Before you figure out how you should invest, it's important to understand why you should invest to begin with and what your investment options are. The more information you have, the better position you’re in to decide how you want to answer the question, "How should I invest?" At the end of the day, there are no absolute right and wrong ways to invest. That’s like asking, "What should I wear tonight?" The answer will depend on your personal style, your age, the weather, the size of your budget and where you are going. The same goes for investing; there are many variables to consider. So here's some background information to help you decide what you want your investment wardrobe to look like.
You invest to make your money work as hard for you as you did to earn it. After the market craziness of the past few years, you may be tempted to just stash those hard-earned dollars under your mattress. After all, you worked hard for your money, and with all the options out there investing can seem complex. Unfortunately, if you leave your savings in cold, hard cash – inflation will eat away at your money's “purchasing power.” This means that in 30 years, $1,000 will only buy what $400 does today (assuming historical inflation levels of roughly 3%... it could be worse). So the reason you invest is to protect your purchasing power from the ravages of inflation.
What Should You Invest In?
The answer depends on when you’ll need to spend that money, your gender, and how old you are right now. If you need to spend that money in the next one to five years, guess what? You shouldn't invest that money. That’s right. If you know you have to spend it in five years or less, your goal is to protect that money from inflation. The way you do that is by “parking” the money in a savings account, money market account/fund, or a CD (certificate of deposit). Each of these financial products offers you a place where you can earn enough interest to hopefully keep up with inflation – and, at the same time, not put your underlying savings at risk.
For money that you won’t need to spend over the next five years, you have three basic options: stocks, bonds and real estate. Stocks are pieces of ownership in underlying businesses. Bonds are loans to governments or corporations. Real estate is tangible structures – and can be residential like homes or apartments, or commercial like office buildings and shopping centers. Personally, I believe that for most people, ownership of their primary residence is enough of an investment in real estate so I recommend splitting the money you don’t plan to spend in the next five years between stocks and bonds, using to this formula: If you are female, 110 minus your age is the maximum percentage of your portfolio that you'd want to allocate to stocks. (If you are male, the rule of thumb is 100 minus your age because your life expectancy is shorter). Say you’re a 40-year-old woman like me. The formula would be 110-40=70. So 70% is the maximum percentage of my portfolio that I allocate to stocks. I would put the rest in bonds.
How Do You Invest in Stocks & Bonds?
Index funds are my favorite keep-it-simple investment tool. Buying individual stocks and bonds can be great, but how do you know which ones to select from the thousands that are available? Here’s the good news: I’d say – don’t even try! Unless you want to analyze companies for a living, the best way to invest in stocks and bonds is by buying a whole basket of them, rather than trying to pick and choose. In the world of investing, these baskets are called mutual funds.
There are two types of mutual funds: Active and passive. Think about it as two styles of fashion. Trying to keep up with the latest fashion trends is very similar to investing in an active mutual fund. Wearing the classics is a lot like investing in passive (or index) mutual funds. Unless you just LOVE investing, I say go with the classics, or index funds. An index fund is a basket of stocks that doesn’t change very often. Personally I use a mix of Treasury inflation-protected securities, municipal bond and corporate bond index funds for the bond side of my portfolio, and a mix of the total U.S. stock market index and total international stock market index on the stock side. Another option I like are Target-Date Retirement funds, where the mutual fund company picks the mix of stocks and bonds for you based on your age. While there are many good sources of Target-Date Retirement funds, my personal favorites are offered by Vanguard, Fidelity and Charles Schwab.
Investing is a very broad subject. If you'd like to learn more, I recommend reading Little Book of Common Sense Investing by Vanguard founder John Bogle. And if you have additional comments or questions, leave them below, and I'll do my best to get back to you.