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The Foundations of Investing in the Stock Market: Part 3

Now that we’re done with Part 1 and 2 and understand the WHY and the WHERE of investing, it’s time to move on to the sexy stuff!  HOW do we actually invest? 

First, we’ll need to understand the investment options.

For long term goals like retirement, most people will invest in stocks, bonds, or real estate.  I’m going to focus on the stock market in this post, real estate later (yes, there are REITS that you can buy on the stock market, but let’s keep this simple for right now).

When I first started looking to investing, I did a deep dive on stocks and bonds and what they’re all about.  But, all of that really isn’t necessary.  If you are interested in the deep dive, I recommend: The Simple Path to Wealth by JL Collins and The Little Book of Common Sense Investing by John C. Bogle.   If you’re not interested in the deep dive, here are the Need to Know’s.  

Investment Options

What is a Stock?

When you buy a stock, you are buying part ownership of that company.  You will get a percent of the future revenue to the company. If the company does great, so do you.  If it goes under, so does your money. So, stocks are risky, but generally give good returns. Stocks generally go up when the market goes up.

What is a Bond?

Bonds are loans you give to a specific entity or company.  The loan is guaranteed to be paid back with a certain amount of interest.  Think, student loans. So, bonds are generally less risky.  The cost to buy bonds usually goes up when the market goes down and stocks fall.  

What is a Mutual Fund?

Actively managed (read: high cost) collection of investments directed by a fund manager.  You basically give the fund manager your money, and he or she invests it.  The fees for mutual funds are usually high because of the need for a fund manager and the costs associated with actively buying and selling stocks. Here is a good video about mutual funds. 

What is an Index Fund?

A low cost (frugal!) collection of stocks or bond designed to mimic the gains of an overall index like the S&P500, WITHOUT active management.  Many believe actively managed funds do not beat the average returns gained from an index fund.  

What is an Exchange Traded Fund (ETF)?

A cross between an index fund and a stock.  A diversified, low cost collection of assets that are traded daily.   Here is a good video about ETF’s.

Your Portfolio and Asset Allocation

For one couple’s “portfolio”, or the total investments a family has, it is generally recommended to have a certain percentage of stocks (for growth) and a certain percentage on bonds (for stability).  I.e. 80% stocks/ 20% bonds or 60% stocks/ 40% bonds. This is called an asset allocation.  

The general rule of thumb is percentage of bonds= Your Age.  So, a 20 year old has 80% stocks, 20% bonds. If you want to be more aggressive, have more stocks than the above rule.  Want to be less aggressive?  Have a higher percentage of  bonds.

See, not that hard, right? If you can calculate the specificity and sensitivity of a diagnostic test, you can do this.

Once you know how you want to allocate your investments, you simply log into your 401k or IRA and go to investment options to choose investments.

See, not that hard, right? If you can calculate the specificity and sensitivity of a diagnostic test, you can do this.

Once you know how you want to allocate your investments, you simply log into your 401k or IRA and go to investment options to choose investments.

Choosing Funds

Target Date Funds

Choosing investments can be intimidating.  Each retirement plan and company will have different options.  

An easy way to put your investments on autopilot is by investing in target date funds.  Basically, you select when you want to retire, and the fund managers do the investing and rebalancing for you.  

The problem with these is that if you have 3 different accounts, you have 3 different target date funds that don’t know about each other, so you can get unbalanced.  Also, the costs for these can be higher (you pay for convenience).

If you’re just interested in getting average returns (and many studies show that active traders generally do not surpass average returns in the stock market due to the costs of buying and selling), here is an easy hack.

Index Funds

When choosing investments, you could gamble and consult your crystal ball to find that one stock that will make you rich.  But, you don’t need to do that. 

If you want average returns, simply invest in the investment designed to produce average results- index funds.  For example, VTSAX is a stock index funds that contains several stocks in several companies (some theorized winners, some theorized losers). The returns from this group are designed to return what the S&P 500 will do on average over time.  

All we need to do is buy a share and hold it for several years, and we will likely get average 7-10% returns. Yes, the market will go up and then will go down, but as long as we don’t freak out and sell, we’ll get average returns once the market goes back up.

Many Bogleheads recommend a 3 fund portfolio: one total domestic stock market index fund, one international index fund, and one total bond market index fund- and you’re done!

Sure, you can get more complicated but the gains from that are questionable.  

Remember to look at Expense Ratios

The biggest hit to your returns will likely be the expense of investing.  An expense ratio tells you how much of your money will be used to maintain your investment.  Low cost index funds usually have expense ratios of 0.04% to 0.1%. 

If you can keep your costs low, you will come out ahead.  

Stay Frugal, Y’all!


Standard Disclaimer: Not meant as individualized medical or financial advice.

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