The Fundamentals of Investing

Stocks, bonds, 401(k)s, IRAs, oh my!

The list of financial jargon is endless. For most people that don’t make it a full time job the world of investing is a complex, confusing, and oftentimes scary place.

The challenge is, you know it is essential to build your wealth and be in a position to make work optional. So you Google “how to invest”. And you get over 4 billion results. 

Now what…

The challenge with investing is there is no single perfect answer. There are so many different ways to invest (maybe 4 billion?). So really the best place to start is what makes the most sense for you.

I believe the most important place to start is with why. Why are you investing? Common answers might include, to grow my wealth, to retire, to make money for a large purchase, etc.

Okay, second question, what is your time horizon? How long do you have to accomplish the goals above? If you want to get rich tomorrow, the ways to do that are a lot different than getting rich in 20 years (note: all methods to get rich tomorrow are going to be extremely speculative and have a very low probability of working).

If you are about to retire versus having 20 years ahead of you before you are at that point, that is also very different.

If you want to buy a house in the next 3 years, putting all your savings into high volatility assets is probably not the best idea.

What is your timeframe for needing the money you intend to invest?

• <1 year?

• 1-3 years?

• 4-8 years?

• 8-20 years?

• 20+ years?

Let’s take a look at these different timeframes (percentages are average annual investment returns):

<1 year:

Any planned expenses within the next year should be invested conservatively. You don’t want a sudden drop in the market to put you in a position where now you can’t afford what you were planning on buying. Below are several options to consider that provide limited returns but have limited volatility such that you can expect all your money to be there when you need it.

• Savings accounts (3-4%)

• Certificates of Deposit (CD) (3-5%)

• Treasury Bills (4-5%)

1-3 years:

For shorter time horizons you still want to be fairly conservative as there isn’t much time for the market to correct if things take a dip.

• Savings accounts (3-4%)

• Certificates of Deposit (CD) (3-5%)

• Treasury Bills (4-5%)

• Treasury Notes (3-4%)

4-8 years:

As you start to get out to longer time horizons you can be more aggressive by adding bonds and some stocks. Stocks generally offer the highest return over longer time periods but are also more volatile. Bonds can provide decent returns and are generally less volatile than stocks. 

• Treasury Notes (3-4%)

• Bonds (5-7%)

• Stocks (7-10%)

8-20 years:

As you have a longer time horizon, consider moving to more stocks.

• Bonds (5-7%)

• Stocks (7-10%)

20+ years:

For the longest time frames, stocks generally provide the best return and volatility is less consequential.

• Stocks (7-10%)

There are many other types of investments than just stocks, bonds, notes, bills, and CDs but those are the basics. For most people that is usually where they start and then once they have mastered the fundamentals, move on to other types of investments. Check out our other post What Should I Invest In? for a broader look at different types of investments.

What vehicles can you use for these types of assets?

Bank Account

Most banks offer different types of savings accounts as well as certificates of deposit (CD). These are usually FDIC insured (up to $250,000) per account holder per bank. 

Treasury Account

An account can be opened with the US Treasury at www.treasurydirect.gov. Here you can directly buy treasury bills, notes, bonds, and TIPS.

Brokerage Account

A brokerage account is a standard investment account that allows you to purchase stocks, bonds, ETFs, mutual funds, etc. Common providers are TD Ameritrade, Schwab, Fidelity, eTrade, Robinhood, etc. There are no tax savings with this type of account as all money is both after tax and taxed on capital gains. 

Retirement Accounts

Retirement accounts are similar to a brokerage account but offer special tax advantages depending on the type of account. There are also rules that come with these accounts as far as what you can and can’t do with the money.

1. 401k

• Employer sponsored retirement account (can only access through employer)

2. IRA (Individual Retirement Account)

• An account that can be opened by any individual that does not need to be sponsored by an employer

3. SIMPLE 401(k)

• Special type of 401(k) for smaller businesses

• Lower contribution limit than a standard 401(k)

4. SIMPLE IRA

• Similar to a SIMPLE 401(k) but with slightly different rules

5. SEP IRA

• For self-employed people with no employees

6. Solo 401(k)

• Similar to SEP IRA but with different rules

7. 403(b)

• Retirement plan offered by public schools, charities, and other non-profits

• Similar to a 401(k)

8. 457(b)

• Retirement plan offered to state and local government employees

• Similar to 401(k)

• Not impacted by 10% early withdrawal fee

9. TSP (Thrift Savings Plan)

• Retirement plan offered to federal employees and uniformed service members

• Similar to 401(k) but with more limited investment options

10. ESOP (Employee Stock Ownership Plan)

• Employer gives shares of company stock to employee as part of compensation

11. HSA (Health Savings Account)

• Tax advantaged account for qualified medical expenses

12. Pension

• Defined benefit plan from an employer 

1. Employee does not make contributions

2. Payout is based off the success of pension fund and time worked

Roth versus Traditional

Some of the above plans also offer two different types, a Traditional version and a Roth version.

1. Traditional

• Pre-tax contribution (reduces taxable income)

• Tax-free growth

• Taxed as ordinary income upon withdrawal

• Can’t withdraw until 59-½

• Early withdrawal penalty of 10%

• Can use for 1st time homebuyer or qualified higher education expenses

• Required Minimum Distributions (at 73 years old - soon to be 75)

• Must have earned income to contribute

2. Roth

• Post-tax contribution

• Tax-free growth

• Tax-free withdrawal

• Can withdraw contributions at any time without consequence

• Withdrawals of capital gains would be subject to taxes prior to 59-1/2

• No Required Minimum Distributions (RMDs)

• Subject to income eligibility restrictions

How much do you need to invest?

I don’t have to be a mind reader to know that you wish you had more money to spend. So how do you balance your desire to travel, spend, live, etc. with growing your wealth and making work optional?

There are 4 steps to this process.

1. Set goals

• You aren’t going to be able to figure out how much you need to invest if you don’t know ultimately how much you need. Set some specific goals for what your investments are for. Make sure to include dollar amounts and when you would need to use the money. You can use your current spending as a baseline for if you will need more, less, or the same in the future.

2. Determine your starting point

• How close are you currently to your goals? What would happen if you changed nothing about what you are doing currently? Would you make it?

3. Develop a plan

• By now you have figured out where you stand currently and where you want to be. Connect the dots. Some simple calculations can help you determine how much you should be saving/investing over those time frames to accomplish your goals.

4. Allocate cash flow accordingly

• Now you know how much money you need to save for each bucket in order to reach your goals. Do you have enough to hit all of them? If not, then you will need to start prioritizing which goals are the most important. You can also look at reducing the dollar value of the goal, increasing the time to achieve it, or look at ways to increase your income to be able to allocate more money.

Just Get Started

We have covered a lot in this overview of investing but there are still so many other things that weren’t mentioned. The most important thing is just to start. You are never going to have all the information or be able to do things perfectly. Don’t let analysis paralysis prevent you from starting.

The most valuable piece of investing is the power of compounding. As much as your investment returns factor into that, arguably, time is an even more important factor. Get started today with the basics, learn over time, and adjust your strategy as you gain more experience.

If you are still not sure on what to do or want to discuss with an expert, we are happy to help with a free consultation.