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Beginning investors don’t realize what they don’t know. It’s all unfamiliar territory.
Purchasing individual stocks for investing is too risky for beginners, who lack the experience to predict which stocks will perform well and when to exit an investment.
Novices tend to look for stock advice in all the wrong places, says U.S. News & World Report blogger Steve Beck, co-founder of MarketRiders, an online investment management company. He wrote:
[T]he dumb money is the individual investor who watches CNBC for stock tips. It is the investor that gets a hunch, or better yet, a stock tip from a friend, and acts upon it. The dumb money is the lemming-like masses that plunge off the bluff and into the sea when despair is on tap, and double down on their investment when a sector is running hot.
Do participate in the stock market. But instead of buying individual stocks, buy shares of mutual funds that invest in many companies. That way your investing risk is less because it is distributed broadly.
It’s seductive to think you’ll find an ace manager who delivers terrific results.
Instead, research shows, most investors do better using unmanaged (“passive”) index funds. Index funds mimic a market index’s movements and have lower fees.
Looking at advanced portfolios holding 10 asset classes between 1997 and 2012, researchers found index fund portfolios outperformed comparable actively managed portfolios a staggering 82 percent to 90 percent of the time. And the longer investors held those investments, the better shot they had at outperforming active funds over time.
Index funds are a no-brainer for beginner investors.
In 2013, The Associated Press says, the average expense ratio (operational costs) for a stock mutual fund was 0.74%, that’s $74 per $10,000 invested. But you can do even better. For instance, the Vanguard Total Stock Market Index Fund charges 0.17%.
How much you pay in fees can make a big difference. The U.S. Securities and Exchange Commission says:
For example, if you invested $10,000 in a fund that produced a 10 percent annual return before expenses and had annual operating expenses of 1.5 percent, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5 percent, then you would end up with $60,858.
If your money isn’t growing, it is losing purchasing power to inflation, the rise of prices over time. For instance, you’d need $288 in 2014 to buy the same stuff you could get for $100 in 1980, according to this Bureau of Labor Statistics inflation calculator.
Inflation has been about 3% a year or less for the past 20 years, this chart at the Federal Reserve Bank of Minneapolis shows, so your savings must earn a minimum of 3% a year just to retain their current value.
Burying cash in coffee cans in your yard is a terrible long-term investing plan. If it manages to survive the elements, it will still be worthless given enough time.
When markets are hot and your savings are growing nicely, there’s a risk, for beginning investors especially, of becoming overconfident. For example, between November 2013 and November 2014, the S&P 500 index grew more than 14%. With returns like those, it can be tempting to pour all your savings into stocks.
Don’t do it. It’s safer to spread risk among different types of investments. When the economy favors one type, others may decline, giving your portfolio a way to balance gains and losses.
To help decide how much savings to put into stocks, here are a couple rules of thumb:
Divide the rest of your savings in half. Put one portion in a low-cost intermediate bond fund and the rest in a money market deposit account or other insured fund.
Stock are too risky an investment for the money you’ll need as income within five years, Stacy Johnson says.
Instead, pick interest-bearing accounts or short-term investments like bonds, bond mutual funds and CDs. Choose based on the best yield you can find for the time period you need.
Larry Rosenthal of Next Avenue advises:
It’s often helpful to “bucket” assets for different time horizons, with conservative investments allocated for short-term needs, moderate investments for midterm goals (three to five years from now) and more aggressive for longer-term goals (five-plus years away).
It can be scary to see your savings plummet in value in a market downturn. The impulse is to pull your money out of the stock market and stay out, as some investors did after the Dow Jones Industrial Average fell 514 points, or 5.7%, on Oct. 22, 2008.
But those investors missed out: The market eventually recovered and pushed on to new highs.
If you’re spending more than you make, living on credit or have no emergency fund, you are creating financial stress that can lead you to make risky investment decisions.
Financial pressure can undermine your retirement savings in other ways. If you are forced to borrow from investments or take cash out, you may suffer penalties and fall behind on savings.
Investing is a skill. It takes time and effort to read, research and find a safe but rewarding path. You can learn through your mistakes, but it’s simpler and cheaper to learn from others.
Hire a fee-only financial planner. Two places to look:
Read investing books. Three classics:
Read online:
Other resources:
This post originally appeared on Money Talks News.
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