So you've got some money you want to invest for the long-term, but aren't sure how to get started. Don't be intimidated - you can start slowly and then get more involved as you gain confidence.
Investing is actually a lifetime's worth of learning. Even seasoned pros regularly encounter situations they haven't quite seen before. No one knows it all, but the following are some basics you should know as a beginner investor:
1. Come to terms with asset allocation
Asset allocation is the mix of stocks, bonds and liquid investments that you own, and it can have a huge effect on the risk/reward characteristics of your portfolio.
Stocks can give you a chance for growth over the long-term, but they can also have years like 2008 when the U.S. stock market lost 38.5 percent, or 1931 when it lost 47.1 percent.
In their simplest form, a liquid asset could be a bank savings account but it can also include cash equivalent funds that investors can use to hold their money between investments. These have stable values, but only offer a modest interest rate as a return.
Bonds are somewhere in between. They typically pay income at regular intervals, but their prices can go up and down depending on the issuer and how far off the maturity date of the bond is.
Within the broad categories of stocks, bonds, and cash, there are even more precise distinctions such as large cap vs. small cap stocks, U.S. vs. foreign investments, etc. Also, there are additional categories such as commodities or real estate, but these often take more specialized knowledge than the typical beginner investor has.
Whichever categories of investments you choose to participate in, make a conscious decision about how to allocate among these asset classes based on your desired risk/reward characteristics.
2. Decide whether to make individual picks or achieve broad representation
Within a given asset class such as stocks, you can choose individual securities or use a diversified mutual fund to get a broad range of representation efficiently. There are even multi-asset class mutual funds that can take care of asset allocation decisions for you.
Picking individual stocks typically has a higher upside but also a riskier downside than investing in broad segments of the market. Between the two extremes, you can invest in specialized mutual funds if there are general themes to your investment outlook. For example, you might invest in a technology fund if you think it's a good time for tech stocks.
3. Take advantage of your employer's retirement fund
If your employer has a retirement plan like a 401(k) that allows participants to direct their investments, this is a great way to gain some experience with investing. Not only do 401(k) plan contributions have tax advantages, but the plan's investment menu is likely to offer you cost-effective access to professionally-managed investment vehicles. One drawback though is that you could be limited to the investment choices on that menu.
4. Consider whether to own funds or individual securities
Even if you want a broadly-diversified portfolio, you may still have a choice between investing in mutual funds or owning a portfolio of individual securities.
For relatively small investors, owning mutual funds may be the most cost-effective way of achieving diversification. However, owning and trading individual securities gives you more flexibility to make specific investment decisions.
5. Understand the benefits and limits of diversification
As noted previously, owning an individual stock is riskier than owning a broad array of stocks. Diversification - spreading your money across several different securities - is one way to dampen the risk of your portfolio.
A variety of studies have demonstrated that you can achieve most of the benefits of diversification by owning 20 or 30 stocks. However, this depends somewhat on how similar those stocks are. If all of your stocks are in one economic sector, many of them may perform similarly and not be representative of the overall market. So, diversification is more than just a numbers game. It involves owning investments with substantially differing economic exposures.
Note that even full diversification does not protect you from what is known as systematic risk. This means that if the whole market goes down, a fully-diversified portfolio is likely to go right down with it.
6. Find the right online broker for your needs
Online brokerage firms make securities trading and investment resources widely available on a very cost-effective basis.
If you are starting out with a modest amount of money to invest, the key things to look for from an online broker are cost-related. The commission rate is important, but you also need to find an online broker with a minimum account size you can meet. In addition, try to avoid those that charge a monthly maintenance fee, as this will represent an especially large percentage of a smaller portfolio.
As you become more sophisticated as an investor, the flexibility of the trading platform, tools like portfolio simulators, and the availability of research sources are likely to become more important to you in your choice of an online broker - but cost should remain a factor.
7. Ask yourself some tough "what if" questions
Before you start to invest, ask yourself some tough "what if" questions. What would happen if the value of this investment dropped in half? Would I be able to live with an investment that took a decade or so to work out? Etc.
Questions like these confront some of the risks of investing. Asking yourself these questions up front will help you decide whether you can afford the risk of a given investment, and they can help you make better decisions if things do go against you.
Good luck as you begin your journey as an investor. At worst, it is an opportunity to learn, but at best it is an opportunity to make money for a more comfortable future.