Investing for Beginners
There is a lot of information out there on investing. In fact, there is so much terminology its intimidating. This is why I wanted to take a step back to explain the basics of investing for beginners by going over the common jargon.
What is a Bond?
When you buy a bond, you are lending money. Companies pay bondholders a fixed stream of interest income called a coupon payment. All bonds have this thing called a maturity date. A maturity date is the day the loan principal is due to the person that owns the bond. This principal is the face value of the bond. Are you still with me?
It works like this…
When a Company wants to raise money they can issue these things called bonds. So, if a Company wants $10 million, then they can sell 10,000 bonds with a face value of $1,000.
Bonds can sell for more than the original face value. When this happens, the bonds are selling at a premium.
Bonds can also sell for less than the original face value. When this happens, the bonds are selling at a discount.
The amount of money bonds sell for depends on interest rates. When interest rates are high, bonds sell at a discount and when interest rates are low bonds sell at a premium.
There is a lot more to bonds but what is described above are the basics.
What is a Stock?
When a Company wants to raise money they can do so through issuing stock. Individual stocks represent ownership interest in a Company. Ownership is known as equity. When someone says you have a lot of equity in something they mean you have a high ownership interest.
Stocks are very volatile. This means they swing up and down very frequently and those swings can be intense. Because of the high volatility, stocks are more risky investments.
There are different types of stock you can own. But the two main categories are preferred shares and ordinary common stock.
Preferred Shareholders get paid dividends before owners of common stock. Additionally, preferred shareholders do not have voting rights.
There are some other differences as well but the main ones are the two I mentioned above.
Ordinary Shares (Common Stock) is the last in line to get paid. The owners of these shares do have voting rights however, unless you know an absolute massive amount of shares in one company then your individual vote doesn’t really matter. The person with control of the Company is the one with the most common stock. For instance, Jeff Bezos is the largest holder of Amazon stock – he determines the direction of the Company.
Common Shareholders face the biggest upside potential because they also hold the highest risk investment.
Hierarchy of Payment
There is a hierarchy of payment. The best way to describe this hierarchy is through a worst-case-scenario example. The rule of thumb is – the more risk the more reward.
Company A is going through bankruptcy proceedings. They need to liquidate all of their assets.
The first people to be paid as assets are liquidated are creditors (the people that loan the Company money). Creditors make the least amount of money when “investing” in a Company because they are the first ones to be paid. Therefore, creditors face the least amount of risk.
Creditors include banks, private individuals, and bond holders.
After all creditors are paid, the next on the list for getting paid are those with preferred shares. They earn more than the creditors since they have second priority to the creditors and therefore have more risk.
If there is any money left then it will go to holders of common stock (ordinary shares). This group is last to get paid and faces the most risk of any of the investors. However, the upside potential is very high when the company does well.
What is a Mutual Fund?
A mutual fund is when a bunch of people pool their money together to buy a bunch of stocks and bonds. Mutual Funds can be composed of just stocks, just bonds, or both.
When you contribute money to a mutual fund you get shares of the mutual fund. Mutual funds are good for diversifying your investment portfolio. Mutual funds are also a lot easier for the average person to invest in because you do not need to perform the complex and time intensive process of analyzing the future profitability of individual Companies.
An index fund is a type of mutual fund.
Index funds are a bunch of random stocks, bonds, or both in a portfolio. Index funds have the buy and hold strategy. The goal for these investments is simply to do whatever the market is doing.
There is no research that goes into trying to outperform the market and therefore, there is very little if any buying and selling.
As a result, the investment fees on index mutual funds tend to be a little bit lower. You will notice this in their expense ratios.
Some index funds buy a little of everything, these are called “total stock market” index funds. Others are just comprised of a little of everything from the S&P 500.
An active fund is a type of mutual fund.
The goal of actively managed funds is to pick and choose a portfolio of stocks, bonds, or both that will out perform the market average.
Because these funds try to beat the market, they have a lot of people researching, doing all kinds of crazy calculations, and frequently buy and sell the investments inside the mutual fund.
As a result of all this activity, the investment fees on actively managed mutual funds tend to be a little bit higher. You will notice this in the expense ratio (I will explain this a bit later).
If you buy an actively managed index fund, it is important to know that what you purchase on day one will be different on day 100 because of all the analysis/buying/selling that happens.
Alright, I mentioned expense ratios earlier…
Expense ratios are basically what your fees are going to be to own the investment. The lower the expense ratio, the lower the fees.
If you see an expense ratio of 1.5% and your earnings are $1,000, then your fee is $15. Typically, active funds have around a 1.5% expense ratio.
On the other end of the spectrum, index funds typically operate around a 0.2% expense ratio. This means if your earnings are $1,000 ten the expense is $2.
A dividend is a way for companies to share their profits with shareholders (those that own stock) in the Company. Some companies do not issue any dividends while others issue dividends regularly.
A Company that decides not to issue dividends (such as Tesla) will use the earnings to reinvest in the Company to help the Company continue to grow. When the Company grows, the owner of the stock will see appreciation in the value of their shares.
Companies that issue dividends are often long established and have saturated the market place (like Coca-Cola).
Qualified dividends are dividends that are taxed at the Capital Gains Tax Rates (see below for details). Because of the preferential tax treatment, qualified dividends must meet the following criteria:
- The dividend must be paid by a US Company
- If the Company is a Foreign entity, then the Company must be incorporated in the US, the Company is eligible for the tax treaty with the US, or the dividend is paid on traceable US securities
- You must own the asset for a specific period of time (differs depending on whether you own preferred shares or ordinary shares).
Non-qualified, ordinary dividends are taxed as ordinary income. Meaning if your salary is $50,000 and you earn $1,000 in dividends for the year, then your taxable income is now $51,000 using the regular income tax brackets.
Non-qualified dividends include the following:
- Real Estate Investment Trusts (REITs)
- Dividends where you do not own the asset long enough to meet the holding requirement for qualified dividends.
- Interest earned from money market accounts
- Master Limited Partnerships
- Special one-time dividends
- Dividends from tax-exempt entities
- Employee stock options
Is it a good idea to invest in dividend stocks? For the purposes of this article, I am going to focus on blue-chip dividend stocks. Blue-chip dividend stocks are high-quality shares of companies paying dividends regularly, even when the market takes a tumble. There are a few defining characteristics of blue-chip companies, such as:
- Reinvesting a portion of their earnings into the company to grow the business.
- Keeping debt to a reasonable level.
- Buying back some of their shares.
- Consistently pay dividends.
An individual may want to invest in dividend stocks for a number of reasons. For instance, they may use the dividends to purchase additional shares of stock to grow net worth or they may use the dividends to live on. This way, the individual does not touch the principal invested.
Some individuals may decide not to focus on investing in dividend stocks. Why? Well, when a company pays out dividends, they have less money available to grow the business. Business growth is essential to being more profitable. The more profitable a business is, the higher the stock value. Therefore, an opportunity cost exists when paying dividends.
Typically, index funds contain at least some dividend stocks. For instance, VTSAX contains about 2% of dividend stocks. Other index funds focus on investing in blue-chip stocks. For instance, FBGRX contains upwards of 80% dividend stocks. Should you invest in dividend stocks? Whether you decide to focus your investment portfolio on dividend stocks or not, the choice is a personal decision. There are positives and negatives to each strategy so it is very important weigh the pros and cons.
Types of Investment Accounts
IRA stands for Individual Retirement Account. This is a retirement account independent of your employer sponsored plan. You can open an IRA a brokerage firm such as, Vanguard, Fidelity, Charles Schwab, TD Ameritrade, and E*TRADE.
There are three types of IRA which I will discuss in more detail below. The first two types are much more common. The third type is not for the beginner investor but you should know it is available.
IRAs are powerful tax advantaged accounts to help you save for retirement. You can have all three types of accounts listed below but the maximum contribution across all accounts is $6,000 for 2021.
For instance, If you open a Roth IRA, Traditional IRA, and Self-Directed IRA you could contribute $1,000 in a Roth, $2,000 in Traditional, and $3,000 in Self Directed. The sum of all contributions across the three accounts equals $6,000.
When you open a Roth IRA, money put into the account is AFTER tax dollars. This means if you earn a salary of $50,000 and contribute the maximum amount allowed of $6,000, then your taxable income for the year is $50,000.
As time goes by, that money will continue to grow. Eventually, when you are ready to withdraw the money from the account, all of those earnings over the years are not taxed!
Also, with a Roth IRA, after 5 years, you can withdraw the contributions tax and penalty free. This means if you put $6,000 into the account then 5 years later you can withdraw that $6,000. Since you have already paid the taxes, you do not need to pay taxes again.
If you expect your future tax rate to INCREASE, then it is better to invest in a Roth.
NOTE: There are income phase-out limits to a Roth IRA. Explaining the phase-out limits is beyond the scope of beginner investing. However, if you would like to know more then check out the IRS guidance here.
When you open a Traditional IRA, money put into the account is BEFORE tax dollars. This means if you earn a salary of $50,000 and contribute the maximum amount allowed of $6,000, then your taxable income for the year is $44,000.
Additionally, there is a Tax Savers Credit for those who contribute to a Traditional IRA and have an adjusted gross income (AGI) under a certain amount for the year. This is not for everyone is beyond the scope of this beginners guide. However, the important thing to understand is that you might be eligible to take advantage of the Savers Credit in addition to reducing your taxable income by the amount you contribute.
There is no income limits for contributing to a Traditional IRA.
Self Directed IRA
A Self Directed IRA is not nearly as common as a Roth/Traditional IRA noted above. The purpose of a Self-Directed IRA is to invest in non-traditional asset classes such as real estate and private equity funds.
The major brokerage accounts (Vanguard, Fidelity, etc.) do not offer Self Directed IRAs. These accounts are not for beginners. SD IRAs are more complex, have strict rules and regulations, and require a custodian. The fees on these types of IRAs are often higher because they require more maintenance.
The important thing to know is that SD IRAs exist and are an option if you choose this as the right path for you.
A Brokerage account is an account where you can buy stocks and bonds. A brokerage account is not a retirement account. You can buy and sell as many stocks and bonds as you want and use the money whenever you like.
When you open a brokerage account and start buying and selling stocks, it is important to understand that all of these transactions have tax implications.
For instance, if you buy a stock and sell it after less than a year of ownership then you will pay short-term capital gains tax. Short-term capital gains are taxed like ordinary income.
If you buy a stock and hold that stock for more than one year and then sell it, you will pay long-term capital gains tax. Long-term capital gains is taxed at a much lower rate than short-term capital gains. Long-term capital gains are taxed at 0% (woohoo!), 15%, or 20%. Below is a chart of the long-term capital gains tax rates as of 2021.
What do the above tax rates mean? If you are single and sell stocks in 2021, then you can earn up to $40,400 in net gains (purchase price less sales price) and be taxed $0.00. Yep, that’s right – no taxes. Even more astonishing is that you can earn up to $445,850 as a single tax payer and only pay 15%. How much tax do you pay at your w-2 job? I bet it’s a lot more than 15%!
A 401k is an employer sponsored retirement plan. If you work for a private employer (non-government) then you probably have a 401k. Many employers offer an employer match which is essentially free money. You should always take advantage of the employer match. Not taking advantage of the employer match is the same as flushing money down the toilet, and who actually wants that? Not me!
Similar to IRAs, 401(k) accounts can be both Roth and Traditional. However, unlike the Roth IRA, the Roth 401(k) does not have any income limitations.
If you are interested in learning more about traditional vs. roth retirement accounts check out my article here.