Stock Market Basics: Understanding How To Invest Part 3

Hey everyone! I thought it would be interesting and fun to start a series on stock market/investing basics for people that are just starting out. I know firsthand how scary everything can seem and it’s easy to get overwhelmed with so much information. So, I just wanted to break down the basics into an easy to understand series. Click here to get part 1 of this series and click here to get part 2.

In part 2 of the series, we discussed stock indices and key financial terms you should know when reading a stock quote. In part 3 of this series we’ll go over building portfolios and indexing.

Building A Portfolio

A portfolio is a just a fancy term for a collection of stocks, bonds, real estate, and other investments. The purpose of an investment portfolio is to grow wealth and maintain it throughout retirement.

When creating an investment/retirement portfolio, diversification should be a key consideration. You’ll want exposure to many different asset classes such as cash, stocks, bonds, commodities, real estate, and others.

The level of diversification needed in a portfolio is really dependent on your investing needs, risk appetite, liquidity, and other factors.

Here are a few things to keep in mind. Stocks and commodities are typically the most volatile asset classes. Bonds and fixed income instruments are typically the safest.

As a result, only include a higher equity allocation if you have a higher risk appetite. For younger investors, I would recommend putting a higher equity allocation because you’re still growing your wealth/portfolio.

For example, a young investor’s portfolio might consist of:

70% stocks

30% bonds

As you get older, the focus might shift from building wealth to keeping it safe. As a result, older folks typically shift into safer investment categories such as fixed income.

In contrast, an older (and more conservative) portfolio might consist of:

40% stocks

30% bonds

20% real estate

5% cash

5% commodities

The idea behind diversification is simple. Each asset class or stock market sector have different risks and economic cycles. By getting broad exposure to each category, you can offset weakness in one asset class with strength from another.

A key part of monitoring your portfolio is rebalancing. Over time, your target asset allocations will begin to change for better or worse as prices go up and down.

For instance, if stocks rally for the year, your equity allocation may now be 50% of your net worth instead of your target of 40%.

Rebalancing is important to make sure your target asset allocations are in place. I would suggest rebalancing on a quarterly, semi-annual, or annual basis to make sure everything is in order.

Mutual Funds and Index Investing

If you don’t have time to actively invest in stocks, mutual funds or index investing is a great strategy.

A mutual fund is an investment vehicle where money is collected from many different investors to invest in stocks, bonds, or other assets. A mutual fund’s shares can be bought and sold on a daily basis like any other public stock.

Mutual funds are operated by money managers who invest the fund’s money in order to generate returns for the shareholders.

A mutual fund’s portfolio is structured and managed in accordance with the fund’s objectives (as disclosed in the prospectus).

Mutual funds charge investors a fee known as the “expense ratio” for managing their money. The expense ratio consists of an advisory/management fee and administrative costs.

It is essentially the fee you are paying to hire the investment professional to manage the mutual fund portfolio.

You can check out what the expense ratio is in the fund prospectus. 

An exchange traded fund (or ETF) is a somewhat new financial product. It is a marketable security that tracks an index, commodity, or group of bonds.

The ETF trades on a stock exchange like shares of individual companies. Most ETF will track an index like the S&P 500 or the Dow.

Due to the passive nature of indexed strategies that ETFs follow, their expenses are typically lower than mutual funds. This makes them an attractive alternative for individual investors.

Be Careful Of Fees

When investing in mutual funds, ETFs, and other financial products, be very careful and monitor fees.

A fund that charges 1% of assets each year may not seem like much.

However, with the power of compound interest, those fees can add up over time. Say you invested $10,000 into a fund that earns 5% a year. That 1% fee will cost you $1,487 after 10 years and $4,622 over 20 years!

To track fees, I highly recommend using Personal Capital. Not only does it have a lot of great tools for tracking spending and saving, but it has a great mutual fund/ETF fee tracker.

Just enter a ticker symbol into the fee analyzer and it’ll tell you how much fees are eating into your retirement.

Dollar Cost Averaging To Build Wealth

In my opinion, the best way to invest in an index long-term is to dollar cost average.

Dollar cost averaging means you set aside a fixed amount of money to buy an index on a regular basis.

For example, you can set aside $1,000 a month to buy a S&P 500 index. Most people implement dollar cost averaging on a monthly, quarterly, or semi-annual basis.

By investing the same amount over a long period of time, you will be buying the average return of the index. This strategy is great because it is easy to execute, requires no market timing, and is relatively stress free.

Final Thoughts

Alright, that’s it for this week. I’ll be brain storming about the next logical post for next week. I think it’ll have something to do with investing strategies.

Have a great weekend everyone! I’ve got a couple busy weeks as I prepare for my first vacation of the year 🙂