Now for the fun part: figuring out how your money can make money. One of the ways to do that is to start investing.
In the stock market.
Maybe you’ve got a friend in finance that’s tried to tell you how important it is. Maybe they even helped you pick your 401K investments. And maybe even despite all that, you honestly still have no idea what’s going on in there.
The idea of investing in the stock market is intimidating, I get it. There’s a whole other level of jargon that finance people seem to get hyped up about (I should know, I’m one of them), and it can feel like you need to know everything about it before you can even get started.
Well, I’m here to tell you you don’t need to know everything. In fact, if you can grasp a few fundamental basics about stocks, bonds, and asset allocation, you’ll be well on your way to setting up an investment account that works for you (read: makes you that money).
Stocks, you’re an owner; bonds, you’re a loaner.
Companies issue stocks and bonds as a way to raise money for the company to grow. The very first thing to understand is what a stock is and what a bond is, and why stocks are riskier investments than bonds.
Just the other day, I learned this amazing rhyme the from another financial planner to help you remember the difference: “Stocks, you’re an owner; bonds, you’re a loaner.” Rhyming is my favorite.
When you buy stock, you buy ownership in a company. If you buy Apple stock, you own a very, very, very (very) tiny part of Apple.
This means if Apple is in the news for any reason—like if a product flops, or they don’t make as much money as investment analysts anticipated—the stock could go up or down. It could also go down in a situation that has nothing to do with Apple, but based on how the stock market as a whole reacts to a global news story.
Because stock prices are sensitive to so many things, investing in stocks is considered riskier. It’s very hard to predict what the stock market is going to do on a daily basis. We can look at historical trends and try to predict how stocks will trend over the long term, but trying to look at your stocks every day could drive you a little crazy.
When a company issues bonds, they are choosing to raise money by borrowing it from investors. You purchase an Apple bond for $1,000 that will pay you 5 percent interest over the next five years. So after five years, Apple gives you your money back, plus the interest. Not too shabby, right?
Now let’s imagine that you want to cash out of your bond sooner than five years. Apple won’t buy your bond back before the designated time, so you see if someone else on the secondary bond market is willing to pay you $1,000 for your bond.
But now there’s a hitch in this hypothetical: Apple has issued another bond that’s paying 6percent interest. Uh-oh.
This means if you tried to sell your bond to someone else, you would have to discount the $1,000 you initially paid, because no one wants to buy a 5 percent-interest bond from you when they could get a 6 percent interest bond somewhere else.
If you decided to keep the bond, you would get your $1,000 back when the bond “matures” in five years. But it’s kind of a bummer knowing you missed out on that higher interest rate, no?
The main risks with bonds are buying them in a time when interest rates are low and locking in the bond for a long period of time. If you purchased a bond that had a 20-year maturity at 3 percent interest, you’d be stuck with that interest rate for 20 years, or else have to heavily discount it order to unload it should interest rates rise.
But the great thing about bonds is that the value of your bond isn’t beholden to what happens in the news or how well (or poorly) a product release goes. The bond market tends to act independently of the stock market, so it’s a good way to reduce the overall risk of your investments.
Why the heck did I just make you slog through all of that?
Two words: asset allocation.
By understanding how stocks and bonds work and what the risks are with investing in each of them, you have the foundation for understanding what asset allocation is, which is the basis for how all investment portfolios are built.
This is the simplest way to think of asset allocation: What percentage of your investments are in stocks and what percentage are in bonds? If you have significantly more stocks than bonds, your asset allocation is riskier, because as we just learned, stocks are riskier than bonds.
Asset allocation can get way fancier, though. You can play around with mix of large, mid-size, and small U.S. companies; you can invest in international stocks, corporate bonds and municipal bonds—all kinds of stuff.
The goal of a proper asset allocation is to make sure your investments are fully diversified—that is, you’re not just invested in one kind of stock or bond.
Still stressed about it? Here’s even more good news: You don’t have to figure all of this out by yourself. Some very smart people have created what the industry calls “robo-advisors”—somewhat of a derisive term in the biz, but I love ‘em.
Basically, investment analysts at these robo-advisors have put together professionally managed asset allocation models that are invested in a bunch of different index funds (which are just big containers full of thousands of stocks and bonds).
By having your money in a handful of different index funds, you’re not investing in 10 different stocks and bonds, you’re investing in literally 10,000different stocks and bonds.
The percentage you’ve invested in each index fund is what makes up your asset allocation and determines how much risk you’re taking with your investments.
Another big thing to consider: When you’re young, risk is good! If you have 20 to 40 years to invest, you most likely want to have your investments in significantly more stocks than bonds. The ratio of stocks-to-bonds is going to be based on how long you plan to keep the money invested (your “time horizon”) and how comfortable you are with risk (your “risk tolerance”).
As you get older or as you get closer to needing to use the money, you’ll want to dial down the risk so the value of your investments stays mostly intact when you need to access it.
And that’s all there is to it! Sort of. There is, of course, much more to investing if you’re looking to dive deeper. But for the average investor, as long as you understand these fundamentals, you can create an investment portfolio that you understand, will grow with you, and stand the test of time.