New investors fall into some common traps when they start out. Here's how you can avoid those pitfalls.
Beginning investors don’t realize what they don’t know. It’s all unfamiliar territory, so it is natural to feel a bit unsure about selecting and maintaining a portfolio.
Following are nine information tidbits that can get you started.
1. Don’t try picking stocks
Purchasing individual stocks for investing is too risky for beginners, who lack the experience to predict which stocks will perform well and when to exit an investment.
Novices tend to look for stock advice in all the wrong places. Instead of buying individual stocks, buy shares of mutual funds that invest in many companies. That way, you lower investment risk by distributing it more broadly.
2. Fire your fund manager
It’s seductive to think you’ll find an ace manager who delivers terrific results.
Instead, research shows that most investors do better using unmanaged — or “passive” — index funds. Index funds mimic a market index’s movements and have lower fees. As Money Talks News founder Stacy Johnson writes:
There’s a mountain of evidence suggesting market timing is tough. For example, despite the fact that mutual funds employ both the smartest people and best technology on the planet, the average professionally managed mutual fund underperforms a simple, unmanaged index.
Index funds are a no-brainer for beginner investors.
3. Keep fees low
How much you pay in fees can make a big difference. The U.S. Securities and Exchange Commission says:
For example, if you invested $10,000 in a fund that produced a 10 percent annual return before expenses and had annual operating expenses of 1.5 percent, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5 percent, then you would end up with $60,858.
Morningstar‘s 2015 fee study found that the average asset-weighted expense ratio across all funds was 0.64 percent. But you can do even better. For instance, the Vanguard Total Stock Market Index Fund charges a mere 0.16.
4. Savings erode if you’re not investing
If your money isn’t growing, it is losing purchasing power to inflation, the rise of prices over time. For instance, you’d need $293 in 2016 to buy the same stuff you could get for $100 in 1980, according to this Bureau of Labor Statistics inflation calculator.
The Federal Reserve has a goal of maintaining a 2 percent inflation rate. If the Fed is successful, your savings must earn a minimum of 2 percent a year just to retain their full value over time.
5. Don’t put it all in stocks
When markets are hot and your savings are growing nicely, there’s a risk — especially for beginning investors — of becoming overconfident. When returns are great, it’s tempting to pour all your savings into stocks.
Don’t do it. It’s safer to spread risk among different types of investments. When one type of investment sinks, other types may rise, giving your portfolio a way to balance gains and losses.
How much of your savings should be invested in stocks? There are many different possible approaches, but Johnson suggests you subtract your age from 100, and put the difference as a percentage of your savings into stocks. For example, keep the following percentages of savings in stocks:
- 60 percent if you are 40
- 50 percent if you are 50
- 40 percent if you are 60
What should you do with the rest of your money? Again, opinions vary. One suggestion is to divide the rest of your savings in half. Put one half in a low-cost intermediate bond fund and the other half in a money market deposit account or other insured fund.
6. Invest some money conservatively
Stocks are too risky an investment for the money you’ll need as income within five years, Johnson says.
Instead, pick interest-bearing accounts or short-term investments such as bonds, bond mutual funds and CDs. Choose based on the best yield you can find for the time period you need.
7. Expect market declines
It can be scary to see your savings plummet in value in a market downturn. The impulse is to pull your money out of the stock market and stay out, as some investors did after the Dow Jones Industrial Average fell 514 points, or 5.7 percent, on a single day — Oct. 22, 2008.
But such investors missed out. It took a few years, but the market eventually recovered and pushed on to new highs.