16 Investing Concepts for the New Investor
Market volatility. Dollar-cost averaging. ETFs. If you’re confused about investing concepts, you’re not alone. Investing lingo can be intimidating.
But most of these concepts can be broken down into layman’s terms to make investing easier. Get past the investing jargon with our guide of the 16 most important investing concepts.
1. Active Investing
Active investing is a hands-on approach to investing. It means that you’re trying to outperform the market through frequent trading (aka actively buying and selling assets like stocks). It’s the opposite of passive investing where you are mirroring the market’s performance such as the performance of the S&P 500.
An asset is something with current, future, or potential economic value like stocks. Investing includes three building blocks:
- Buying assets
- Holding assets
- Selling assets
Use these three building blocks as the foundation for your investing knowledge and decisions.
3. Asset Allocation
Asset allocation means that you invest in different asset classes like stocks, bonds, and ETFs. Why? When some assets perform well, others perform poorly. A good mix of assets helps you balance risk vs. reward.
Bonds are investments where you lend money to a borrower to earn interest over time and eventually receive your initial investment back.
With bonds, you are essentially lending money to companies and local, state, and federal governments for a certain time period. The money that you lend earns interest (typically paid out twice a year).
It’s a low-to-medium risk, medium return option. U.S. Treasury Bonds are one example (a bond issued by the federal government).
5. Compound Interest
Compound interest is a tool that can significantly grow your money over time and makes your savings work harder for you. Compound interest is a key ingredient to investing.
Here’s how it works: you contribute a certain amount of money into an investment account. Through the magic of compounding, your principal or original deposit earns interest, and this interest earns interest of its own. Your money multiplies without you having to lift a finger. Interest might be compounded daily, weekly, monthly, yearly, etc.
Compound interest’s best friend is time. Maybe you invest $1,000 into the stock market with an estimated return rate of 7%. You also contribute $100 per month and the interest is compounded monthly. You’ll have over $19K at the end of ten years.
But at the end of thirty years? You’ll have over $130,000 ($93K of that is earnings from interest)! That amount will be much larger if you contribute more to the account every month. If you’re not taking advantage of compound interest yet, you’re missing out on money.
Hint: Use Investor.gov’s free compound interest calculator to calculate how much you could invest and earn with compound interest.
Diversification is the act of spreading out your money into different investments such as stocks, bonds, cash, and alternatives. It’s also investing in different industries, companies, etc. This approach helps lower your risk.
For example, you wouldn’t want your entire portfolio to be made up of tech stocks. Diversifying your portfolio lowers your risk of losing a lot of money. Basically, don’t put all your eggs in one basket.
Dividends are portions of a company’s profits that are paid to its shareholders. These dividends are paid in cash or as more stock. Dividends must be approved by a company’s board of directors.
So why are dividends important? Because if you add dividend stocks to your portfolio, you can expect regular income and earn profits without selling stocks.
There are different types of dividends including:
- Cash dividends. These dividends are normally paid quarterly in cash.
- Special dividends. Special dividends are typically a one-time cash payment.
- Stock dividends. Stock dividends mean that more shares or stocks are given to shareholders in place of cash.
Cash dividends are the most common type. Say that you own 100 shares in a company. If that company pays $0.50 per share in cash dividends per quarter, you’ll receive $50 per quarter or $200 per year in dividends.
8. Dollar-Cost Averaging
Dollar-cost averaging (DCA) means that you regularly invest the same amount of money over time in stocks, mutual funds, or ETFs, no matter what the price is. It’s a strategy that helps you reduce risk.
Instead of purchasing stocks at a single price point, your money purchases more shares when prices are down and less when prices are up. It takes guesswork out of investing decisions.
An exchange-traded fund is a basket of investments (think stocks, bonds, and even other assets like gold!). Many ETFs mimic movements of an index like the Dow Jones or the S&P 500. Most ETFs are also index funds (aka indexed ETFs).
Money is pooled from different investors to invest in ETFs. These funds are traded on a stock exchange (just like stocks) and shares are bought and sold throughout a trading day. Some ETFs simply involve buying some or all of an index’s stocks and bonds and holding them (or not selling them) over time.
A fund is a pool of money that’s often invested with other investors. It’s also normally managed by professional managers. Two common types of investment funds include:
- Mutual fund
- Exchange-traded fund (ETF)
The money in a fund is used to purchase a portfolio that’s made up of assets like stocks and bonds. But rather than owning the underlying assets, investors or shareholders own shares of the fund.
11. Index Fund
An index fund is a type of investment (normally a mutual fund or ETF) that mimics the performance of a market index. Instead of trying to beat the market like with trading, you’re matching the market and hopefully getting the same returns.
One type of index is the S&P 500 – an index that holds 500 of the largest U.S. companies. Just like a market index, an index fund is made up of a collection of stocks and bonds.
The investing strategy behind an index fund is simple. Select an index that you want to track. Next, find a fund that tracks this index. You then buy shares of this index fund. To get the most money, it’s best to invest in index funds over the long-term (think 30 years).
Hint: Sign up for the Complete Investing Course (Stocks, ETFs, Index/Mutual Funds) on Udemy to learn how to invest as a beginner.
IRA stands for Individual Retirement Account. This investment account offers tax advantages for retirement savings. It’s designed to help you save for retirement.
A common type of IRA is the Roth IRA. You pay taxes on money going into your account now, but don’t have to pay taxes when you withdraw the money when you retire. Unless you’re age 50 or older, the Roth IRA contribution limit is $6,000 a year for 2021-2022.
M1 Finance is one option where you can open a Roth IRA and make monthly contributions to grow your retirement.
13. Passive Investing
Passive investing, unlike active investing, means that you’re holding your investments for a long time without buying and selling. It’s the strategy that we recommend at NoBS Investing. It takes the emotions out of investing.
Basically, ignore the news and hype with passive investing. Stick to a buy-and-hold strategy. Focus on growing your money over time.
“Risk is the probability of a loss and the amount of money you could lose.”
Risk means that there’s uncertainty involved with your investments or the potential to lose money. This consideration includes the actual risk of the investment (some investments are riskier than others) and your risk tolerance (aka how much risk you’re comfortable with).
Use the risk vs reward equation to make investment decisions. Investments will be “High risk, high reward,” “Medium risk, medium risk,” or “Low risk, low reward.”
Stocks allow you to own a small portion of companies. As certain companies increase in value, their stock prices often go up, along with the value of your investment. Because stock prices can also decrease, stocks are a higher risk, higher return investment.
However, stocks have still proven to outperform all other investments over the long-term. In fact, the stock market has an average return of 7% each year after inflation (aka prices rising over time).
The stock market is an overall public system that allows you to buy and sell company stocks (as well as other types of financial investments). There are 11 different stock market sectors which helps you avoid putting all your eggs in one basket and lowers your risk of losing money when investing.
16. Mutual Fund
A mutual fund is a professionally managed fund that pools together money from investors to buy a basket of investments (like stocks). Money is earned through dividends, interest, and gains.
The level of risk and return depends on the type of mutual fund you invest in. For example, stock mutual funds have a higher risk/return than bond mutual funds.
Use these investing concepts to start investing
Now that you know key investing concepts, create an investing portfolio and start investing today! Here’s how in four steps:
- Step 1: To build a portfolio, select a trading platform through the brokerage of your choice (e.g., M1 Finance).
- Step 2: Use this platform to practice buying and selling individual stocks and ETFs (you can do this through a demo or simulation account).
- Step 3: Select a portfolio that matches your personal situation and risk tolerance. You can choose a pre-made portfolio or allocate assets on your own.
- Step 4: Buy the portfolio. This means that you buy the specific portfolio assets such as ETFs or stocks within the trading platform.
Contribute a set amount to your portfolio each month. Let compound interest and time do the rest.
Want to learn more about investing for beginners? Take the Complete Investing Course (Stocks, ETFs, Index/Mutual Funds) on Udemy and learn proven investing strategies. Check out the course here.