron or WorldCom.
- Mutual Funds. A basket of investments, usually run by a professional fund manager. Most try to beat an index and so they have higher fees. Mutual funds can invest in stocks, bonds or money market assets. Mutual funds are less liquid, they trade only once at the end each business day. It is worth noting that many actively managed mutual funds often fail to beat their index.
- Exchange Traded Funds (ETFs). An ETF is a basket of investments that trades on an exchange like a stock, with the diversification of an index fund. ETFs have become very popular with individual and institutional investors. They offer a low-cost and liquid way to invest in a wide variety of asset classes. It is also possible to buy as little as one share, sell short, or write options on ETFs.
- Index Funds. An index fund can either be an ETF or a mutual fund. This type of fund mirrors an index rather than trying to beat it. I recommend building a diversified portfolio using index ETFs. They have lower expense ratios when compared to mutual funds. And index ETFs beat actively managed funds. Since they have no share minimums, they make it easy for small investors to get started. Index ETFs are a good way to build your wealth over time.
These are the building blocks for proper portfolio management. Make sure you understand these basic investments before moving on to products that are more sophisticated.
Investing for Beginners: Basic Account Types
You have two main choices when it comes to investment accounts, taxable and tax-sheltered.
There are now 14 different types of tax-sheltered retirement accounts available. Let us examine three of the more common retirement accounts:
- Traditional IRA. An individual retirement account allows investors to set aside income that grows tax-free. You can use traditional IRA contributions to offset your taxable income. Qualified withdrawals from this type of account are taxable, and early withdrawals are subject to penalties. The 2013 contribution limit for a Traditional IRA is $5,500.
- Roth IRA. A retirement account that is similar to a Traditional IRA, but with some differences. Contributions to a Roth are not tax-deductible, but you can pull the money out tax-free once you retire. A Roth is more flexible. You can sometimes withdraw from it without serious tax implications. The 2013 contribution limit is also $5,500.
- 401(k). If you have a corporate job, you are probably familiar with this type of account. A 401(k) is a tax-sheltered retirement offered by private employers. Your contributions are tax-deductible, meaning you can use them to lower your taxable income. In many cases, your employer will match your contributions. If your employer offers matching, you should take advantage because this is like free money. The 2013 basic 401(k) contribution limit is $17,500.
The alternative to a tax-sheltered account is a taxable cash account:
- Taxable Account. Taxable accounts have no contribution or withdrawal limits. Long and short-term capital gains, interest, and dividends are all subject to taxation in this type of account. Be mindful of gains when selling holdings. Consulting with an accountant is a good idea for those trading in a taxable account.
If you are new to investing, do not be discouraged or overwhelmed by the amount of information out there. Take the time to learn about the basics, and you will have solid foundation from which to build your knowledge. In later posts, we will explore taxes, alternative investments, and finding a broker. I hope you’ve enjoyed my Investing for Beginners guide.
