Disclaimer: I am not a licensed financial advisor and the information in this article is not meant to be individualized financial advice. Everyone’s situation is different, so if you are unsure about what to do with your funds, please seek an advisor that can consider your own individual case and make recommendations to you.
Once you have opened your IRA or brokerage account and have begun contributing, you may run into a problem. Where should you invest the funds in the account? Is it worthwhile to try to choose stocks on your own to invest in? Are mutual funds the best option for safety? What about index funds? This can all be very complicated as there is a nearly unlimited number of options for your investment accounts. After reading several books on the subject, as well as blog posts and podcasts, I determined how I will invest the majority of my funds. Before I talk about what I chose, let’s discuss some of the options. There may be additional options for very high net worth individuals, but I will keep this more geared to the new investors which will mean that you likely don’t have millions of dollars to invest.
- Choosing your own individual stock funds: This is by far the most risky option and not one that I would recommend for 99% of people. There are people who choose stocks for a living and still lose money in this realm. The possibility of someone with no investment knowledge and limited amounts of time to study individual stocks succeeding here is very rare. Please do not buy stocks of a company just because you like the company but have no knowledge about the business aspects or finances of that company, this is just asking for trouble.
- Picking a mutual fund and letting the fund manager choose where to put your money: A mutual fund is a collection of individual funds. These could be stocks, bonds or other assets. Because of this, mutual funds are less risky because your money is more diversified across multiple funds instead of just one fund. At any given time an individual fund could drop significantly in value due to some unforeseen circumstance, but it is much more unlikely that this will happen to several funds at the same time. This is a much better option that choosing individual funds for the majority of people. So what about the cons of mutual funds? Mutual funds charge fees for managing your money and this fee is charged no matter whether your money is increasing or decreasing in the market. In addition, although some mutual fund managers are able to do a good job of picking funds and “beating the market” in an individual year, the amount that are able to outperform the market in the long term is very low.
- Investing in index funds: An index fund is a fund that literally tracks an index. An index is made up of many, many individual stocks. You’ve probably heard of the S&P 500- this is an index made up of the 500 biggest stocks on the New York stock exchange. If the majority of the individual stocks contained in the index increase in value, then the index also increases. It is possible to put your money into an S&P 500 index fund or into the index fund of any number of other indices. There are also index funds for different sectors of the market such as energy, precious metals, international funds, etc. Since an index fund’s holdings are based on the index it tracks, it is considered a “passive” investment. That means that there is no manager who makes decisions regarding the fund, but instead the holdings adjust based on the holding contained in the index that it tracks. This means that you can achieve the same amount of diversification, or more, than you can with an actively managed fund without the extra fees associated with having someone “actively” make adjustments to the holdings.
- Exchange traded funds (ETF): These are very similar to index funds and for most part time investors, it won’t make a very big difference if you chose an index fund or an ETF of a certain index. To learn more about ETFs vs. Index funds, here is a very good article.
It is important to take these options into account and fully understand what they mean before making a decision on the matter. Due to the fact that mutual funds charge fees and are only occasionally able to outperform the market, I choose to follow a more “passive” strategy with a portfolio of index funds. This makes the most sense for me because I do not have the knowledge or time to allocate to choosing individual stocks. If the indices in which my money is invested go up, then my money will increase; but the opposite is true as well.
It is also important to come up with an “asset allocation” and consider it before making choices. Your asset allocation is a very individualized decision and where a good financial advisor can really be of value. I will write more about asset allocation in a later post, but this is basically where you decide how much of your money you would like to have in stocks (domestic or international), bonds (domestic or international), and cash equivalents (cash, gold, silver, etc.).
There are two books that I would highly recommend on the topic of investing and those are:
- The Four Pillars of Investing of Investing by William Bernstein
- The Bogleheads’ Guide to Investing by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf
I have read several others, but these were the two that taught me the most about the stock market and investing. They both strongly support index fund investing as well, which I believe is the best option for the majority of people reading this post.
Where do you put your money? Do you believe that index funds are the best option? I would love to hear other opinions on the subject. Thank you for reading!