TL;DR? Skip to Taking Action at the bottom.
There are a lot of options for investing, and they can seem daunting. Here’s a quick overview of the major ones and what they really mean.
When you buy stock, you are buying a portion of a company. As that company earns money and grows, they will return some of those earnings to you as dividends. Companies are a core part of how our economy works, and by owning them, you participate in the growth of our economy as a whole.
When you buy bonds, you are loaning money to the federal government (treasury or agency bonds), local government (municipal bonds), or a company (corporate bonds). The entity borrowing your money promises to pay it back along with some interest.
When you buy real estate, you own some of the housing, office, or retail space where people live, work, and shop. You participate in another big part of the economy through the rent you collect from your tenants.
You can also buy commodities, like corn, gold, or gasoline.
You can trade your dollars for other currencies, like euros or bitcoin.
Finally, you can buy and sell options, which are usually the right to buy or sell something specific (like gasoline) at a pre-arranged price (like $3.50 per gallon) at a future date (like next July).
Which Investments are Best?
So, which investment options are the best?
Critically, stocks, bonds, and real estate generate some income for you while you hold them. Companies return some of their earnings to you as dividends. Bonds pay interest. Real Estate generates rental income. Holding these investments means holding a part of our economy and getting some ongoing benefit as a result.
In contrast, when you hold commodities, currencies, or options, there is no automatic income. The only way you make money from them is if you sell them for more than you bought them for. For every buyer, there must be a seller. If you make money from them, someone else had to lose that money. Across the whole market, the overall profit from these investments is zero. In other words, these three categories are a zero sum game.
With stocks, bonds, and real estate, there are still buyers and sellers, and with prices going up and down, people can make and lose money trading with each other. However, in addition to that, there’s a positive sum game where the people holding these investments are also making a profit from the income they generate. If you buy the investments and hold them for a long time without selling them, any amount you over- or under-paid initially will be a lot less important than the income generated while you’re holding it.
For this reason, many experts recommend stocks, bonds, and real estate as the primary investments to hold.
Risk (or Volatility)
Ultimately, your goal when investing is to grow your money as much as safely possible over the long term.
Why do I say safely? Because investments go up and down in value (they are volatile). Suppose you own a house. You can sell that house, but the price you’ll get for the house changes over time. Maybe there’s a new housing development or many of your neighbors are selling, so prices drop. Maybe a new company set up in town, so prices rise as new people are trying to move to town.
Most of the time, the price doesn’t matter, because you are not anxious to sell your house or buy another one. Also, you have the same house you did last week, and the mortgage you’re paying isn’t changing. You’re getting the same house for the same money as you did before.
Stocks, bonds, and real estate are like a house. The prices fluctuate, but prices only matter when you want to buy or sell them. If you’re saving for retirement, you’re buying investments that you won’t sell for a very long time, so the long term trend of prices matters, but the week-to-week (or even year-to-year) ups and downs really don’t.
If you are anxious to sell soon (you’re investing for your daughter’s college next year), these fluctuations do matter. Don’t buy stocks or bonds with this money - choose an investment which doesn’t have big daily ups and downs, like a savings account or a CD (certificate of deposit) at a bank.
However, if an investment permanently lost value, like your house burning down, that would be a much bigger problem. Unfortunately, investments can experience losses like this, too. You can buy stock in a company which later goes bankrupt. You can lend money through bonds and then the borrower could default (fail to pay you back). You can buy real estate and it can burn down, or the town it’s in can enter a long-term depression.
So, how do you deal with this problem? Basically, “don’t put all of your eggs in one basket”. If you own stock in one company, you’ll lose everything if that company goes bankrupt. If you own a hundred companies, one may go bankrupt each year, but the others will likely grow enough to make up for it. If you own a hundred houses in different towns (and states), one house burning down or one town going into decline aren’t catastrophic. If you own a hundred different bonds, one defaulting is ok.
Mutual Funds and Index Funds
Ok, so stocks, bonds, and real estate are good categories to invest in, but you don’t want to put all of your eggs in one basket. How do you buy a hundred companies or houses with the money you have to invest? You buy a mutual fund.
Mutual Funds are where investors pool their money together and choose a manager to invest it for them. They allow people with a small amount of money to invest in a lot of different things easily. You can buy a US stock mutual fund which allows you to invest in all of the thousands of US companies with just $50.
Of course, the people who run mutual funds want to make money. They do this by charging you a percentage of your money to buy and sell the fund (a “load”) or every year (an “expense ratio”). This is fine, if it’s reasonable, but it’s common for some funds to charge drastically more than others.
In addition, the person who chooses the investments for the mutual fund could be good or bad at picking investments (or could be winning this year, but losing next year after you’ve invested).
So, ideally, you’d like to find a mutual fund with very low costs and where you get all of the income from holding the investments over time without the risk of losses from bad trading choices. Enter the index fund.
An index fund is a specific type of mutual fund. Instead of the manager trying to actively choose winning stocks (and make money at the expense of the other managers and investors out there), an index fund just invests money to follow a particular index. If the index is a basket of all of the businesses in the US, for example, then the fund will just buy a slice of every stock. These funds tend to be very low cost, because you don’t need to hire a hotshot stock picker and pay handsomely hoping they’ll beat the other hotshots.
However, the index also matters. If the index is 10% each in ten different companies, the fund will have to trade every day as the prices change to keep up with that ratio. Also, maybe those ten companies are all having a rough time in the economy overall.
Fortunately, you can get a broad, capitalization-weighted index and you don’t have these problems. These indices hold most or all companies, and weight each company according to the total value of all shares. If a fund is big enough to buy 1% of the stock market, it will be 1% of Apple, 1% of Amazon, 1% of Microsoft, and so on. If the price of Apple doubles and Amazon stays flat, there’s no trading to do - it still has1% of Apple and the others. The winners and losers of the economy go up and down, but the index represents everything together.
The S&P 500 is one of the oldest US stock capitalization-weighted indices, and the first index fund open to retail investors, the “Vanguard 500 Index Fund”, has provided better results than the vast majority of mutual funds over decades by just owning a slice of everything. Bonds have similar indices, most notably one called the Barclays Capital Aggregate Bond Index. Since capitalization-weighted indices all have basically the same strategy - buy everything - you can compare the indices to each other to confirm they behave similarly and then choose an index fund based on any of them.
Note that while stocks and bonds have good capitalization-weighted indices, it’s hard to invest in real estate this way and the companies that organize the real-estate funds (“REITs”) often take any extra return as profit. For this reason, we invest in stock and bond index funds and settle with just our own house as our real estate investment.
Percentage Stocks and Bonds
Ok, great. You know what to invest in, but how much of your money should go to stock versus bonds? Unfortunately the answer is “it’s complicated”. Stock has a higher long term return, but also much more volatility. The decision about how to split your money up is called ‘Asset Allocation’, and different people will often choose differently based on how well they handle the day-to-day ups and downs of the market and how many years from now they’ll want the money.
People a long time from retirement often want a high percentage of stock (80-90%) to maximize long term growth, and those close to or in retirement want less (40-60%) for less exciting ups and downs. It’s really not necessary to have more than 80% stock (returns are barely higher at 100% stock than 80%), and less than 30% stock is a bad idea even in retirement because returns become too low to keep up with spending and inflation over time. See “How Much Stock vs Bonds” for more detail.
We’ve just been talking about “stock” here, but you can buy stock in US companies or companies from other countries. Opinions vary about how to much of your stock should be international. People often think having more stock in your local country is good. After all, the returns are in the currency you want to spend. Others want to own as much of the world as possible, and try to own the “capitalization-weighting” of every country. In our case, about a quarter of our stock investments are international stock.
To actually buy these funds, set up a mutual fund or brokerage account with a financial company and buy index funds from them. We personally invest through Vanguard and Fidelity, though you can usually buy these funds from a brokerage account with any other company, and BlackRock also offers excellent low cost index funds.
|US Stock Index||VTSAX||FSKAX, FZROX|
|International Stock Index||VTIAX||FTIHX, FZILX|
|US Bond Index||VBTLX||FXNAX|
Don’t Take My Word For It
Investing advice is all over, and it can be hard to decide what to believe. Please, don’t read just one source (even this one) to decide what to do with your life savings. Here are some other great resources which agree with the principles of investing I’ve outlined:
- Bogleheads - Investment Philosophy
- Warren Buffet
- Investopedia - Index Funds
- NerdWallet - Index Funds vs Mutual Funds
- SPIVA - S&P 500 vs Active Mutual Funds Comparison
- Book: The Millionaire Next Door
- Book: The Automatic Millionaire
- Book: The Little Book of Common Sense Investing
Whew, that was a lot of territory to cover! In summary, stocks, bonds, and real estate are good investments because they generate income for you. Prices change from day-to-day, but the fluctuations only matter right when you’re buying and selling. You can buy stocks and bonds easily and efficiently through index funds. Make sure the index fund has a low expense ratio (0.10% or less), has no “loads” (no fees to buy and sell), and follows a capitalization-weighted index.