There are a lot of investment choices. There are stocks, bonds, REITs, Options, Warrants, and convertibles. Then there are funds that buy and sell these different investments for you, which would make things simpler, except that there are many different funds out there. In fact, there are actually more mutual funds buying and selling individual stocks than there are individual stocks. So, how do you choose?
The good news is, there are really only a few things that you should invest your money in. Once you know these few investments, you can cut through all of the noise and make a wise choice of where to place your money. I would say that there are three investments you really should make before you get near retirement. Ignore the rest. Here are the three:
1. Total Stock Market Index Mutual Fund
This investment does what it says – it buys stocks in the total US stock market. Buying just this one mutual fund will mean that you are diversified over the whole stock market. You’ll want this because it eliminates the risk of picking a bad stock or a bad sector. It is possible that one company could go out-of-business and you’d lose your whole investment if you try to pick a stock. But what are the chances that every company in the US stock market will be wiped out? If that happened, you wouldn’t be too worried about your portfolio. You would be worried about finding enough ammo to keep the wandering bands of marauders at bay.
You need to have stocks when you are investing for a long time since they are the only investment that will grow over time. This means that you will make real money, even when inflation is taken into account. Put your money in the bank for 30 years and you’ll find that you’ll be able to buy maybe 75% of the stuff you could have bought with the money when you put it in. Put your money in the stock market for the same period of time, and you’ll be able to buy about eight times as much stuff.
You buy an index fund because they are cheap. The fees are really low, often below 0.25% of the amount of money in your account each year. If you go out and buy a managed mutual fund where someone, or a team of someones, buys and sells stocks for you, you’ll pay 1% or more per year. Given that most managers match the indexes at best over long periods of time, you’ll probably make a lower return in a managed fund than an index fund. So, go for the index.
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2. A Corporate Bond Index Fund
A bond is a loan to a company. In exchange for the loan, they pay you interest payments twice a year for a period of time. At the end of the period, they pay you your money back. Bonds are good because they give you steady income that quiets down the gyrations caused by a stocks. If you have an all-stock portfolio, you might be up 30% one year, but then down 30% the next. Over time you’ll make about 7% after inflation, but it is a wild ride in the mean time. Add 20-30% bonds, and you’ll see lower swings since the bonds will always be there, paying out interest, which helps offset the swings in stock prices.
You don’t want to have all bonds. That is even more risky than having a mix of bonds and stocks. You also don’t want to hold a lot of bonds for thirty years or longer since the returns you’ll get will be lower than they will be from stocks. Over shorter periods of time, however, bonds will sometimes outperform stocks, particularly if there is a big downswing like we saw in 2008 and early 2009. In that period, while stocks lost 40%, bonds actually went up a few percent. They did a lot worse than stocks in late 2009 and 2010 as the markets recovered, but people who were holding bonds during 2008 and 2009 felt a lot better than those holding stocks. Again, buy an index fund that holds a lot of different types of bonds for low cost and diversification.
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3. An International Stock Fund
US stocks are often the place to be since the economy is stable and often growing, but it is not always the best place. You’ll always want to have some of your money in whatever segment of the market is doing the best at any given time. You should therefore put some of your money, maybe 20-25%, into an international stock fund. Here you want to look for inexpensive index funds that invest all over the world, rather than picking a niche fund that invests only in Asia, for example.
So there you have it. A total stock market fund, a bond fund, and an international fund. Find cheap index funds, send in a check, and never look back. Happy investing!
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.