What to Know Before You Invest in Stocks

Photo (cc) by rednuht

If you want to retire rich, you only need to do three things. The first is to keep debt to an absolute minimum, because paying interest simply increases the cost of whatever you’re financing. The second thing you need to do is to live below your means: to always spend less than you make and set money aside.

Thousands of tips and suggestions to spend less and pay off debt appear on hundreds of websites, including this one, and in dozens of books, including my latest, Life or Debt 2010.

Less often discussed but just as important, however, is the third thing you’ll need to become financially independent: knowledge about investing. Because while cutting up your credit cards and skipping $4 lattes is smart, how you invest those savings can determine success or failure in reaching your goals.

Let’s say you’re determined to save extra money by reading stories like 28 Tasty Tips to Save on Food, 18 Tips to Dress for Less or 26 Ways to Save on Entertainment. And as a result of all this sage advice, you find yourself with an extra 10 bucks a day, or $300 a month. If you have any sense, the first thing you’ll do is use that new-found money to pay down debt. But what then? If the only thing you do is put your savings in 1% money market account, after 20 years you’ll compound your way to a balance of $80,000. Nice. But if you earn 10% instead of 1%, your nest egg will increase to about $228,000. Way nicer.

So learning to invest your spare money wisely, including the money you’re (hopefully) putting aside in your retirement plan, is nearly as important as learning to find it. And if you approach it properly, it’s really not that hard.

When it comes to investing, while it may seem there are dozens of options, there are really only two. You can either be a loaner or an owner. A loaner is someone who allows others to borrow their money in exchange for interest. An owner, on the other hand, invests in somebody else’s business with the hope that their ownership interest grows in value.

If you put money in the bank, or in any kind of bonds, you’re a loaner. You’re investing in debt. If you invest in the stock market or real estate you’re an owner. You’re investing in equity. Over decades, loaner investments like government bonds have paid a little less than the inflation rate: about 4%. Owner investments, like stocks, have paid a lot more, beating inflation by a few percentage points: about 8%. This is as it should be: after all, ownership investing carries additional risk. If it didn’t pay more, nobody would do it.

But that doesn’t mean owner investments are better than loaner. Both are necessary. Loans offer relative safety, depending, of course, upon who you lend your money to. And ownership investments offer the opportunity for growth, depending on whose business or what real estate you invest in. If you try to play it too safe and put all your money into super-safe loan investments, you’re practically guaranteed to lose to inflation over time. But if you put all your eggs in a risky ownership basket, you’re likely to lose both sleep and your savings. So you need both. The trick is how to determine how much of each, then to learn about both.

With that in mind, check out this recent story I shot on the floor of the New York Stock Exchange that describes some things beginning investors should consider. Then meet me on the other side for more.

To recap those tips:

  • Don’t ever put any money into stocks that you could possibly need within five years. The longer your time horizon, the lower your risk. This is also true of real estate investments.
  • Don’t put all your eggs in one basket. If you can’t afford to buy more than one stock, use a mutual fund or Exchange Traded Fund. That way you own a sliver of lots of different companies rather than just one or two. (I’ll be explaining those in more detail in future stories.)
  • Don’t invest in stocks all at once: invest small amounts monthly. That way, should the market fall, you’ll have money on the sidelines to buy at lower prices.
  • To decide how much to put in loaner investments (the bank) and how much to put in owner investments (stocks or real estate) here’s your rule of thumb: Subtract your age from 100 and that’s the percentage you might want to put in stocks. So if you’re 25 years old, you’d take 25 from 100 and put that amount, 75%, of your long-term savings into stocks. If you’re 75 years old, you’d only take that kind of risk with 25% of your savings.

Sound overly simplistic? Maybe, but as I turned on the news during the 2008-2009 market decline, the airwaves were full of retirees who were being forced back to work by the 50% thrashing their retirement funds had suffered at the hand of stocks: a sure sign they were over-invested. And for a little salt in the wound, many of these same people, unable to tolerate the risk of ownership investments, left the market just in time to miss a 65% one-year rally: one of the biggest bull market runs in history.

I spent 10 years as a stockbroker and have been investing in stocks and real estate for nearly 30. I know how to make money in both of these areas, but not because I’m a genius. I learned this stuff the hard way; by losing many thousands of dollars. In fact, I paid a lot more to learn proper investing than I did to attend college. But that’s not going to happen to you. You’re not going to be a sad story on the evening news. You’re going to use the above tools to make sure you don’t take too much risk, and in other stories I’m going to give you more specific information so you won’t make the same stupid and expensive mistakes I did.

Want to learn more about investing, and for free? Check back often and if you know someone who could use the advice, tell them to join us too.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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