You have $1,000 to invest. Perhaps you earned it or received it as a gift. Either way, you’re considering ways to invest it. Two investments that most people consider include real estate and financial securities such as stocks and bonds. This post will tackle the latter. Alternatively, you might want to invest in yourself to develop or upgrade a skill. Investing in yourself is a fantastic idea, and unlike decades past, you can learn for free through e-learning platforms like CreativeLive and Coursera. Thus, you can invest in yourself for free and allocate all your money to investments.
Investing money isn’t the same as trading it. The goal of investing is to build wealth over time whereas the purpose of trading is to realize profits much sooner. For example, an investor makes a couple of trades annually to rebalance his portfolio while a day trader makes hundreds of trades daily to take profits and minimize losses. If you want to trade your money by buying and selling stocks or cryptocurrencies, this post is not for you. I will focus on investing for the long term.
To invest your money wisely, you must understand five critical aspects:
- Why people invest
- Investment risks
- Investment strategies
- Investment products
- Ways to manage your money
Why People Invest
Individuals invest for different reasons. You might invest for long-term growth while I might invest to generate passive income. There are four common reasons for investing in securities:
- To increase one’s wealth
- To preserve one’s wealth
- To receive fixed-income
- To generate passive income
Many people want to grow their wealth in preparation for retirement and other financial needs. Retirement is the point where a person stops employment completely. To supplement income needs in retirement, a person depends on his or her savings, company pension, and government benefits like social security. Individuals attempt to build wealth for other reasons, for example, saving for a niece’s college tuition or saving to purchase a home.
Having sufficient financial resources increases the odds of living well in every stage of life. By contrast, individuals who don’t build wealth or fall short of their financial goals risk losing their standard of living and quality of life. Income shortfalls may require individuals to downsize their homes, live on less, adopt minimalistic lifestyles, or change neighborhoods.
Wealth preservation, also called asset protection, seeks to preserve capital and prevent loss in a portfolio. Individuals want to protect their money against wealth erosion factors, like inflation, fees, and taxes. The preservation of capital is a common goal of retirees who depend on their savings for income. Suppose Judy wants to preserve her wealth. She buys investment-grade government bonds, which yield 3 percent. By attracting a yield higher than the inflation rate, she protects her capital and purchasing power. If Judy puts her money under her bed, instead of investing in bonds, a year later her money will be worth less due to inflation.
Alongside capital preservation, many retirees seek unearned or non-work income. Fixed-income securities, like bonds, and dividend-paying stocks can meet this objective.
Passive income is revenue that’s received on a regular basis with little or no ongoing effort made to obtain it. It can continue indefinitely after the initial attempt has been put in. Receiving dividends, interest payments, and other types of distributions are some of the oldest ways to make passive income. I had a client who had $500,000 invested in the stock market, and every month he would generate approximately $2,000 in dividends for an annual yield of close to 5 percent. Naturally, the market went up and down, but his passive income kept coming. After he invested, he did not spend any time earning this money.
The transition from choosing goals to selecting investments involves understanding who you are as an investor. An investor profile identifies a person’s investment preferences regarding goals, time horizon, risk tolerance, and other factors. Your investor profile will dictate your investments. Individuals usually complete investor-profile questionnaires to determine their investor profiles (search “investor profile questionnaire” for examples). There are five standard profiles: conservative, moderately conservative, moderate, moderately aggressive, and aggressive. Investment companies, brokerages, and advisors may use different names like “balanced” instead of moderate. Investor profiles have corresponding asset allocation models. For instance, a moderate profile corresponds to 40/60, 45/55, 50/50, 55/45, and 60/40 splits between cash/fixed-income and equities. Weightings differ depending on the institution or advisor.
Investor profile questionnaires are helpful, but you must go deeper to understand yourself and the asset mix that makes sense for you. For instance, you complete a survey and receive a moderate weighting. However, you have an aggressive, type A personality and can afford to take risks, which better corresponds to a moderately aggressive or aggressive profile. Secondly, an investor can have different profiles for different accounts, that is, a general profile and account-specific profiles.
Investing in securities and with financial institutions invites risk. Even bank deposits can be risky in a country that is experiencing economic and political upheaval. In most cases, risk can be managed efficiently through diversification, which is the practice of spreading risk among asset classes and securities that differ by industry, sector, market capitalization, country, and so forth.
Risk, in financial circles, is the chance that an investment’s actual return will be different than expected. It is measured by a statistical formula called standard deviation. Risk invites the possibility of losing some or all monies. However, risk comes with upside potential in the form of gains and profits. For example, a stock returns 8 percent compared to an expected return of 5 percent.
Given two investments with the same level of risk, all else equal, rational investors will select the investment with the potential for higher returns. Naturally, investors would want the best possible outcome for the least amount of risk. However, no two securities have the same risk-reward profile. Investors must decide to either take on less risk, which is associated with potentially lower returns, or more risk, which is associated with potentially higher yields. Here are the risk-reward profiles of various securities. By understanding risk-reward trade-offs and common investment risks, you can construct a portfolio that suits your appetite.
Two investment strategies dominate the financial industry, that is, passive and active management. Passive management seeks to replicate the holdings and weightings of an index or benchmark such as the S&P 500 index. An investor, advisor, or fund manager would purchase, hold, and weigh securities to mirror an index. Alternatively, an investor can purchase a managed fund that achieves the same objective. For instance, the State Street Global Advisors SPDR S&P 500 ETF seeks to provide investment results that, before expenses, generally correspond to the price, yield, and performance of the S&P 500 index.
While the term “passive” suggests inactivity or laziness, the underlying contributions to passive returns are anything but passive. An investor who buys an index fund is buying the joint efforts of thousands of market participants. You could say that passive management embraces the collective wisdom of a market.
Active management seeks to outperform a specific index or benchmark. Instead of replicating an index, an investor, advisor, or fund manager would purchase and weigh securities to beat the market. For instance, Fidelity’s Contrafund seeks to outperform the S&P 500 index with the following investment strategy, “Investing in securities of companies whose value Fidelity Management & Research (FMR) believes is not fully recognized by the public. Investing in either ‘growth’ stocks or ‘value’ stocks or both. Normally investing primarily in common stocks.” You could say that active management attempts to outsmart the collective wisdom of a market.
To try to beat the market, portfolio managers analyze securities using fundamental and technical analyses. Fundamental analysis is a method of evaluating a stock to measure its intrinsic or fair value. Managers examine a company’s financial statements, news and announcements, economic data, industry reports, competitors, customer sentiment, and so forth to determine a security’s value.
Technical analysis is a methodology for forecasting the direction of prices through the study of past market data including price and volume. Technicians and chartists evaluate charts and other quantitative indicators to identify potential price patterns.
Active management comes in several flavors including value, growth, and contrarian investing. Value investing seeks to invest in stocks that trade for less than their intrinsic values. Value investors actively purchase stocks they believe the market has undervalued and sell stocks they believe the market has overvalued. For example, a value investor might buy low price-to-earnings, low price-to-cash-flow, or low price-to-book ratio stocks. For books on value investing, I recommend reading Security Analysis and The Intelligent Investor by Benjamin Graham, the “father of value investing.”
Growth investing seeks to invest in stocks with high growth potential. Growth investors invest in companies that exhibit signs of above-average growth, even if the share price appears expensive. Technology and emerging markets are common places to look for growth stocks.
Contrarian investing is characterized by purchasing and selling in contrast to the prevailing market sentiment or direction. A contrarian believes that investor groupthink and behavior can lead to exploitable and mispriced securities. For instance, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, then selling them after the company recovers can lead to above-average gains. On the other hand, widespread optimism can result in unreasonably high valuations that will eventually lead to declines, when those high expectations don’t pan out.
The passive versus active debate has become a weak case-study and more of a landslide victory for passive management. I make a case for passive management with facts and empirical evidence in my book.
Many investors seek convenience and ease. If each of us had to build and rebalance our portfolios stock by stock and bond by bond, the process would be a time-consuming headache. Managed funds simplify the investing process and often yield immediate diversification.
A fund is a group of securities packaged together for investment purposes. It’s mainly the difference between buying one peanut representing an individual stock or bond and a bag of peanuts representing many stocks or bonds. Managed funds are created by investment management companies that pool investor money for specific investment objectives, for example, investing in large capitalization US technology stocks like Alphabet, Apple, Cisco, and Microsoft. Most funds provide instant diversification by holding many securities, thus lowering the risk posed by carrying just one security. The two most common types of managed funds are mutual funds and ETFs.
Mutual funds come in two types: open-end and closed-end, but most discussions involve open-end funds. Investment companies that offer open-end mutual funds continually issue (create) and buy back (redeem) shares for investors. By contrast, a closed-end fund is a publicly traded fund that raises a fixed amount of capital through an initial public offering. Both open- and closed-end funds have a net asset value (NAV) that corresponds to the fund’s price. The NAV is calculated by dividing the fund’s assets (minus liabilities) by the number of shares outstanding. This is calculated at the end of every trading day by the investment management company.
Exchange-Traded Funds (ETFs)
ETFs are investment vehicles that combine features of mutual funds and individual stocks. Like mutual funds, many ETFs hold a basket of securities. Like stocks, they can be bought and sold on exchanges, with their prices available throughout the day. Many ETFs were designed to track market indexes like the S&P 500 index. However, innovation has led to actively managed, leveraged, inverse, and other types of ETFs.
I recommend using either mutual funds or ETFs for your portfolio. Alternatively, you can use funds of funds and target date funds to achieve your objectives.
Ways to Manage Your Money
Many people hire advisors to manage their funds, and this approach is often a huge mistake. Smart ways to manage your investments include using a robo-advisor or managing your portfolio as a do-it-yourself investor.
Gold standard robo-advisors, like Betterment and Wealthfront, provide low-cost account management starting at 0.25 percent. Many robo-advisors are fiduciaries and avoid conflicts of interest. They invest in low-cost, index funds from Vanguard, BlackRock, and Schwab. Some robo-advisors such as Betterment, Vanguard Personal Advisor Services, and Personal Capital, provide access to financial advisors. For example, investors who have at least $100,000 with Betterment will receive unlimited access to certified financial planners for an annual fee of 0.40 percent. Vanguard Personal Advisor Services requires a $50,000 minimum and charges 0.30 percent. Personal Capital is more on the expensive side, but excellent for affluent investors who need complex financial planning solutions. Finally, some robo-advisors implement automated tax minimization strategies.
My short list of favorite robo-advisors includes:
- Schwab Intelligent Portfolios
- Vanguard Personal Advisors
Investment advisers can help their clients in several ways. They can encourage their clients to invest. They can build and manage portfolios consisting of passive and smart beta funds for their clients. They can be a wedge between clients and investments to prevent mishaps from happening. However, why pay an investment adviser or robo-advisor to build a portfolio of ETFs when you can do it? Why not skip the middleman and keep more of your returns? DIY investing is a smart approach to take, and I cover the steps involved in my book.
To invest $1,000 intelligently, you need to:
- Understand your objective and investor profile
- Understand the risks involved
- Select an investment strategy, preferably passive management
- Select an investment product, preferably low-cost index mutual or exchange-traded funds
- Decide who will manage your money, preferably you or a robo-advisor
For more on investing including asset classes, risks, managed funds, fees, and ways to increase your returns, grab my book, Investing Is Easy: Investing for Beginners and Investors Who Want Better Returns.