Making Your First Investments

You may already be investing through your retirement plan at work, but at some point you may have funds you want to invest on your own. This article focuses on some simple issues you should consider and provides details on how to take that step.

The decision to invest

Investing is really only done for one reason – you want to earn more on your funds than you can by leaving your money in your savings account or in insured Certificates of Deposit at your bank or credit union.

Investing in stocks (equities) or bonds (fixed income) involves risk. There is the risk that the value of stocks you own may go down, as well as the risk that bonds may stop paying interest, may not be repaid at maturity, or that their values may decline while you own them. You decide to take those risks in the hope that the higher return (more than what you can get on a CD) justifies the risk.

It does not always work out that way, but over time, the average returns of equities and fixed-income investments have been better than those of lower-risk (or guaranteed no-risk) ways of investing. However, the year 2008 was a bad one for stocks, with the S&P 500 index falling 38%. Here is some information to help you put the risk/return consideration into perspective.

How does investing work

The actual mechanics of investing can be a bit complex, mainly because different types of investments are handled differently and because there are different types of companies you can invest in. Here are some of the basics:

Buying stock through a stockbroker – You tell your broker to buy 100 shares of XYZ stock at a specified price. The broker sends the order to the New York Stock Exchange (NYSE), where it is executed very quickly (usually within seconds or minutes). If the stock is traded on NASDAQ (in the over-the-counter market), the broker sends the order to a trading desk, where it is executed.

Buying a stock online without a broker – You provide the details of the purchase online, and the order is sent to the NYSE or a NASDAQ trading desk, and the order is executed.

Buying a mutual fund through a stockbroker – You tell your broker to buy a certain number of shares or a certain dollar amount of a mutual fund. The broker sends the order, and the order is executed at that day’s closing price.

Buying a mutual fund directly from the mutual fund company – You can usually do this over the phone or online, with the order executed at that day’s closing price.

Creating a beginning investment strategy

First, understand that investing should be a long-term process. Markets fluctuate, so you should aim for a 5- to 10-year time horizon for your investments. That is not to say you should hold all your investments for that long, but if you expect to need your investment funds in the near term, perhaps you should keep them in more liquid, safer forms.

Next, you should practice diversification. Diversification means not putting too much of your money into any one investment. Many professionals suggest that you own stocks in at least 5 industries, with 2 or 3 stocks in each industry. That way, you are not overly exposed to any one part of the economy or any one company.

You should also consider how you divide your investments among different types of investments. The way you divide your investments among stocks, bonds and cash is called asset allocation. It can serve as a logical starting point for your investment strategy. Individuals should base their asset allocation on their time horizon and risk tolerance. Here are some sample allocations by age.

Sample Asset Allocations

You will note that the chart shows younger individuals holding more stocks, with the percentage decreasing over time. This is only logical. While you are younger, you can take a longer-term approach – you have more time to recover from declines in your investments and more time to participate in the long-term performance trends of different types of investments.

The numbers in this chart are only sample guidelines, and you may want to vary from them depending on your feelings about risk and other aspects of your situation.

Deciding what to buy

Choosing individual stocks to buy is often the most difficult part of investing. You want to buy stocks that will increase in value, but there are no guarantees. Thousands of professionals spend their entire careers trying to find those winners. Many books and evaluation services are available to help you make better choices.

Another way to invest in equities is through mutual funds. The concept of a mutual fund is quite simple. A mutual fund is a company that invests in other companies. You buy shares in the mutual fund. Your money is pooled with the money of other investors, and the mutual fund buys a diversified portfolio of stocks or bonds of other companies. The investment manager, or portfolio manager, is responsible for the fund’s buy, sell, and hold decisions.

Your benefits include distributions the fund makes from interest or dividends it receives, as well as distributions of the fund’s realized capital gains. You can usually have any distributions paid to you in cash or reinvested in additional shares. You also benefit from rising mutual fund share prices if the values of the underlying portfolio rise. However, if the value of the underlying portfolio falls, the value of your mutual fund shares will fall as well.

Most libraries have information on mutual funds, and you can find information on most mutual funds on their websites. As with individual stocks, some will perform better than others. Even the best-managed mutual fund will probably decline in value if the overall stock market falls. Although past performance is no guarantee of future results, be sure to examine a fund’s performance and expense level before you consider buying it.

Monitoring your investments

Along with monitoring how your individual investments are performing, you should also review your asset allocation on a periodic basis to make sure it still matches your objectives. You may have added more funds to certain sectors as you get older, and your risk tolerance can change. Usually, an annual review is enough. Rebalancing generally makes sense if your actual allocation has deviated more than 5% from your objective.

You may want to consider reviewing your asset allocation every six months. Here is a chart to help. Be sure to include all your investment assets.

Compare these allocation percentages with your current asset allocation. Using asset allocation can help provide some discipline to your investment strategy.

This article is meant to be educational only. Every individual must consider his or her specific situation when making investment decisions. The services of a qualified professional can help in this process. Remember, past performance is no guarantee of future results.