More Advice for a Beginner: Where to Start
Last week in Advice for a Beginner, I shared some advice for a friend who is ready to start investing. The focus of that column was to mentally prepare my friend for the kind of volatility the stock market can experience.
We love it when the S&P 500 gains 25% in a year, but it can just as easily lose that much in a year. The focus needs to be the long term. Think of it as constantly taking a few steps forward, and then a few back, but making slow progress over time.
My advice isn’t designed to make you rich in a few years. It is designed to make you rich over a longer period with a much higher degree of certainty. People do get rich by taking huge risks, but often those huge risks leave them broke.
Now that my friend has considered the risks, where exactly should he put his money? I am going to break it down into several categories.
Investments for the Ultra Conservative Investor
For a younger investor, I would caution against being too conservative. To make huge gains over time, you are going to have to accept more risk. Let me illustrate.
If you have a 30-year investment horizon, can save $500 a month, and achieve the average long-term return of the S&P 500, you would accumulate $1.2 million in a tax-protected account like a 401(k).
However, let’s say you can’t stand the idea of losing 30% in a year. In that case, you might stick to really conservative investments like bonds. You certainly won’t experience a lot of volatility investing in 10-year US Treasury bonds, but you will also get much lower returns.
Over the past 50 years, 10-year US Treasury bonds averaged approximately 5.8% returns per year. In recent years, those returns have been much lower. But plug that return into the previous paragraph and at the end of 30 years you have less than half a million dollars. Conservative investing would have cost you more than $700,000 in 30 years.
Nevertheless, investors that are at or near retirement should become more conservative, because they may not have time to recover from huge stock market losses. So, while I would caution against this strategy for younger investors, investors that rely on a nest egg for income should consider bonds or bond funds.
Vanguard has a number of index funds that essentially invest in a wide range from a specific market segment. For example, the Vanguard Total Bond Market Index Fund (VBMFX) consists of a diverse portfolio of investment-grade U.S.-dollar-denominated bonds.
You won’t get rich investing in such bond funds, but you should be able to generate low-risk income with this strategy.
Investments for Higher Returns
If you have a longer time horizon (at least 5, but preferably 10 years or more), then here’s the strategy I recommend. If you want a low maintenance portfolio, then look for an index fund that tracks the S&P 500. These index funds have low expense ratios, because there isn’t a lot for the fund manager to do except match the components and weighting of the S&P 500.
Vanguard (as well as several other investment companies) also has a total stock market fund, the Vanguard Total Stock Market Index Fund (VTSAX).
VTSAX has become popularized by a number of personal finance writers because it is designed to provide investors with easy exposure to the entire U.S. stock market, including small-, mid-, and large-cap growth and value stocks.
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You can step up your risk from there, and potentially receive higher long-term rewards (accompanied by higher overall risk). For example, the Nasdaq Composite Index is heavily weighted towards technology companies, so its returns may not be representative of the broader stock market. It tends to do a bit better than the S&P 500 over a longer time horizon, but the year-to-year swings can be greater.
As with the S&P 500, an investor can invest directly into a fund that tracks the Nasdaq. If you believe technology (or any sector for that matter) will outperform the overall market over the next 30 years, you may want to concentrate on that sector. Personally, I overweighted the healthcare sector over time, and my returns over 30 years have beaten the S&P 500. But, you have to realize this entails more risk.
The Most Important Step is to Get Started
Just pick up the phone and call any of the major investment firms, like Vanguard or Fidelity to get started. Explain what you need, and they can help tailor investments to suit your personal situation. If you are investing through a 401k and your investment choices are limited, just try to keep your risk and reward profile in perspective.
If you want a more hands on investment style, you can buy and sell individual stocks. The writers here at Investing Daily specialize in that kind of advice. Once an investor catches the investing bug, they find that they want to become more involved in trading. It’s certainly not necessary, but it could help boost your returns a bit more, which adds up over time.
Editor’s Note: If you’re hunting for high yields, but you also want to mitigate risk, consider our colleague Nathan Slaughter, chief investment strategist of High-Yield Investing.
As a high-yield expert, Nathan has devised a simple strategy that could help you generate a steady stream of cash. Even investment beginners can follow his profitable advice. Click here for details.