Practical Investing Guide For Beginners (Reprint)

Neither one of my parents know how to invest in the stock market, and it wasn’t a part of my formal education. I had to learn everything on my own, so I know how intimidating it is for people who are new to investing. Where do I start? What do I invest in? How am I doing? There are just so many questions.

In this post, I am going to try to make it as easy as possible for someone brand new to investing to get started.

1. Money That You Can Afford To Lose

Investing is unlike putting money into savings or CDs, there is risk involved. So you need money that you can afford to lose. This means that if you owe any money that you are paying interest on — i.e., credit card debts, student loans, car loans, etc. — you need to pay these off first. The only exception to this rule is your mortgage.

2. Brokerage Account

Next you need to find a place where you can trade your money for investment securities. You can invest through three main types of financial institutions:

• a bank,
• a discount brokerage firm, or
• a full service brokerage firm.

Out of the three, I recommend using a discount brokerage firm. Banks and full service firms generally charge too much and push products that are not always the best for you, because they are motivated by commissions and fees.

Personally, I use TD Ameritrade. But you could use any other discount brokerage firms, such as Charles Schwab. I have used both TD Ameritrade and Charles Schwab, and I am comfortable recommending them.

3. Taxable Account versus Tax-Advantaged Account

You will also have to decide if you want to start a normal taxable account or a tax-advantaged account.

• Taxable Account – You can liquidate your investment and get your money back at any time, but you have to pay taxes on capital gains yearly.
• Tax-Advantaged Account — Investment accounts like 401k, Traditional IRA, and Roth IRA where you can’t touch your money until you reach a certain age. The advantage with 401k and Traditional IRA include tax deduction on the amount you contributed, and your investment grows tax-free until you start to withdraw the money. For Roth IRA, there is no tax deduction, but your investment grows tax-free and the withdrawal is also tax-free.

Which one you choose will depend largely on your personal financial situation.

4. Invest

I have over 10 years of experience and I have made my fair share of mistakes, so believe me when I say don’t start with individual stocks. As a first time investor, I would recommend that you start with exchange traded funds, or mutual funds, instead. Let me briefly explains how each works:

• Stocks – Each share represents a part ownership in a company. For example, if you buy 100 shares of AAPL, you’ll own a tiny part of Apple Inc. When you purchase shares, you have to pay the brokerage firm trade commissions which can be as low as $0 (i.e., via Zecco) to somewhere around $6 to $30 for discount brokerage firms. Usually, you’ll have to pay more if you purchase through banks or full-service firms.
• Mutual Funds – Each mutual fund is a collection of many stocks. Throughout the year, the fund manager can buy and sell stocks inside the fund on your behalf. In essence, you buy the underlying stocks and pay for the fund manager’s services. When you buy shares of mutual funds, you could potentially pay 4 kinds of fees: (1) Trade commission, (2) Front-end load, (3) Back-end load (or redemption fee), and (4) Expense ratio. The ones that you should stick to are low expense ratio, no load, and no transaction fee mutual funds — meaning you are not paying anything but the expense ratio.
• ETFs – I believe this is by far the best investment vehicle. Similar to mutual funds, an ETF is a collection of many stocks; however, the stocks are more defined and they are rarely traded. Likewise, there is an expense ratio, but it’s generally lower than similar mutual funds. But like stocks, you have to pay trade commission each time you buy and sell shares.

The strategy that I believe is best for new investors is to build a globally diversified portfolio of low expense passively managed ETFs. For example, if you have $6,000, you could potentially split it up in $2,000 chunks and buy 3 ETFs: Large US Stocks ETF, Small US Stocks ETF, and International Stocks ETF.

The subject of asset allocation — i.e., how you should divide your money across multiple types of investment is fairly complex, and I will not be explaining it here. If you are interested, you can take a look at my 401k asset allocation to get a better idea.

How to find the right ETFs?

There are several ways to do this. Brokerage firms like Charles Schwab and TD Ameritrade offer online tools where you can do your research. For example, you can use their online tools to find “low cost, Large US Stocks ETFs,” but it takes a bit of time to learn the web interface. The good news is that you can visit one of their branches and ask for help, or you can just ask one of the representatives to help you make the purchases. Remember, you are not looking for ETFs with the best performance (this is called chasing past performance), you are looking for ETFs that:

• Has low expense ratio
• Represent the asset class well — i.e., small-cap, large-cap, international, etc.

How to buy the ETFs?

Once you identify which ETFs you will be buying, you will need their ticker symbols. For example:

• IVV is the ticker symbol for “iShares S&P 500 Index,” a Large US Stocks ETF
• VB is the ticker symbol for “Vanguard Small Cap ETF,” a Small US Stocks ETF
• VEU is the ticker symbol for “Vanguard FTSE All-World ex-US ETF,” an International Stocks ETF

At this point, you can enter a buy order through the online system, or ask the representative, to buy X shares of IVV, Y shares of VB, and Z shares of VEU. If you want to invest $2,000 in each, you just divide $2,000 by the latest ask price to get the number of shares.

What’s next?

Read as many books and web sites that you can to learn about investing. My caution is to avoid hot tips and hot stock picks. What you want to learn is how the market works, effect of expenses on investment performance, asset allocation, risk management, investing for specific goals, etc.

If you have any question, please feel free to leave a comment and I will do the best I can to answer them. Please note that it’s also worthwhile to pay a fee-based financial advisor to help you through your first investing experience.

Photo by thinkpanama via Flickr

This was a guest post I wrote for Being Frugal on January 30, 2008.

This post was featured in:

• The Carnival of Personal Finance #151 hosted by Alpha Consumer. For more information please visit the Carnival of Personal Finance.