Investing is the key to growing your money and meeting long-term financial goals. But it’s not easy to understand: there are lots of options, jargon and competing advice out there.
There are many ways to invest, but the best way depends on your needs and goals. This guide explains the basics of investing, how to get started and how to manage your investment portfolio.
What is Investing?
Investing is the act of buying financial assets in hopes they will grow in value and earn income, like interest or dividends. Investors can also choose to diversify their investments to help protect against risk.
Unlike savings, which is meant to provide immediate or short-term benefits, investing is long term in nature and seeks to increase wealth over time by appreciating in value and/or earning returns (like interest or dividends) compared to the initial investment. People often invest for big long-term goals, such as retirement or buying a home.
To invest, you need to open an investment account, such as a brokerage or retirement account, and fund it with cash that can be used to purchase securities, or shares in publicly traded companies, bonds or exchange-traded funds. To minimize your investment risk, it’s typically best to start small with a plan to invest regularly over time, a strategy known as dollar cost averaging. The types of investments you choose depend on your desired return and how sensitive you are to risk.
Asset allocation is the process of dividing your investment portfolio among different asset classes. These include stocks, bonds and cash (or cash equivalents like money market funds or certificates of deposit). Each has a unique level of risk and return.
The goal is to create a diverse portfolio that minimizes risk and maximizes returns given your personal financial goals and tolerance for risk. This is an incredibly complex and highly personal decision.
A common framework is to divide your portfolio into three broad categories: growth-oriented investments, income-oriented investments and cash or cash equivalents. Within each category, you can further diversify by industry, company size, geographic region and duration. It is important to periodically rebalance your portfolio, as over time some investments will grow faster than others and may become out of alignment with your original asset allocation. This means selling off over-weighted assets and purchasing investments in under-weighted categories. Also, the more diversified your portfolio, the less volatility it is likely to experience.
While investing can help build your wealth, it comes with risks. Investing in the stock market may involve the risk of losing some or all of your initial investment. That’s why it’s important to know your tolerance for risk before you start investing.
Besides stocks, you can also invest in bonds and mutual funds, as well as exchange-traded funds (ETFs). Bonds are debt instruments that promise to pay interest on the principal at maturity. Mutual funds are pools of money invested in stocks and other assets. And ETFs are similar to mutual funds but trade on national stock exchanges.
Regardless of which investments you choose, you should consider how taxes will affect your returns. Savings held in cash lose purchasing power over time due to inflation, while investments that earn a return greater than the rate of inflation grow your money1. Ideally, you should incorporate investing into your long-term financial plan and see how it can help you reach your goals.
When you have some extra cash, beyond what you need for rent, utilities and debt payments, investing can be an excellent way to grow your money. But, you have to know where to invest your money, how much and for how long. This is known as your investment goal and time horizon.
You also have to decide how hands-on you want to be and if you will manage your own investments or work with someone else. You might even choose to use a robo-advisor that manages your portfolio for you.
Once you figure out where to put your money, there are several account types you can open and start investing. These include individual taxable brokerage accounts, retirement accounts (Roth and traditional IRAs), education and ABLE accounts, which are for saving for disability expenses. You can also invest in a mutual fund or ETFs, which are pools of investments. Each of these account types comes with advantages and disadvantages that you should consider.