By Motley Fool Staff
Once you've figured out why you should invest, the next step is learning how. We'll break that question into two parts. First, we'll talk about how you can structure your financial life to make it possible to invest. Then, we'll delve into the mechanics of investing, such as opening a brokerage or mutual fund account.
What is investing?
Any time you invest, you're devoting your own time, resources, or effort to achieve a greater goal. You can invest your weekends in a good cause, invest your intelligence in your job, or invest your time in a relationship. Just as you undertake each of these expecting good results, you invest your money in a stock, bond, or mutual fund because you think its value will appreciate over time.
Investing money involves putting that money into some form of "security" -- a fancy word for anything that is "secured" by other assets. Stocks, bonds, mutual funds, and certificates of deposit are all types of securities.
As with anything else, there are many different approaches to investing -- some of which you've probably seen on late-night TV. A well-dressed, wildly positive (though somewhat whiny) young man sits in front of lazily waving palm fronds, shaking his head about how incredibly easy it is to amass vast wealth -- in no time at all! Well, hey! That sounds fine! But if it were so easy, wouldn't everyone who saw the same pitch be rich? And how come you always have to send in money to learn those wealth-building secrets?
We suggest you take the $25 you'd spend on the hardcover EZ Secrets to Untold Billions book and the $500 you would shell out for the EZ Seminar, and invest it yourself -- after you've learned the basics here.
First, douse your debt
After learning why investing is a smart thing to do, you're probably itching to take the next step. You want to drop everything and start investing right now. But hold on! Would you start running a marathon without first stretching? Would you pour syrup on the plate before the pancakes are done? Having dazzled you with the power of compounded returns, we want to make sure that same principle's not working against you. Before you start investing, you've got to get rid of your high-interest debt.
The very same principle of compounding that helps your investments grow can quickly transform a dollar of debt into a few hundred dollars. Does it make sense to try to save money even as your debts are multiplying like bunnies? No way. Although some kinds of debt may be low-interest or tax-advantageous (such as your mortgage), you'll want to free yourself from the high-interest stuff before you begin to invest.
Every dollar you can put toward investing will work for you. And every dollar of yours kept out of the pockets of financial professionals or full-service brokers is also creating value for you. (We'll get back to this point later.)
Pay yourself first
To become a successful investor, make investing a part of your daily life. That's not as great a stretch as it may sound. After all, you make decisions that affect your finances every day, whether you're ordering a $7 glass of wine with dinner or getting a home equity loan to pay down credit card debt.
We're not suggesting that you obsess over every penny you throw into a wishing well. (Please don't embarrass your mother by diving in after it.) If you pay yourself first, you won't have to.
You already pay the companies behind your credit card, gas, water, electric, cable, and phone bills every month, right? Why not add yourself to the list? Heck, put yourself right at the top. Set aside a chunk of money to save or invest when you first get your paycheck, and you can happily forget about it for the rest of the month.
The Motley Fool recommends that you save as much as possible; 10% of your annual income (total, not take-home) is a good goal. Depending on your obligations, you may be able to save more or less. The more you save, the more wealth you create -- but anything is better than nothing. Even a few dollars saved now will be worth more than lots of dollars saved later.
With online banking and brokerage services, it's easier than ever to set up automatic monthly transfers between your checking account and a savings account or investing vehicle of your choice. You'll be surprised how easy it is to live on a little less money each month -- in fact, you probably won't even notice the difference.
Don't hesitate to be flexible about your savings. If you find yourself truly pinched for pennies once all the bills are paid, perhaps you're paying yourself too much. Perhaps you're not yet in a position to start paying yourself at all. That's perfectly OK -- but as soon as you can feasibly start saving, jump right in! The earlier you start, the better.
Active and passive strategies
The two main methods of investing in stocks are called active and passive management, and the difference between them has nothing to do with how much time you spend on the couch (or the exercise bike). Active investors (or their brokers or fund managers) pick their own stocks, bonds, and other investments. Passive investors let their holdings follow an index created by some third party.
When most people talk about stock investing, they mean active investing. It may sound like the superior strategy, but active investing isn't always all it's cracked up to be. Over the long haul, most actively managed stock mutual funds have underperformed the S&P 500 Index, the most popular and prominent benchmark for index funds.
In that light, you can understand why some people want an alternative to "active" management. Many people who just want a return roughly equal to that of a major stock index prefer passive investing. Beyond the S&P 500, you can find passive investments in many indexes, including the Russell 2000 for small-cap stocks, the Wilshire 5000 for the broad market as a whole, and various international indexes as well.
Investing versus speculating
Right about now, you may be thinking about that brother-in-law who "made a killing" in options. Or maybe you're reminiscing about the Nevada vacation when your one lucky quarter magically drew out 700 more with the pull of a slot-machine lever. Why put your money in slow-and-steady investment vehicles that merely promise double-digit returns, when you could have near-instant riches? With compounding, you have to wait patiently for years for your riches to accumulate. What if you want it all now?
Granted, there's nothing exhilarating about predictability. Matching the performance of the S&P 500 won't make you the life of the party. But neither will the far more common tales about how you lost your savings on some speculative gamble -- nor a recounting of your subsequent adventures in bankruptcy court.
You don't need a card dealer, dour strangers, or Wayne Newton background muzak to gamble. Plenty of stock market gamblers do an admirable job of losing their money on seemingly legitimate pursuits. At The Motley Fool, we believe investors "gamble" every time they commit money to something they don't understand.
Suppose you overhear your best friend's dentist's nanny talking about a company called Huge Fruit at a cocktail party. "This thing is gonna go through the roof in the next few months," she says in a stage whisper. If you call your broker the first thing the next morning to place an order for 100 shares, you've just gambled.
Do you know what Huge Fruit does? Are you familiar with its competition (Heavy Melon)? What were its earnings last quarter? There are a lot of questions you should ask about a "hot" company before you throw your hard-earned cash at it. A little knowledge could help keep you from losing a lot of money.
Remember, every dollar that you speculate with and lose is a dollar that's not working to create long-term wealth for you. Speculation promises to give you everything you want right now, but rarely delivers. In contrast, patience all but guarantees those goals down the road.
Planning and setting goals
Investing is like a long car trip: A lot of planning goes into it. Before you start, you've got to ask yourself:
Where are you going? (What are your financial goals?)
How long is the trip? (What is your investing "time horizon"?)
What should you pack? (What type of investments will you make?)
How much gas will you need? (How much money will you need to reach your goals? How much can you devote to a regular investing plan?)
Will you need to stop along the way? (Do you have short-term financial needs?)
How long do you plan on staying? (Will you need to live off the investment in later years?)
Running out of gas, stopping frequently to visit restrooms, and driving without sleep (this is the last of the travel analogy, we promise) can ruin your trip. So can saving too little money, investing erratically, or doing nothing at all.
Don't let yourself get away with fuzzy answers, either. Investing demands hard numbers -- get used to them. You'll need to pin down exactly how much it'll cost to send a child to college, or how much you'll need to live on in retirement. It can be liberating to see exactly what you need to reach your destination, and that precision helps you stay accountable to yourself along the way.
Don't worry -- you don't have to do all the math yourself. Online interactive calculators can help you figure your future money needs. The more specific you can be, the more likely you are to set and achieve reasonable goals.
How stock trading works
You've whipped your finances into shape. You've set concrete financial goals. Now you're ready to learn how to start making your investments. If you use a mutual fund, the process is pretty easy: Contact the fund company and ask to open an account. But with stocks, things get a little trickier.
Stocks trade on exchanges. In the U.S., the major exchanges are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq Stock Market. While there are differences in the way the various exchanges handle trades, buying and selling shares on any of them involves a similar process.
Exchanges bring together buyers and sellers. The price that buyers are willing to pay for shares is called the "bid," while the price sellers are willing to accept to sell their shares is the "ask" price. The difference between these two prices is called the "spread." Usually, the spread goes into the pockets of the exchange professionals who handle trades.
The amount of spread will vary, depending on the volume of shares traded. For heavily traded stocks, competition will make spreads quite small. Thinly traded stocks may carry a large spread, in order to compensate exchange professionals for the risk they take.
Investors can set their own bid or ask prices, too, by placing orders to sell or buy only at a specific price. (These are called "limit" orders.) Exchange professionals keep a close eye on these "open" orders, executing them when conditions are met, and using them to gauge demand for the stock.
Brokerage accounts are the most common way to buy stocks. You can either use one of the many way-too-expensive full-service (or full-price) brokers, or execute your trades through a discount broker. Learn more about how to pick one in our Broker Center, where you can compare brokers and open an account.
The perils of margin
When you use a brokerage account, you can have a cash account or a margin account. The former lets you trade only with money you actually have. The latter -- and right about now, you should be hearing alarm bells and warning sirens -- lets you purchase stocks with borrowed money. Margin accounts can increase your returns -- but they'll also increase your risk.
Brokers, who have a vested interest in enticing customers to use margin, like to say that such accounts increase your "buying power." But in reality, buying on margin only enhances your "borrowing power." You'll have to pay all that margin money back at some point -- forget that at your peril.
Brokers make a good part of their money by collecting interest on margin loans. And since margin gives investors more (borrowed) money with which to buy stocks, it generates greater commission fees for those same brokers. The broker has total control over the collateral for the loan, including the ability to step in and force you to sell stock if it thinks you're in danger of defaulting on its loan. For brokers, margin is a cash cow; for investors, it's a double-edged sword.
Dividend reinvestment plans (DRPs) and direct investment plans (DIPs)
Not yet ready to open a brokerage account? These plans offer another, steadier way to buy stock. Lovingly known by many investors as Drips, they allow shareholders to purchase stock directly from a company, with only minimal costs or commissions. Not every company offers such plans, but they're great for people who can only invest small amounts of money at regular intervals.
All right, Fool -- you've got a rough idea of what you want to do with your finances, how much money you'll need, and how much time you have to reach that goal. And you now know how to start investing your money in the market. For your next step, it's time to start thinking about exactly what you should invest in, and the kind of returns you can reasonably expect.