For many, investing can come with baggage. People often make different associations with the term based on past experiences with parents, teachers, and friends. The portrayal of Wall Street culture in American cinema tends to portray a version of investing that quite possibly keeps a lot of would-be investors on the sidelines reading the financial news and wondering how the “wolves of Wall Street” keep finding fresh kills. Being a market-based investor is not just for the ultra-rich. It’s something nearly anyone with a job can do. It’s about setting goals, making a budget that includes investing, staying the course, and remaining disciplined to the basic principles of investing.
Investing isn’t just a good idea, it’s a necessity for most people! Investing a portion of your employment income into a growth-oriented account is the only way many of us will have a shot at a comfortable retirement. It takes years of saving and investing to accumulate enough assets to replace your income during retirement but thankfully there are ways to automate this process.
What types of Investments are out there?
We hear investment terms all the time, but what does it all mean? The basic building blocks are stocks and bonds:
A stock represents ownership of or equity in a company. Investors buy stock in a company hoping the value of the company will go up and the share price of the stock will follow so they can sell it at a higher price than they purchased it for. This is called capital appreciation. A bond is a debt, which means that you are essentially lending money to a business or entity for agreed-upon terms and rates. Investors buy bonds because these debt instruments pay dividends, or interest, back to the bondholders. Stocks and bonds are packaged in different ways to support investors’ needs and simplify investing. Rather than buying and selling stocks and bonds individually, they can purchase shares of bundled investment vehicles:
The most common investment vehicle is the mutual fund, which is a basket of securities that are professionally managed for a specific outcome. There are mutual funds for growth, income, or both! In fact, there are thousands of mutual funds available to retail investors so it’s really important to know how to evaluate them or have a trusted advisor who can manage them on your behalf. The most important aspects to consider when picking a mutual fund are that it accurately represents your personal risk tolerance and time horizon and that you’re comfortable with the fees. Oftentimes, an investor’s risk appetite shrinks the closer they get to retirement and mutual funds often allow you to exchange one fund for another without incurring additional sales charges.
Other common growth investments are individual stocks, ETFs, some variable annuities, and index-linked annuities. Income investments can include bond funds, individual bonds, preferred stocks, real estate investment trusts (REITs), fixed annuities, income annuities, and market-linked CDs. Though there is not enough space in this article to offer detailed information about each of these investments, they all offer their own unique benefits and potential drawbacks. It is best to speak with an advisor to determine which investments are best for you, but if you would like to begin your research online.
Do you have to understand the stock market in order to invest?
A basic understanding of investing is important, but for many, it can seem overwhelming or just plain boring. There are lots of great resources online that will get you up to speed on the “rules” of investing, and most credit unions have licensed financial advisors who are willing to run through their “investing 101” talk. Investing early in life and continuing to contribute during your working years is so essential to funding your retirement that even if you don’t feel like you understand everything about the stock market, you should still invest! Make it a goal to learn a little more each year so that as your investments grow, so does your knowledge.
What are the risks of investing?
Investing in anything is an expression of optimism. It indicates hope for the future and long-term thinking. Why do we invest in anything? We apply effort, energy, and resources to things we want to improve and/or enjoy later. Some non-financial investments we all make include changing the oil in our vehicles, brushing our teeth, exercising, planting a garden, and learning new skills. What are the risks involved in NOT doing any of those activities? Our freedom, health, and diet might suffer. Investing in financial products are equally as important for many but the risks are a little less obvious! Let’s talk about a few of the primary risks involved:
- Market Risk: This is the risk of your investments declining in value because of economic or other disruptions that affect the entire market. Think stock market crash! In March of 2020, we saw the global financial markets decline significantly due to the threat of COVID-19. This isn’t a typical genesis story for market risk, but it certainly gained everyone’s attention!
- Liquidity Risk: Liquidity risk, which is tied to market risk, occurs when you are unable to sell your investment (stock, bond, etc.) at a fair price when you need to. If you suddenly need cash and all your money is invested in the stock and bond markets, you are at the mercy of the market’s purchasing power or the perceived value of your investment. Being forced to sell an investment at a lower cost than you purchased it for can be one of the most discouraging experiences of investing!
- Concentration Risk: The old adage about keeping all your eggs (concentrated) in one basket applies to this type of investment risk. Thankfully, this one is very easy to avoid! A diversified portfolio is the key to avoiding concentration risk. You can work with your advisor to diversify your investments. Often, they will suggest that you use certain types of mutual funds and invest in a mix of different types of assets to ensure that losses in one asset class are balanced out by gains in another asset type.
- Credit Risk: This risk relates to bonds (debt instruments) and their issuers. Just like your credit union takes a risk when they lend money to individuals, hoping they will make payments on time and in full, a bondholder also risks losing money if the company they have lent money to (invested in) is not able to pay back their debt. Credit risk can be difficult to assess. Thankfully, impartial agencies provide investors with a bond rating score that indicates the credit rating of bond issuers.
- Reinvestment Risk: Investors encounter reinvestment risk when they are unable to reinvest returns from their current investments into investments with a similar or higher interest rate. This often happens with CDs, or bonds. When interest rates go down, maturing CDs will be renewed at lower interest rates, and bonds will often pay off their debt early and reissue new shares at the new lower rate. This risk can have the greatest effect on retirees who are using their portfolios for income and is one of the primary concerns addressed when creating a financial plan.
- Longevity Risk: This is the risk that you will outlive your assets. No one knows how long we will live and it is prudent to have protection in place against both an untimely passing and extreme old age.
This is by no means an exhaustive list of possible investment risks but as you can see, there are a lot of things to consider when developing a financial plan. Risk management is arguably the most important aspect of financial wellness and worth learning more about. Speaking with a financial professional after carefully considering your own risk tolerance and goals is recommended.
When should you start investing?
Investing, ideally, should be put into practice as soon as you start interacting with money. Encouraging your child or grandchild to save some of their allowance or birthday money for the future establishes healthy behavior and associations. Too often we don’t really get serious about money until we are faced with the need to borrow it, then concepts like debt-to-income ratios and credit scores are explained. Then, usually at the age of 30, you realize that you could pay less income tax by opening and contributing to a traditional IRA. Unfortunately, that’s also when you see all the charts that show you how much more money you could have accumulated if you had just started when you were 18! Don’t let all that get you down because the best day to start investing is TODAY.
Are there other types of savings you should have in place before you invest?
It’s very important to hold onto money that you might need to spend within the next 12-24 months. What does that mean? Keep cash for planned expenses in a money market or high-yield savings account as well as 3-6 months of living expenses. So, if you know you will need to buy three cords of wood and replace your generator this fall, keep those funds liquid. Additionally, keeping some emergency savings available in case your tooth explodes or your dog gets Lyme disease is also a must! The best way to know what 3-6 months of living expenses add up to is by creating a household budget. It also helps to track your expenses and spending for a few months to get an average. Once your cash reserves are in place, you can consider directing some of your monthly savings into an investment account.
What about debt? Can you invest even if you have debt?
When you take on debt, you are betting against your future earning power to achieve your goals faster. This is a very important step in securing housing and transportation in today’s world. Debt is a tool, just like investments! It’s normal, and necessary, to be working toward more than one objective at a time. Debt should always be manageable, allowing you to save a portion of your income while paying down debt. There are a myriad of opinions on this topic, but the best way to keep debt low is to put off purchasing things you don’t need. Live within your means and set achievable savings and investment goals that will help you achieve the lifestyle you seek.
How do you start investing?
Establish financial goals. Make a budget. Determine your excess net income. Pick a firm to work with, and open an account! There are platforms and programs for all personality types, from the DIY crowd to online-only brokerage to full-service, in-person financial planning. Only make it as complicated as it needs to be! Determining the optimal program to start with is a very important decision and shouldn’t be made based on a commercial on TV or what your Uncle is doing, but should rather be made based on what is best for you at your stage of life.
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