10 Things You Need to Know Before You Start Investing

The risks you should take, and the ones you shouldn’t

Photo by Austin Distel on Unsplash

So, you are curious about investing, but you aren’t sure where to start? These are 10 key things you need to know before you begin.

1. Understand what you are investing in.

When you invest, you are purchasing financial assets. Here are some common examples:

  • Bonds are obligations of debt, typically created by governments and corporations. By buying a bond, you hold a share of that government’s/corporation’s debt, and you are entitled to receive repayments on that debt. Bonds are typically less risky than stocks, but pay a lower return.
  • Stocks are a way of owning a small part of a company. Stock owners are called shareholders, and you can make a return through the appreciation (increase) of the stock price and dividend payments made to shareholders. Purchasing individual stocks can be very risky, but the potential returns are much higher than bonds.
  • Funds are managed by investment managers and are formed of stocks, bonds and other assets. Funds can either be passive or active. Passive funds track indices like the S&P 500 (the 500 largest publically traded US companies). Active funds are managed by fund managers who make adjustments to the composition of the fund over time. Funds are typically a good way to start investing because they provide higher returns than bonds but usually with less risk than picking individual stocks.

2. Investing is risky.

The most important lesson to learn is that investing is inherently risky.

Risks occur when you invest because it is difficult to value a company’s stock. Stock prices are constantly moving and so there is a good chance you could buy a stock and the next day, its stock price could fall.

Some investors may think a stock is undervalued, and so buy the stock, whilst others may think it is overvalued, and sell the stock. As investors buy and sell stocks, the prices adjust.

You can imagine the stock market like an auction: if lots of people like a stock, they will bid up the price. If no one likes the stock, the price will fall.

Over long periods, history has shown the total value of the US stock market usually increases, but you can never be sure that the individual stocks you buy will increase or decrease in value. If you are investing in a company that fails, you can lose the whole investment you made.

Different types of investments have different risks. To have the possibility of making a higher return, you also have to take on more risk.

  • Bonds are normally much less risky than stocks; in fact, US government bonds are considered effectively ‘risk-free’.
  • Stocks are much riskier than bonds. Note that different stocks have different risks: stocks that have a very volatile stock price will earn you a higher return, but you risk losing more money by investing in them.
  • Funds are typically less risky than individual stocks because of diversification.

3. Diversify.

One of the key ingredients to successful investing is diversification.

Diversification means investing in different types of asset that aren’t related to each other. You could imagine this as ‘not putting all your eggs in one basket’.

Diversification works by eliminating risk. There are two types of risk:

  • Systematic risk represents the chance of the whole market crashing, like during the Great Recession in 2008. Almost all stocks are threatened by this risk and it’s the main risk investors face.
  • Unsystematic risk is related to individual companies, like Nike’s factories burning down affecting its profit. Just because Nike’s factory might burn down, this is unlikely to affect other companies and so their stock prices wouldn’t be affected.

If you diversify (by investing in a variety of companies over different sectors), you can reduce the threat of unsystematic risk to almost zero. If you invest in 500 companies, then Nike’s factories burn down and their stock price halves, you only lose 0.1% of your investment. The 499 other companies are unaffected.

If you don’t diversify, and only invested in Nike, if their stock price halves, you’d have lost 50% of your investment.

Diversify so that you eliminate unsystematic risk. You can do this by investing in a well-diversified fund rather than individual stocks.

4. Invest over a long period.

Investing over a shorter period is riskier than investing long term.

Over time, the volatility in the stock market usually averages out.

For example, if you invest in the entire stock market (like in an S&P 500 fund) over a period of one month, it is hard to predict whether your investment will rise or fall in value.

However, if you invest for 10 years, it’s highly likely that your investment will rise in value.

Use this to your advantage. Invest in the market over a long period (e.g. 3+ years).

5. Invest with reputable managers.

There are all kinds of investments available. Unfortunately, some of the investment opportunities advertised online are scams.

Make sure you invest with a reputable investment manager like Vanguard, Hargreaves Lansdown or Fidelity. Alternatively, check if your bank offers reasonable investment management fees, and use them. These managers should offer you legitimate investment opportunities and financial advice.

6. Dollar-average.

Dollar-averaging is a form of diversification over time. The idea is that if you invest a small amount every month. After several months of investing, you will have ‘averaged out’ the price at which you entered the stock market.

Like diversification, you can eliminate some risk by dollar averaging; the risk that you enter the market at the wrong time.

7. Automate.

A good behavioural trick is to set up your bank account to regularly invest your money (e.g. once a month). Because your money is sent automatically, there is no danger that you forget to invest each month. Plus, you don’t notice the money leaving your account as much as you would manually sending it.

By automating your investing, you are more likely to stick with investing and achieve your financial goals.

8. Look out for fees.

Before investing, always check for fees.

It is important to understand the types of fees that you can be charged. There are typically three types:

  • Front-end fees or front-end loads are charges applied to your investment when you initially purchase it. For example, if you invest $1000 on a trading platform, deposit into an investment account or buy a fund, there may be a percentage charge that will be deducted off this initial amount. If this fee is 1%, you’d pay the platform or manager $10, and have $990 remaining to invest. Research different reputable investment platforms to find ones with lower front-end fees.
  • Level fees are ongoing fees, usually charged annually, on the amount you have invested in a fund. For example, if you invested $1000, suppose you make a 6% return on your investment over a year, or $60. Ongoing charges may then be charged at 0.5% of your investment, so $5 is paid to the investment manager, and you are left with $1055. These charges may be levied by the platform you trade on as well as the fund you invest in. If you are investing in a fund, passive funds generally have the lowest level fees, and actively managed funds normally have some of the highest.
  • Back-end fees or back-end loads are charges that you pay when you sell a fund. These may be a flat fee (like $100), or a percentage fee of the withdrawal (like 3%). They often fall over time, to incentivize you to not withdraw your money after a short period, for example under 1 year. To avoid back-end fees you can invest in exchange-traded funds, which are referred to as ETFs.

To find out the fees you’ll be charged by a fund, check the ‘Key Documents’ that should be provided alongside information about the historical returns and risk profile of the fund.

9. Start small.

Before you invest everything you own, test the waters with a small amount of money to see how you feel about investing. If you feel anxious about the risk of losing even that small amount of money, it might be best not to invest your life savings.

10. Start young.

Investing young is one of the best financial decisions you can make. Not only will you foster a better relationship with your money, but it pays to start young too!

For example, if you invest $200 a month from age 20, and your money grows annually by the S&P average of 9.8%, you will have $1.69 million saved by age 65. If you start investing a decade later, aged 30, you will have $648,000 saved at 65.

This is due to the power of compounding, which is when your returns from a previous period themselves produce a return. Those new investment returns produce returns, and so on. As you can imagine, the younger you start this process, the better.

Hopefully, these 10 key investing takeaways have been useful. Good luck with your investing!

Tom

The information contained in this article is not intended as and shall be not understood as financial advice. This information is not a substitute for financial advice from a professional. Errors and misprints may occur. Invest at your own risk.

Finance, Tech and Productivity. Studying Economics & Management at Oxford University.

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