How to Invest: A Beginner's Guide to Stocks, Bonds & Funds

Learning how to invest your money is one of the most important lessons in life. You don't need to be college educated to start investing, in fact, you don't even need to be a high school graduate. You just need to have a basic understanding of business and the confidence to make a plan: consider it a business plan for your life. You can do it!

Why Investing Can Be Scary

For many of us, money and investments weren't discussed at home. These subjects may even be taboo within certain households (as is often the case within households that don't have much money saved or invested).

If your parents or loved-ones aren't financially independent, they probably can't give you good financial advice (despite their best intentions). And even if your family is well-off, there's no guarantee that their financial advice makes sense for you. Plenty of parents encouraged their kids to buy a house during the peak of the housing bubble, because in their lifetimes, housing only went up.

Having said this, the first investment that you make will probably be the hardest.

The Goal of Investing

Everyone has different financial goals. The more you learn, the more confident you'll be in determining your own path. But here's a basic financial goal to strive toward:

My goal is to work hard, spend less than I earn and invest the difference. By the time I retire, I would like my investments to yield enough interest and dividends so that I can live on this passive income without having to sell my investments.

Notice the first part of this goal is about hard work. If you're hoping to take a little bit of money and gamble it into a fortune in the stock market (or forbid, Bitcoin), you can stop reading now, this article isn't written for you. But if you plan to work for a few decades, and want to make sure that you don't have to work until life's end, you'll need to spend less than you make and invest the difference.

Also, you'll notice that this goal doesn't recommend selling your investments. Rich people don't sell-off their assets for spending money; if they did, they wouldn't be rich for long. The rich stay rich because their assets provide enough cash flow to support their lifestyle. These cash-producing assets can be passed down from generation to generation through careful estate planning.

All investors should aspire to live off of their investment income and have something left over for their loved ones or a charitable organization. It may not be possible for everyone, but it's the right attitude.

What Should I Invest In?

The most common investments are stocks and bonds, which most financial advisers agree should be held in some proportion based upon your personal circumstances. Stocks represent partial ownership of a company and bonds are a form of "I owe you." Mutual funds can own stocks or bonds (or a mix of both) both on your behalf.

There are other ways to invest: for instance, real estate investment trusts (REITs). These types of investments have their place, but you needn't focus on them if you are just starting out. Sticking to stocks, bonds and the funds that hold them is fine for beginners (and pretty much everyone else).

Should I Invest or Pay Down Debt?

It should go without saying that if you can't make the minimum payments on your debts, you should not be investing at all. But if you have extra money left over from each paycheck, you have a few choices that can each have a positive impact on your finances:


1.) Use all of your extra money to pay down debts (mortgage, credit card, student loans).

If you have interest payments that are higher than 10%, you are almost certainly better off paying down debt than investing. The stock market has returned about 11% per year in the long-term (far less if you consider taxes and fees), but there are no guarantees in stock investing. Your debt, however, is guaranteed (sometimes, even after bankruptcy).

2.) Use all of your extra money to buy investments (stocks, bonds, funds).

If your debts are costing less than 5% interest, you may be better served (in the long-term) by investing your extra money in carefully chosen stocks or stock funds. Think carefully before buying bonds. It makes no sense to buy a bond or bond fund that yields 2% if your mortgage is costing you 5%; you'd be wiser to pay off your home. Even if a bond pays you a higher interest rate than what you owe, that doesn't mean that it's a good investment.


3.) Use some of your extra money to buy investments and some to pay down debts.

Benjamin Graham, Warren Buffett's teacher, once suggested that investors should hold no more than 75% of their investment money in a single asset class (he was referring to stocks vs. bonds). You can apply this same logic when deciding how much of your extra money should be used to make investments.

Think of your low-interest debt like a bond. That means that, at minimum, you'd use 25% of your extra income to pay this debt off; the remaining 75% could be invested in stocks. If stocks or stock funds became too expensive (remember, the higher the stock market climbs relative to corporate earnings, the more expensive it becomes), then 75% of your extra income would be used to retire debt. The remaining 25% of your extra income could be invested in stocks, despite their high price.

It makes sense to pay down debts with the highest-interest rates first. For more complicated situations, it may be best to speak with a fee-only financial adviser who is familiar with your personal situation. A financial planner is only as good as the information that he or she is provided with, so if you consult an adviser, be honest. Mention all of your debts as well as your investments, investment ideas and goals.

Know the Difference Between Saving and Investing

Your investments and your savings are very different things. What if the stock market crashes and you lose your job? If you don't have a cash savings account, you'll probably have to sell your investments at the worst possible time. Don't fall into this trap.

Being employed, having essential insurance coverage, having your personal debts under control and having an emergency savings account in case you lose your job are all things to do before you start investing.

Two Strategies for Lifetime Investing

The two investing strategies below are for investors who plan on working for the next few decades. The first strategy requires minimal effort. The second strategy may seem to require minimal effort, but it requires far more investor education than you'll find in this article alone.

1.) Investing Regularly in Low-Cost Funds

Jack Bogle, founder of The Vanguard Group, has dedicated his life to showing how no-load low-cost index funds (specifically, those that buy the entire stock market) are the best way for an investor to succeed. Indeed, buying low-cost index funds is a smart strategy.

Try to make smaller investments consistently rather than larger investments erratically. By dollar-cost averaging, the practice of buying the same dollar amount of a fund on a regular schedule (many investment companies sync with your bank account so you can automatically invest on a schedule), investors needn't worry about timing their purchases. Their average purchase price will ultimately reflect a "fair" value.

Many low-cost index mutual funds require an initial investment in the range of $3,000 - $5,000, but a fund like the Schwab Total Stock Market Index Fund® (SWTSX) has rock-bottom expenses and a minimum investment of only $1. 

2.) Buying and Holding Carefully Chosen Stocks

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks," wrote Benjamin Graham in his classic book The Intelligent Investor.

It's true: If you buy a total stock market index fund at regular intervals over a long enough timeline, you will almost certainly have satisfactory results. Yet many investors forgo the financial rewards of simplified investing for the psychological thrill of "stock picking."

For small- or beginning-investors, trading stocks is a fool's game. If you buy $500 worth of stock, minus a $10 commission to your stock broker, then sell the stock after it rises 4%, again, minus a $10 commission, you've gained nothing. Transaction costs and taxes will eat away at your winning trades, not to mention you'll be trading against PhD-level mathematicians and the computer programs they've written to pick your pockets.

But there is long-term value to be had in buying the stocks of great companies and holding on to them for many years. Even more so if your stocks pay dividends (an actual cash payment of the company's profits). The amount of wealth that reinvested dividends can create is simply amazing. What's even more amazing is that many online stock brokers offer dividend reinvestment as a free service. This luxury gives the patient investor an even bigger advantage over the frenetic stock trader.

The Living Proof That Buy and Hold Is Not Dead

There's a mutual fund, about as old as Warren Buffett, that has never changed the stocks it holds; not in over 80 years. Had you invested $10,000 in the Corporate Leaders Trust (LEXCX) in 1935, it would be worth tens of millions of dollars today. Yes, some of the fund's original 30 stock holdings disappeared over the years (the fund currently holds 20 stocks) but even so, the fund has outperformed the S&P 500 over most of its history.

Kevin McDevitt, CFA wrote the following when highlighting the fund's 75-year birthday:

With the very long term in mind (the fund was originally scheduled to liquidate in 2015, since extended to 2100), the original advisors wanted to find blue-chip, dividend-paying companies that could thrive for decades...When looking this far out, decisions are driven more by enduring factors such as brands and sustainable competitive advantages rather than earnings projections... It’s notable that no financials companies of any kind were included originally.

If you can find 30 dividend-paying companies that make goods and services that people will use decades from now, you will almost certainly grow richer if you buy stock in those companies, at a reasonable price, and hold it indefinitely.

This is easier said than done.

How to Buy Stocks Without Losing Your Shirt

When you're buying a stock, you're buying part-ownership of a company. Therefore, if it makes financial sense to buy the entire company, it would make sense to buy a fractional part of the company. Figuring this out takes a little bit of math, but nothing more difficult than multiplication and division. Don't get scared off.

There are several ways to value a company and its stock. Read as much as you can on the subject (if you can't make sense of a balance sheet or cash flow statement, you're not ready to invest in stocks). But at the end of the day, the question that you need to answer is:

"If I bought this entire company, assumed all its debts and then collected 100% of profits from now until forever, how long would it take to make my money back?"

Once you have the understanding and confidence to answer this question, you'll see why a $1 stock is not necessarily cheaper than a $50 stock. That's a concept that many folks have trouble with.

Here's where things get a little tricky.

Is a Company Future-Proof?

Valuing a stock would be an exact science if you knew that a company could maintain or grow its profits at a fixed-rate every year in the future. However, many companies (especially those that specialize in technology) can watch their products fade into obscurity and their profits disappear. Remember when Nokia was the king of cell-phones and Apple was a $7 stock?.

To find stocks that have a good chance of surviving into the future, think about the products that you use every day. Did your parents also use these products? Will your children? 

Some of your stock picks will probably lose money, but one great investment can make up the difference and then some. You should do fine in the long run as long as you own at least 20 to 30 stocks that aren't very similar) and you haven't overpaid for them.

Finally, don't invest in companies that you don't like. If you hate smoking, you will not feel good about owning a tobacco company (even if the company makes you money).

Then again, you can save yourself these troubles and buy a mutual fund that owns the entire stock market (see above). Investing in stocks takes a lot of time and research. It's up to you to determine how much your free time is worth.

Learn More About Investing

It takes money, patience and confidence to be a successful investor. Having the confidence to make- and stand-by your financial decisions requires education. Never stop learning.

If you're looking for a good investing book, you owe it to yourself to read Benjamin Graham's The Intelligent Investor. Also, Warren Buffett's annual letters to shareholders make for good reading and are free to download on the Berkshire-Hathaway website. You'd be hard pressed to find two people with more investing wisdom.

I originally published this article on TheStreet.com, but since the original text is no longer online, I've reproduced it here (with minor updates and edits). This article is not personalized financial advice and shouldn't be treated as if it were.