The Basics of Investing
Learning the basics of investing is like learning a new language. It is easy to get lost or feel overwhelmed. The good news is that once you have mastered certain investing basics, you'll better understand how your money is being invested for your future plans.
To assist you on that journey, here is a look at the handful of the most common types of investments you will encounter in your lifetime: stocks and bonds, mutual funds, and real estate.
Basics of Stocks
Without a doubt, owning stocks has been the best way, historically, to build wealth. And for more than a century, investing in bonds has been considered one of the safest ways to make money.
Stocks are shares of ownership in a specific company. When you own a share of Apple, for example, you own a tiny piece of that company. Stock prices fluctuate with a company's fortunes, and also with the economy at large. Public companies list and share their shares on exchanges. There are several exchanges in the U.S. and around the globe. Some companies issue shares but are private—meaning they do not trade on an exchange.
You can buy and sell a stock—in any quantity you like—without the requirement to hold it for any specific length of time. The market price of one share is determined by the supply and demand for that share on the open market exchange. Your broker will usually charge a service charge or commission to process your order to buy or sell a stock.
These investments come in different quality depending on the underlying company's financial stability. Some stocks pay a regular return of company profits in the form of dividends, and others do not. Investors can realize capital gains if the shares appreciate in value above what the paid for them.
If you sell an investment for more than you paid for it, you'll be required to pay capital gains tax on the profits.
When you buy a bond, meanwhile, you are lending money to the company or institution that issued it. Bonds are debt securities and can be in the form of Treasurys, municipal bonds, corporate bonds, and other types of debt. You are lending money that the borrower will pay back by a stated date. Until they pay you back, the borrower will pay you interest on a regular basis.
Like with stocks, bonds come in different quality with the best being AAA. Rating agencies like Moody's set the rating on a bond. Some bonds are called junk bonds due to the instability of the underlying company and are riskier to own.
Bonds have to be held for a period before they mature. However, you can resell them on the secondary market through your broker. Once again, your broker will charge a commission to transact the deal.
In the case of a school bond, for instance, you are lending money to the school district to build a new high school or improve classroom conditions. Buying a bond issued by a company means you're lending money to that company, which it can use to grow the business.
Investing in Mutual Funds
One of the most popular ways to own stocks and bonds is through mutual funds. In fact, most people are statistically less likely to own individual investments than they are shares of companies through mutual funds held in their 401(k) or Roth IRA.
Mutual funds offer many benefits to investors, particularly to beginners who are just mastering investing basics. They're pretty easy to understand and allow you to diversify your investments over more companies. However, mutual funds also have a few serious drawbacks: they charge fees, which can eat into your profits, and with some funds, they may boost your tax bill, even in a year when you don't sell shares.
Mutual funds are pooled money investments that will have a primary focus. As an example, you may see a mutual fund that follows a particular index, invests primarily in a specific region of the world, or focuses their holdings on a specific size of company.
You and hundreds of other people give a fund manager money which they invest in various holdings. The manager uses the pooled money to purchase investments that align with the stated goal of the fund. This professional will buy or sell portfolio holdings and periodically return profits to the investors. These investments will charge various types of fees to pay for the management and promotion of the fund.
Mutual funds price once per day using the net asset value (NAV) at the market's close. Any transaction you made with the fund executes at that time and at that price.
In most cases, there is a broker fee to buy or sell these holdings.
Real Estate Investments
The world is full of people who are convinced that real estate is the only investment that makes sense. Whether you subscribe to that philosophy or not, there are more ways than ever to add real estate to your portfolio.
Yes, you can buy a home for yourself, or properties to rent. But you also can purchase securities called a real estate investment trust (REIT). REITs have a structure much like a mutual fund where a professional manager handles the individual assets held within the trust's portfolio. However, in this case, all the investments are only in real estate.
You will see REITs that focus on the tangible property of land, shopping malls, apartment buildings, senior community facilities, and even medical marijuana facilities. To qualify as a REIT, a fund must meet specific benchmarks set by the Internal Revenue System (IRS).
Investing Structures and Entities
When you move beyond stocks, bonds, mutual funds, and real estate, you encounter different types of investment entities. For example, millions of people will never own a share of stock or a bond. Instead, they invest their money in a family business, such as a restaurant, retail shop, or rental property. Yes, these are businesses, but you also should consider them investments, and treat them accordingly.
More experienced investors likely will invest in hedge funds or private equity funds or trade in futures and options contracts. Others will buy shares of publicly traded limited partnerships through their broker. These special legal structures can have big tax implications for you, and it is important you understand how investing through them can both benefit, and potentially harm, your pocketbook.
Investing in a Bad Economy
It's the nature of the world that sometimes bad things happen. When they happen to your investments or savings, you don't need to panic. Sometimes, you need to take a hit before you can make some money again, and holding on until the recession ends is often the best plan.
Besides reading and learning as much as you can, one of the best things you can do is talk to a financial planner or accountant who can help you better understand the world of investing.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Investor.gov. "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing." Accessed Jan. 15, 2021.
IRS. "Topic No. 409 Capital Gains and Losses." Accessed Jan. 15, 2021.
Vanguard. "Realized Capital Gains." Accessed Jan. 15, 2021.
FINRA Foundation Investor Education—Insights: Financial Capability. "A Snapshot of Investor Households in America," Page 1. Accessed Jan. 15, 2021.
Fidelity. "Mutual Funds and Taxes." Accessed Jan. 15, 2021.
IRS. "Instructions for Form 1120-REIT." Accessed Jan. 15, 2021.