1. Pick an asset class. You could buy stocks or bonds, as well as choose from a slew of other alternative investments. To keep things simple, however, nothing wrong with sticking with just stocks and bonds.
Many experts urge average investors to put their money in mutual funds rather than buy individual stocks and bonds. You can choose a stock mutual fund, a bond mutual fund or a portfolio of mutual funds that includes both stocks and bonds.
In our hypothetical example above, we chose a pure stock mutual fund. That’s because, in the long run, stocks offer a greater rate of return than other asset classes such as bonds.
As Money Talks News founder Stacy Johnson explains in “Beginning Stock Investor? Here’s All You Need to Know“:
Depending on how you measure it, stocks have averaged 8 percent to 10 percent annually over the last 100 years. Of course, stocks entail risk; that’s why they pay more.
Fortunately, mutual funds help mitigate risk because they are made up of a wide variety of stocks. That helps spread the risk — if one company in your mutual fund goes bankrupt, it won’t wipe you out.
2. Pick active or passive management: Actively managed stock mutual funds are run by financial professionals who decide which individual stocks within the fund to buy and sell. They make these judgments based on their expectations of future market performance.
Such managers aim to outperform stock market indices — and they charge higher fees for their effort.
Passively managed stock mutual funds, often referred to as index funds, simply aim to mirror the success of a stock market index.
Here’s Johnson again:
Owning an index fund is like owning the entire stock market, as represented by an index, like the S&P 500. Since all an index fund manager has to do is buy the stocks in the index, a chimpanzee could do it. And because management is simple, the fees charged are minimal.
Study after study has shown that index funds historically have performed better — at a lower cost to the investor — than managed funds over a long period of time.
Johnson is hardly the only expert who champions index funds.
Warren Buffett, billionaire investor and CEO of Berkshire Hathaway, made headlines last year when he wrote in his annual letter to shareholders that his fortune is destined for index funds. Buffett wrote of the instructions laid out in his will:
My advice to the trustee could not be more simple: Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
Perhaps that wisdom is why Buffett is in the No. 2 spot on the Forbes 400.