Everyone knows that the stock market is highly lucrative. But that comes at a price - stocks tend to be a lot more volatile and risky than traditional bonds and savings accounts or GICs/CDs.
So how can you invest in the stock market without getting burnt?
In short, invest in stocks only if you have a long term investment plan, and if you aren’t risk-averse. If you are not a professional trader, you should invest in diversified indexes using low-cost ETFs to easily and cheaply spread your risk across hundreds or thousands of stocks. The most popular indexes include the S&P 500 and the Nasdaq-100 index.
However, before you go and jump into the world of equity investing, it is best to get a basic understanding of the available investment opportunities and how they work/ what they offer you.
Investment Basics for the Average Investor
There is no ‘one size fits all’ approach to investing - everyone has different circumstances and goals that can make some types of investments more preferable than others. There are typically five major ways for the average person to invest their money, namely:
- Fixed income: Guaranteed Investment Certificates (GICs)/Certificates of Deposits (CDs) and Government/Treasury bonds, money market funds, or high-interest savings accounts (HISA). Some may also consider annuities.
- Equity: Investments in the stock market, either as specific stocks or indexes that can cover hundreds to thousands of different stocks. Includes ETFs and mutual funds.
- Real estate: Direct investment in real estate or through proxies and management companies such as Real Estate Investment Trusts (REITs).
- Precious metals: Gold, silver, and platinum.
- Cryptocurrency: Bitcoin, Ethereum, and many more. Despite being easily available, cryptocurrencies are extremely risky, highly volatile, and lack regulation. However, they may be considered by professional investors who can afford to lose their entire investment.
Other less accessible investments can include:
- Commodities: Oil, natural gas, agricultural products, other industrial metals.
- Private equity: Startup funding, buying and managing private companies.
It’s important to understand your different investment options as each is associated with specific risks and rewards. In order from lowest risk to highest risk (as generally considered):
Fixed income < precious metals < real estate < equity (indexes) < equity (active investing) <<< cryptocurrency.
Precious metals are an ancient and traditional form of investment that dates back likely since the dawn of human civilization. While it has always remained popular, especially investment in gold, it hasn’t seen a significant return in the past decade. Gold still hasn’t reached its all-time high in Sept. 2011. Cryptocurrencies, on the other hand, can appear extremely lucrative but have faced sharp drawdowns in a matter of days.
To keep things practical, we will focus on the other three options- fixed income, real estate and the stock market.
Investing in Fixed Income
If you’re very risk-averse, yet still want to have a steady and secure return from your investments, you may consider investing in fixed income assets. Examples include government bonds (e.g. Federal Government Bonds, Treasury Bonds), corporate bonds, CDs/GICs, and money market funds. These investment options are usually very safe - the chance of the government defaulting on your debt or refusing to pay you back is practically zero - but typically yield lower returns than equity investments. This has been especially true since the Great Financial Crisis when interest rates plummeted, and even now interest rates still remain at near historic lows.
Fixed income is generally advised mainly for older people near retirement or if you expect to withdraw your investments within a few years. In these cases, your main priority is to preserve your existing capital rather than look for risky returns. They can also be used for diversification as it is expected that bonds will increase in value during a recession, allowing you to rebalance your other investments.
If you are young and have a long way to go, however, you should look for investment opportunities with a better long-term return. As a matter of fact, investing in a highly conservative manner runs against conventional investment advice for young adults, which says to invest aggressively expecting that you will have time to recover from any drawdowns or recessions. This way, you are also able to reap the increased returns of slightly riskier investments such as real estate and stocks and eventually have more money for retirement.
Investing in the Real Estate Market
Most people who choose to invest in real estate focus on purchasing houses then renting them out. This way, the rental income becomes a means of creating some extra cash flow and helps support costs and mortgage payments.
The most important thing when making this kind of investment is to ensure the house purchased has a combined property tax payment, home insurance payment and monthly mortgage cost that’s not far from the rent accrued. To achieve this, the investor should target areas that command high rental income to price ratios.
Investing in the Stock Market
The stock market is complicated with thousands of different companies and stocks, which can make it much better for an amateur investor to simply buy exchange-traded funds (ETFs) that track market-wide indexes. Compared to mutual funds or actively managed funds, ETFs tend to have much lower costs, with some ETFs in the US now offering zero management fees. The diversification of having hundreds or thousands of different stocks also reduces your investment risk - if any one company or even an industry suffers, your investment won’t be as significantly impacted.
You might be wondering what ETFs are. Simply put, an ETF involves the collection of securities (e.g. stocks) which often track underlying indices. The ETF is traded on an exchange such as the New York Stock Exchange (NYSE), just like stocks, hence its name ‘exchange-traded’. As the shares are bought and sold on the market, ETF shares can fluctuate throughout the trading day depending on the value of their holdings, but they are normally kept close to the real value of the fund by market makers or the fund manager. You also have to buy at least one whole unit (i.e. one share) at a time, which can sometimes mean a minimum investment of a few hundred. This sets ETFs apart from mutual funds, which are traded only once a day after market close and can be bought with any amount.
One of the most popular and prominent indexes, the S&P 500 index, has had a 25.77% return over the past year, with companies in the index expected to pay over $500 billion in 2019. Companies have to face a high standard to be included within the index, and this high-quality has shown to lead to high returns over time. Some of these companies, called “blue-chip stocks”, are household names like IBM, Bank of America, Disney, Walmart that can be expected to do well even in the face of a recession. Rather than having to pick for yourself, an index like the S&P500 will get you high returns with the safety of quality companies.
Creating an investment portfolio is something that requires a lot of consideration about your potential options and how they can fit into your financial plan for the future. Each option has its pros and cons, and it is often prudent to diversify your investments in order to decrease your risk and create a well-rounded portfolio that can take advantage of the benefits of compounding.