Your investing questions are answered.
Investing is murky business, like swimming through cloudy waters. Without goggles. In the dark. With seaweed grabbing at your ankles and trying to pull you down. Anyone could get turned around in those algae-infested pools. In fact, you may be thinking of turning right back around for shore and giving up investing for good. But don’t. Learning how to invest isn’t as hard as it seems. Once you get through the murky parts, such as these often daunting and confusing investing terms and questions, you’ll be paddling like a pro in no time.
What is diversification?
Diversification means not putting all your eggs in one basket lest that basket gets a hole and you end up with Humpty Dumpty. Metaphors are fun, but what are these baskets? They’re the adjectives describing your investments, such as large-cap stocks or tech equities. Diversification isn’t about how many investments you own but rather how those investments work together. You could own 20 companies but if they all make shoes, you’re not diversified because bad news for the shoe industry will take out your whole basket. Diversification means your investments won’t all move together. So if all your investments are up, you better diversify before the next shoemaker fiasco hits.
How do I rebalance a portfolio?
Rebalancing is like maintaining your garden: When certain areas get overgrown, you trim them back. And when growth in others areas lags, you feed them more. Just like your garden, your portfolio can grow more in some areas than others. When you rebalance, you take from the overgrown areas to feed the undergrown ones. To do this, you sell enough of your gainers and buy enough of your laggers to bring them back to the original ratios you intended. And like gardening, your portfolio needs to be rebalanced regularly — annually, or even quarterly.
How does compound interest work?
“Compound interest is when you earn interest on your interest,” says Chris Gaffney, president of world markets at TIAA Bank in St. Louis. When you reinvest the 5 percent interest payment from your $100 investment, your next interest payment is based on $105. So instead of $5 you get $5.25. Reinvest that and you get $5.51 next time. Such is the math behind the magic that allows you to turn $5 invested daily into $400,000 just 45 years from now. It’s also the reason you want to start investing early. “The sooner you start, the more compounding is likely to help your money grow,” he says.
Is there a better time of year to start investing?
“Early and often is the best time of year,” says Andrew Crowell, vice chairman of wealth management at D.A. Davidson & Co. Waiting for an opportune time to invest is akin to timing the market, which never works well in the long run. That said, “research shows that there is some seasonality” to stock market returns. For instance, summer and early fall are often volatile, which can “be an excellent time to invest by taking advantage of lower prices,” he says. Following Warren Buffett‘s rule to be “fearful when others are greedy and greedy when others are fearful,” new investors could benefit from buying during summer and fall, he says.
I paid off my student loan and credit card debt. Now what should I do?
Congratulate yourself. “Paying off debt is an achievement worth celebrating,” says Carrie Schwab-Pomerantz, board chair and president of Charles Schwab Foundation. After patting yourself on the back, create a budget and live within your means so you don’t accumulate any more debt, she says. Build an emergency fund then start investing. “The best action a long-term investor can take is to invest at the first possible moment because time in the market beats timing the market,” she says. “Always contribute enough to [your workplace plan] to get the company match; otherwise you’re turning away free money.” Supplement this with an IRA or taxable brokerage account.
What percentage of my savings should I start investing with?
Short answer: Invest everything except your emergency fund of three to six months’ living expenses. “It’s more important to start investing than get hung up on how much,” Crowell says. Even $50 per month could become more than $100,000 in 40 years. Longer answer: Aim for 10 to 15 percent of your income in your 20s, 20 percent in your 30s and 30 percent or more in your 40s, Schwab-Pomerantz says. As you gain confidence, challenge yourself to invest more, Crowell says. If you get a raise, invest half of it. “Just be sure you’re not investing money that you think you’ll need in the next five years,” Schwab-Pomerantz says.
How risky should I be with my investments?
“Investing shouldn’t be in the context of risk,” says Ric Edelman, founder and executive chairman of Edelman Financial Services. It should be about achieving goals. When you get into a car, the first question isn’t, “How fast am I willing to drive?” That depends on your destination and how long you have to get there. Likewise, your investment goal and time frame determine how much risk you take. If your investments need to earn 8 percent per year to reach your goal, you need to be aggressively invested in stock, Edelman says. But if you can reach your goal at a 2 percent rate of return, you can be more conservative.
Should I invest with the same company where my 401(k) or bank account is?
Keeping all of your accounts under one roof can make keeping track of your finances easier. Whenever reviewing your investments, you should look at them as a whole, which means your 401(k) and other investments together. Likewise, some firms offer lower-cost options when you have more money with them. That said, “this decision really depends upon a variety of factors including expenses, depth and breadth of offerings, access to personalized investment counsel and other services,” Crowell says. Consolidation can be helpful, but “should not be the exclusive deciding factor.” If you can get better or lower cost investments or services elsewhere, go there instead.
What are the best investments for a beginning investor?
“Broad-based mutual funds and exchange-traded funds (which pool the money of many investors to purchase a variety of securities) give you a simple way to begin,” Schwab-Pomerantz says. Invest in a mix of stocks and bonds. You want “a good mix of asset allocation (your mix of stocks, bonds and cash) and diversification (investing in different types of stocks and bonds).” For instance, you may have 80 percent of your portfolio in stocks with half of that in large companies and half in small companies. “Always research performance and fees from a trusted website or financial advisor before investing,” she says.
What are active funds and passive funds?
Active funds have a manager who is trying to beat a benchmark, like the S&P 500, by actively selecting investments. Passive funds like index funds simply try to track their benchmark by holding the same investments. They follow the efficient market hypothesis, which believes it’s very difficult to consistently outperform the market. Instead, passive funds aim to provide a low-cost way of participating in market returns. Active funds often outperform in certain market conditions, such as during market rallies, and specific sectors, like international large-cap and U.S. small-cap. But investors pay more for these funds through higher expense ratios.
What is an expense ratio and where does that money go?
An expense ratio is the annual fee charged to shareholders to cover fund costs, expressed as the percentage of fund assets that go toward costs instead of being invested. The majority of the fee goes to management fees. This is why an active fund with a manager who spends a lot of time selecting investments has a higher expense ratio than a passive fund. Other expenses include administrative costs, taxes and accounting fees. It does not include trading costs incurred by the fund. “You should generally spend less than 0.5 percent,” and lower is better, Edelman says.
What’s more important: the cost of the fund or past performance?
While past performance is important, costs are even more so. Investors often “overlook how much investment costs can add up over time,” Schwab-Pomerantz says. She illustrates this with an example: If at age 45 you invest $1 million in a fund costing 2 percent per year, by 85 you’ll have $4.8 million at a 6 percent return. If your total cost was only 1 percent, by 85 you’d have about $7 million — $2.2 million more. And costs are one of the few things investors have control over. Past performance is no guarantee of future results, but you can be sure you’ll pay your share of fund expenses.
What other fund fees should I be aware of?
Other investment costs include turnover, or how much buying and selling a fund manager does. Since every trade has a transaction cost, funds with high turnover ratios can be costly to investors. Avoid funds with over 30 percent turnover, Edelman says, “and the less the better.” The turnover ratio is on Morningstar.com under Fees & Expenses. Also “avoid funds that pay a 12b-1 fee,” Edelman says. This marketing fee mutual funds pay to brokers can be up to 1 percent per year. You can view a fund’s 12b-1 fee and other costs on U.S. News & World Report’s fund pages under Costs and Fees.
What is downside capture and why do I care?
Downside capture measures a fund’s performance in down markets. It calculates how much the fund declines when the stock market goes down. A downside capture of 90 indicates the fund generally experiences only 90 percent of declines. Lower is better: “Funds which exhibit a low downside capture generally go down less than their benchmark during down markets,” Crowell says. “Research shows that funds with low costs, high manager ownership and low downside capture tend to outperform their benchmarks over longer time periods.” You can view the downside capture of any fund as well as that of its overall category on Morningstar’s website under the Risk & Ratings tab.
What is the annual percentage yield?
The annual percentage yield (APY) is for investments what the annual percentage rate is for loans. It “represents the effective annual rate of return taking into account the effect of compounding interest,” Gaffney says. A standard rate of return, which is simply how much an investment grows over a given period represented as a percentage, makes comparison difficult when investments compound at different rates, such as monthly versus annually. The shorter a compounding period, the faster the investment grows. APY restates the rate of return assuming annual compounding, assuming the funds will remain invested for a full 365 days. In essence turning all investments into apples for fair comparison.
What are emerging markets and should I invest in them?
Emerging markets are “countries that have ’emerging’ economies,” Gaffney says. There’s no definitive “criteria for size or growth rates, but the largest emerging economies are Brazil, Russia, India and China,” collectively called BRIC. Emerging markets typically have a financial infrastructure including a national currency, banks and a stock exchange but low to middle per capita income. Because they’re still developing, EM investments can grow faster than investments in developed nations. But EM can be risky: political and currency instability can make investments volatile. While international exposure is an important part of a diversified portfolio, EM exposure should be taken with a grain of risk tolerance.
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16 Investing Questions That Intimidate You, But Shouldn’t originally appeared on usnews.com
