A credit score is a three-digit number that represents your creditworthiness, that is, how likely you are to repay a debt. Credit scores range from 300 to 850, with higher scores indicating better creditworthiness. A credit score is calculated based on various factors, such as your payment history, credit utilization, length of credit history, types of credit used, and new credit accounts.
How are credit scores calculated?
Let’s take a closer look at how credit scores are calculated. Payment history is the most important factor, accounting for 35% of your credit score. It refers to how you’ve paid your debts in the past and whether you’ve made payments on time. Late payments, defaults, or collections can significantly lower your credit score.
The second factor is credit utilization, which makes up 30% of your credit score. It’s the amount of credit you’re using compared to your credit limit. Keeping your credit utilization below 30% is considered good, and exceeding it can negatively impact your credit score.
The length of your credit history makes up 15% of your credit score. The longer your credit history, the better, as it indicates a more stable financial track record.
The types of credit you use also matter, accounting for 10% of your credit score. Having a mix of different types of credit, such as credit cards, car loans, and mortgages, is considered good, as it shows you can handle different types of debt.
Finally, the last factor is new credit accounts, which make up 10% of your credit score. Opening too many new credit accounts in a short period can negatively impact your credit score.
Why are credit scores important?
Now that we know how credit scores are calculated, why are they important? Your credit score can affect your ability to get approved for credit cards, loans, or mortgages. A higher credit score can lead to lower interest rates, saving you money in the long run. Additionally, employers and landlords may also check your credit score to evaluate your financial responsibility and trustworthiness.
Now, let’s look at some examples of credit scores and how they’re typically categorized:
A credit score of 750 or above is generally considered very good or excellent. This indicates a strong credit history and may qualify you for the best interest rates and terms on loans and credit products.
A credit score between 700 and 749 is typically considered good. This shows that you have a solid credit history, but there may be some room for improvement in certain areas.
A credit score between 650 and 699 is generally considered fair or average. This means you may have some negative items on your credit report or a shorter credit history, but you may still be able to qualify for credit products.
A credit score between 600 and 649 is typically considered poor. This indicates a higher risk to lenders and may result in higher interest rates or less favorable terms on loans and credit products.
A credit score below 600 is generally considered very poor. This indicates a significant risk to lenders and may make it difficult to qualify for credit products or result in very high-interest rates.
It’s important to keep in mind that credit score ranges and categories can vary depending on the scoring model used and the lender’s specific criteria. However, in general, a higher credit score is typically viewed more positively than a lower score.
CONCLUSION
In conclusion, understanding credit scores is crucial for your financial health. It’s a three-digit number that represents your creditworthiness, calculated based on various factors such as payment history, credit utilization, length of credit history, types of credit used, and new credit accounts. A higher credit score can lead to better financial opportunities, while a lower score can limit your options. So, be sure to monitor your credit score regularly, pay your debts on time, and keep your credit utilization in check.
Deciding whether to buy or rent a home is a big decision that can significantly impact your finances. In this post, I will discuss the pros and cons of both options and provide you with some tips on how to make the best decision for your finances.
Pros and Cons of Buying a Home:
Let’s start by discussing the pros and cons of buying a home.
Pros:
Potential for long-term financial gain through property appreciation
Freedom to make changes to the property and customize it to your liking
Building Equity in your home
Stable housing costs (fixed mortgage payment)
Cons:
High upfront costs (down payment, closing costs, etc.)
Responsibility for maintenance and repairs
Potential for the property value to decrease
Limited mobility (selling a home can be a lengthy and expensive process)
Pros and Cons of Renting a Home
Now let’s move on to the pros and cons of renting a home.
Pros:
More flexibility and mobility
No responsibility for maintenance and repairs
Lower upfront costs (typically just the first and last month’s rent)
No need to worry about property value fluctuations
Cons:
No equity building
Rent payments can increase over time
No control over property changes or customizations
Potentially less stable housing (landlord could sell or choose not to renew the lease)
How to Make the Best Decision
So, how do you decide whether to buy or rent a home? Here are a few tips to help you make the best decision for your finances.
Determine your budget and what you can afford
Consider your long-term goals and plans for the future
Think about your lifestyle and how it may change over time
Research the housing market in your area
Weigh the pros and cons of each option carefully
Conclusion:
In conclusion, whether to buy or rent a home is a complex decision that requires careful consideration. While both options have pros and cons, it ultimately comes down to what is best for your unique financial situation and lifestyle. By considering your budget, long-term goals, and the local housing market, you can make an informed decision that will benefit you in the long run.
Thank you for reading this post on the economics of buying versus renting a home, and I hope you found this information helpful.
A stock market is a place where people buy and sell shares of publicly traded companies. These shares represent ownership in the company and can increase or decrease in value based on various factors such as the company’s performance, economic conditions, and investor sentiment.
When a company goes public, it issues shares of stock that investors can purchase. People can then buy and sell these shares on the stock market. The stock market provides a platform for investors to trade these shares with each other.
How does the price of a company’s stock move?
Supply and demand determine the price of a stock. If more people want to buy a stock than sell it, the price will go up. If more people want to sell a stock than buy it, the price will go down.
The bull represents a growing market while the bear represents a falling market. The name comes from the way these animals attack.
There are two main types of stock markets: primary and secondary. The primary market is where new stocks company issue and sell to the public for the first time. The secondary market is where investors trade previously issued stocks.
Overall, the stock market plays an important role in the economy by allowing companies to raise capital and investors to participate in the success of these companies.
How’s the stock market related to the economy?
The performance of the stock market can be an indicator of the health of the economy, as it reflects the collective sentiment and expectations of investors about the future prospects of companies and the economy as a whole.
When the stock market is doing well and prices are rising, it often indicates that investors have confidence in the economy and expect companies to perform well in the future. This can lead to increased investment, job growth, and economic expansion.
But, when the stock market is performing poorly and prices are falling, it may indicate that investors are pessimistic about the economy and the future prospects of companies. This can lead to decreased investment, job losses, and economic contraction.
In addition, changes in the economy, such as interest rates, inflation, and government policies, can also impact the stock market. For example, if the Federal Reserve raises interest rates to combat inflation, it may lead to higher borrowing costs for companies and decrease their profits, causing their stock prices to fall.
Therefore, the stock market is an important component of the overall economy. It can be affected by, and also impact various economic factors.
I will cover more on the main types of stock exchanges in the US and globally in my next post. Thanks for reading!
If you want to watch my videos on the same topics, you can check out my Youtube channel here. https://www.youtube.com/channel/UC1wFKF1FTBI90qdn4HH2QhQ
In today’s post, I will talk about what you should consider if you haven’t started investing in stocks yet or if you are a beginner investor.
Why do people fear investing in stocks?
Before we do that, let’s look at the reasons why people may be afraid to invest in stocks. Here are some of the most common reasons:
Lack of knowledge: Many people are afraid to invest in stocks because they don’t understand how the stock market works or how to analyze stocks. They may feel overwhelmed by the amount of information available and worry about making a mistake.
Fear of losing money: Investing in stocks always carries some degree of risk, and many people are afraid of losing money. They may worry about a stock market crash or about investing in the wrong company.
Past negative experiences: Some people may have had negative experiences with investing in the past, such as losing money or being scammed by a fraudulent investment scheme. These experiences can make them hesitant to invest in stocks again.
Perceived lack of control: Investing in stocks can feel like a gamble to some people, and they may worry about not having control over their investments. They may feel more comfortable with traditional savings accounts, where they feel they have more control over their money.
Peer pressure: Some people may feel pressure to invest in stocks because of their friends or family members, but they may not feel confident in their ability to make good investment decisions.
So what is the solution?
Infact, investing in stocks for long-term growth can be a great way to build wealth over time if done correctly. By following some simple tips, you will mitigate the risk associated with investing and will grow your wealth over time. Here are some tips on how to invest in stocks (and other assets) for long-term growth:
Set your investment goals: Before you start investing in stocks, it’s important to define your investment goals. Do you want to save for retirement, a down payment on a home, or another long-term goal? Understanding your goals can help you create a long-term investment plan.
Determine your risk tolerance: Investing in stocks comes with risk, and it’s important to understand your risk tolerance before you start investing. Conservative investors may want to focus on blue-chip stocks with a history of stable returns, while more aggressive investors may be comfortable with higher-risk, high-growth stocks.
Research companies and industries: When investing in individual stocks, it’s important to research individual companies and industries to make informed investment decisions. Look for companies with strong financials, competitive advantages, and growth potential, and consider investing in industries that are poised for growth in the long term. This does require quite a bit of research by looking at companies’ financials. For conservative investors, it is best to start with a broad-based index fund or an ETF. By setting up monthly or weekly contributions, you can ignore market fluctuations. Predicting the future of a specific company is uncertain. Thus this risk is much higher compared to investing in a fund, which is a pool of many companies from different sectors.
Build a diversified portfolio: Diversification is key to managing risk and maximizing returns when investing in stocks. Invest in a variety of companies and industries to spread your risk (through index funds or ETFs). Vanguard, Charles Schwab, and Fidelity are all good brokerage companies offering index funds. It’s important to research and compare the fees, historical performance, and other factors of different index funds and providers before making any investment decisions. Also, consider adding other asset classes, such as bonds and real estate, to your portfolio.
Invest regularly and stay disciplined: Investing in stocks for long-term growth requires discipline and consistency. Set up automatic contributions to your investment account and stick to your long-term investment plan, even in times of market volatility. As I mentioned in my previous posts, investing in funds is a great way to do that. Also, by following a strategy called dollar cost averaging you can remove emotions from your investment decisions.
Monitor and adjust your portfolio: Finally, it’s important to regularly monitor and adjust your portfolio as needed. Rebalance your portfolio periodically to maintain your desired asset allocation, and consider adjusting your investments as your financial goals or risk tolerance change over time.
Conclusion
Overall, investing in stocks can be a great way to build wealth over time. However, it is important to do your research and understand the risks involved. If you are feeling hesitant about investing in stocks, consider consulting with a financial advisor or taking a course on investing to gain more knowledge and confidence.
Whether investment should be done for the long term (retirement) or short term (if you are looking to pay for downpayment of a house), we should consider these key points:
Short-term gains can be risky: While making quick profits through short-term investments is possible, it often involves taking on more risk. Fluctuations in the stock market can cause investments to lose value quickly, making short-term gains unsustainable.
Long-term investments offer more stability: By investing for the long term, you are able to ride out market fluctuations and take advantage of compounding interest over time. This can provide more stability in your portfolio and increase your chances of achieving your financial goals.
Patience is key: Investing for the long term requires patience and discipline. It is important to avoid making impulsive decisions based on short-term market movements and instead focus on the long-term potential of your investments.
Diversification is important: To mitigate risk, it is critical to diversify your portfolio by investing in a mix of different asset classes and sectors based on returns and risks. This can help to offset any losses in one area with gains in another.
Consider your goals and risk tolerance: Your investment strategy should be aligned with your personal financial objectives and risk tolerance. While long-term investments may be suitable for some, others may prefer a more active approach to investing. Some safe ways to make a reasonable return in the current market situation are investing in CDs and high-yield savings accounts. These are currently giving around 4%-5% interest rate annually. The US treasury bills and notes are also offering similar rates. It is essential to consider what works best for you and your financial situation and how soon you need the money.
In summary, while short-term investments can offer quick gains, long-term investments provide more stability and the potential for compounding interest over time. By focusing on a long-term investment strategy and diversifying your portfolio, you can mitigate risk and increase your chances of achieving your financial goals.
In 2022, the U.S. stock market experienced what we call in finance a bear market. There was a prolonged drop in stock market prices because of the Russia-Ukraine war and tightened monetary policy. The S&P500, the U.S. broad market index kept falling by more than 20% from its high at the beginning of 2022.
With continuous interest rate hikes, S&P 500 index showed a downward trend in 2022 and hasn’t recovered to its Jan 2022 level Source: Google Finance
But if this scared you and you concluded investing in stocks is not a good idea, you must think again.
Financial literacy is critical for building wealth. It is important for any person to know how market trends work, but particularly important for younger adults who are in their 20s.
Although I have taken the U.S. stock market as an example for this post, the principle applies to almost any country with a developed stock market.
In this blog, I will highlight two key points:
Investing in stocks should always be done for the long term. If you look at the data over the long run, the overall stock market gave an average annual rate of return of 10% to 14%.
This chart from Google Finance shows that S&P 500 index, which is the benchmark index for US stock Market has an upward trend over the long run.
Source: Google finance S&P500 index
Sure, there are years (including 2020, 2022 as you see in the chart below) when it has fallen sharply because of various economic reasons. However, in the long run (5 yrs or more), if you see the trend line, it is going upwards.
Source: Google finance S&P500 index. I added my captions to explain the dips
So, yes if you just invested at the beginning of 2022 and wanted to take out your money after that, you would lose money on your investment. But if you plan to withdraw the same money in the next 5 or 10 years, I am sure it is going to fetch a much higher return.
2. Business Cycles are real
The reason for this is due to the occurrence of business cycles or sometimes what we call economic cycles. Most stable economies exhibit boom and bust. The chart below shows how there are periods of expansions and recessions where the GDP and stock market grow and contract respectively.
Most governments including the U.S. government through their fiscal policy and the Fed, through monetary policy, take corrective measures to bring the economy back on track. For the US, the target rate of inflation is 2% and the target unemployment is around 5%.
Over the long run, most stable countries show a pattern of economic growth as seen by the black trend line sloping upwards.
So yes, if you invest in the stock market for a long term, greater than 5-10 years, you should get a positive return. It will still be positive even after adjusting for inflation.
So don’t panic and start selling when the market starts falling, instead, wait and let it recover.
This actually would be the best time to start investing or adding more towards your monthly contributions. The best way to do that is by following a safe investment strategy such as dollar cost averaging. I have discussed that in detail in my previous articles on personal finance.
Have a balanced portfolio
But don’t put all your money in the stock market. For any investor, it is critical to have a balanced portfolio. Make sure to have an optimal mix of riskier and safer asset classes based on your age and risk tolerance.
Bonds are a relatively safer investment option compared to stocks, real estate, and gold, and therefore, have low returns on them.
Anyone who is less than 50 years old can have more of their money invested in the stock market versus anyone who is 50 and above. As you approach retirement age, you would like to have less money invested in the stock market and more in safer options. So, whenever you want, you can withdraw your money without worrying about market fluctuations.
Investing in stock is done to make your money grow over time. Yes, overtime is the keyword here. It is not meant for becoming rich overnight or for short-term gains.
Also, it is best to start investing early to reap the maximum benefits. Although, starting at any age is better than not starting at all unless you are close to your retirement age. Ideally, as soon as you get your first job you should think about investing a portion of your salary. You can start with 10-15%.
Create an emergency fund and pay off debt first
But before you start any type of investment, ensure you have enough cash to cover at least 3-6 months of expenses in an emergency fund. Usually, people like to keep it safe in an FDIC-insured high-yield savings account. This is the liquid money that will cover any type of contingency, which you can withdraw whenever you want to.
So it is essential you save enough money to cover the downpayment of your house, job loss, car breaking down, or any unforeseen event where you need immediate cash.
This is especially true if people fear a recession coming in 2023. Having a buffer in a safe place such as a savings account will give you peace of mind.
Also, don’t forget to clear all the high-interest loans (over 5%), such as credit cards. Western countries have taught the world to live on credit. We buy almost every single day so many things on credit cards. But sometimes people don’t realize it and by living above their means, go into a debt spiral.
The interest rate that you are paying on credit card loans is usually higher than what you earn from savings.
We must remember that we do most investments for the long run. We won’t get a 10%-12% guaranteed return from investing in stocks the very next year. It takes at least a couple of years to average out market fluctuations.
Cherry-picking stocks is not worth it
As I mentioned in my other article, it’s always best not to invest too much money in individual stocks. It’s too much work to go through the company’s financials, thoroughly reading their annual reports (10-Ks) and quarterly reports (10-Qs) to understand the company’s fundamentals and prospects.
Even professionals and seasoned investors cannot time when to buy or sell stocks based on the earnings call of the companies. The reason is simple. The stock price that we see on the market has already incorporated any type of news that is available to the public. Thus everybody already knows and you won’t know any better story.
You will not know any insider news about the company’s prospects unless you are the owner of that company or in the senior management. Speculating what the price is going to be tomorrow will be nearly impossible to do.
Diversification is the answer
Index funds or ETFs in this case are the best and safe options because they diversify your risk across so many different stocks. So even if one or a few companies underperform, you will be still fine.
With ETF you have to set reminders for periodic contributions. Which type of fund is right for you depends on many factors. I have a detailed article on this topic here if you want to learn more.
My two cents
So, after you have saved for an emergency fund and paid off high-interest debt, start by investing at least 10%-15% of your paycheck every month. You can put this money in some type of broad-based index fund on an ETF. You make monthly contributions so that your investment grows over time. The good thing about index funds is that they are automated. Money automatically transfers to your brokerage account from your checking account.
The key takeaway from this article is that do not panic if you see the stock market going down in a particular year. This is not the time to sell. In the current scenario, it is a good idea to invest the money that you have sitting idle in your bank account. Do it after paying off your high-interest debt and establishing an emergency fund to meet your 6 months’ expenses.
Spend wisely and realize the importance of saving and investing. Most millionaires are not just born wealthy. They just make good investment decisions early in their life and build wealth. Instead of spending a lot of money on things that actually depreciate in value, such as buying a fancy car, they save and invest that money from the beginning. As their investment grows, they begin to reap its benefits for a substantial part of their life. Investment in a diversified portfolio is an easy passive way of getting rich, where money does the work for you.
Do you wonder where to save and invest when the interest rates are still rising?
In this post, I list some of the options I have looked at, used myself, and thought would be worth sharing with you all. This post is about savings and investment options in the US. But even if you are not from the US, some of the info will still be of good value to you if your country is experiencing interest rate hikes, so please continue reading till the end.
I would start with the safest option – the US treasury bills. These are currently paying between 3.9% and 4.6% annual interest, a significantly higher rate than what they did in the past 5 years.
Below is the chart I got from St. Louis Fed, where you can see the interest rate on 4 weeks’ T-bills in the last 5 years. As you can see from the chart, the interest rate has been growing since March 2022.
T-bills rates have been rising sharply since March 2022
What are T-bills and are these a good investment option right now?
For those of you who do not know what T-bills or treasury bills are, these are short-term borrowing of the US government from the people. These are backed by the complete faith of the US government, and thus, are virtually risk free.
The US treasury’s official website called treasurydirect.gov auctions new T-bills twice a month with the duration of four weeks, eight weeks, 13 weeks, 17 weeks, 26 weeks, and 52 weeks. On their website, they publish this table showing the current interest rates for each t-bill. As we would expect, they pay slightly higher interest with a longer duration.
When and how do T-bills pay?
T-bills are always issued at a discount to the par value and pay interest and the principal at maturity. What it means is that if you want to buy $100 worth of T-bills, you will actually be paying less than $100 now. Suppose you buy them for $95, and once the bill matures you will get the full $100 back. So the difference between the $100 and $95 is the interest that you earn, in this example it is 5%.
One of the tax advantages of T-bills is that they do not incur state or local income tax. However, you have to pay federal income tax on the interest earned.
Another benefit of investing in short-term T-bills such as 4 weeks or 8 weeks, is that these are relatively liquid investments. So this is something to consider if you have extra cash sitting in your savings account, you can move some of it to invest in 4 weeks t-bills, as a part of your emergency fund.
Also, there is no maximum amount of investment that you can do in T-bills. It can be up to millions of dollars, unlike the series I-bonds, which I will discuss next.
What are I-Bonds?
Government-issued I-bonds (also called treasury savings bonds) hit the headlines this year for a record high-interest payment. If you bought series I bonds between the end of April 2022 to the end of October 2022, they paid 9.62% annual interest.
I-bonds are mainly for long-term investment for 5 years or more. The interest we earn from them comes from a fixed rate and a variable rate. The variable rate is adjusted twice a year based on the inflation rate. As inflation rises or falls, the variable rate moves in the same direction to offset it. So they are inflation-protected.
I-bonds can earn interest for as long as 30 years or until you cash it out. They are also perfectly secure as they are backed by the U.S. government.
The current interest rate valid for the next 6 months for I-bonds is 6.89% on an annualized basis. It is almost 3% lower than what it was a few months ago, but it is still not bad compared to last year.
I bonds are not liquid as they need to be kept for a longer duration such as 5 years. If you withdraw the money before 5 years, you will lose 3 months of interest rate.
Also, keep in mind that i-bonds are not for emergency funds, as they are not liquid in short term. You can’t cash them out before 12 months.
Also, the maximum investment per person is only $10,000 per year, and up to $5,000 in the paper I bonds (with your tax refund).
High yielding Savings account
The next option would be to save your money in some high-yield saving accounts like Marcus by Goldman Sachs, and Capital one. These accounts don’t have any minimum balance requirements and monthly fees and pay 3% or more currently. These are also FDIC-insured. Below is the table I compiled using Bankrate data showing the different options.
Bank
APY
Monthly Fees
Minimum balance
Additional Notes
Citbank
3.6%
$0
$0
Upgrade
3.5%
$0
$1000
Upgrade is a financial technology company, not a bank. Premier Savings accounts are provided by Cross River Bank, Member of FDIC.
SoFi
3.25%
$0
$0
LendingClub
3.25%
$0
$0
$100 to open an account. A min balance of $2500 needed to earn top APY
Marcus by Goldman Sachs
3%
$0
$0
Marcus has a competitive yield on its savings account and only requires $1 to earn a competitive APY
CapitalOne
3%
$0
$0
Stock Market Investing
As I have said before, the best approach would always be to invest in a broad-based index fund or an ETF, rather than investing in individual stocks. This is especially true for risk-averse investors. Index funds are a great way to diversify your portfolio, which even the seasoned investor, Warren Buffett recommends.
Some of the index funds that I personally like and have invested my money in are Vanguard S&P 500 Index fund VFIAX, and Vanguard value index fund VVIAX. By following dollar cost averaging, you take away the emotional factor of investing and don’t get impacted by market fluctuations. Over the long run, the index fund that mimics a broad index should do as well as the market and will yield a return of 10-12% a year.
There is almost a continuous upward movement in these three stock indices from 1981 till present, showing significant positive returns over the long term. Source: CNBC
The stock market can go up and down for various reasons. It could be related to macro economic factors like changes in interest rates and inflation, but it is very hard to predict that. However, over the long run, all the leading stock indices, like S&P 500, NASDAQ, and Dow Jones have done great in providing great returns, as you see in the three charts above.
Also, if you want to compare how the market has done, as measured by the return on S&P 500 vs the inflation rate as measured by CPI, you can see the chart below. The market fluctuates, as we see from the blue line peeks, but most of it has been positive peeks, with the exception of a few years. Thus, over the last 50 years or more, on average, the annual market returns have been much greater than the inflation rate.
https://datawrapper.dwcdn.net/Kh8rl/4/
Real Estate Investment
If you are thinking of investing in a real estate, the question is whether you should buy a house now or should you wait. Well, I would say that if you could wait a little bit longer maybe after the next six months that would be a better time.
The next interest rate hike is most likely going to happen at Fed’s December 14 meeting. In their last meeting on Nov 2, the Fed indicated that the interest rates will continue to rise until the US economy returns to the desired inflation rate of 2%. To learn more about how Fed works, please stay tuned for my upcoming post.
Because the interest rate will keep going up in 2023, the demand for houses will likely fall. Once the demand for houses is low, the price of houses will also decline further.
The interest rate would still be high probably for the next 6 to 9 months but when they start dropping you can always refinance it.
Conclusion
But let me close by saying, with rising interest rates, the first thing you should do is pay off any type of credit card debt if you have one. If you look at the rates compiled by the Bankrate website, the average credit card rate is 19% as of Nov 30, 2022. So yes, before you invest anywhere, please take care of that.
Should I invest in a mutual fund, index fund, or in ETF?
In my previous post about funds, I mentioned that there are mainly four main types of funds. These are mutual funds, exchange-traded funds or ETFs, index funds, and hedge funds.
Today we will look more closely at each one of these funds but will focus on the first three types. Hedge funds are for very wealthy people, so let’s not worry about those for now.
Also, for comparison purposes, we will only look at funds that invest in stocks or what we call equity mutual funds for simplicity.
We will learn how these three funds are similar and how they differ from each other. I think it is good to know their characteristics because often people don’t know the distinction and use them interchangeably.
So let’s start with mutual funds- the oldest of all three!
Mutual funds have been there for the longest time. The first mutual fund was created in the U.S. in 1924.
You can buy mutual funds from mutual fund companies or through stockbrokers. The price of a mutual fund is set at the end of each trading day based on its net asset value or NAV.
Benefits of mutual funds
The main benefit of a mutual fund is the diversification it offers you. Diversification is an investing strategy that reduces your risk by spreading out your portfolio. I talked about this in my earlier post, that you don’t want to put all your eggs in one basket. By investing in a mutual fund, you get a tiny slice of each of those companies that are in the fund.
The other benefit is convenience. Investing in a mutual fund reduces your cost and the transactions you have to do. When you invest in mutual funds, you only make one purchase when you start. You get a share of each of the stocks that are in the fund, without having to pay a commission on each company’s stock trade. You can then invest more money in it periodically.
Without a mutual fund, if you want to buy a lot of stocks, this will involve a considerable amount of your time and money.
Are there any cons of investing in a mutual fund?
The second key feature is that mutual funds are mostly actively managed Funds. What do we mean by actively managed?
It simply means some finance professionals are doing the research and selecting the stocks for you based on their judgment. The main aim of these professionals is to pick and choose securities that can beat the market return. For their service and time, they typically charge you 1%- 2% of your account balance annually.
Fund manager doing analysis in an actively managed fund
This is irrespective of the performance of that fund. So, even if the stocks they chose in the fund are not performing well and your account balance goes down, you still have to pay the fees annually.
This 1%-2% fee might seem low but if you have a bigger balance, then this will eat into your invested money over time.
Also, historically, the data shows that most of the time these fund managers are not good at beating the market. This means that the stocks that they cherry-pick do not give you better returns than the broad-based market index such as the S&P 500 index.
Mutual funds also have some holding restrictions in terms of the minimum duration of time you need to hold the fund. There could be a penalty if you sell it before that time depending on the type of mutual fund.
Let’s look at index funds now!
An American investor, John Bogle created the first index fund that mirrored the S&P500 index in Dec 1975. He believed in a long-term investing strategy over day trading and speculation. He also didn’t like paying high unwanted fees to mutual fund managers. So, an index fund was a perfect solution!
Thus, unlike traditional mutual funds, Index funds are passively managed funds. They just track a certain market index such as S&P500, Dow Jones Industrial Average, or some other index. This is how they got their name index funds. Simple, right?
The index fund mimics a market index and is a form of lazy but worthwhile investing
Index funds buy and sell securities based on the index they copy. So, their portfolio will reflect any type of change in the index they follow.
Here, I would argue that for a beginner investor, an index fund would be a better choice for many reasons. Even investing experts like Warren Buffet favors index funds.
Advantage of an Index fund
First, they are very well diversified because they invest in all the stocks that make up an index.
Another advantage of investing in index funds is that they are passively managed and have incredibly low fees. Vanguard S&P 500 index fund has fees as low as 0.04%. The main reason for that is you don’t have to pay the brokers and research analysts to pick and choose companies to invest in.
Data has shown that Index funds are less volatile and give decent returns over the long run compared to individual stocks. Thus it makes sense to make these the main part of your portfolio, especially for retirement accounts like 401k and IRA.
You know what is really cool about index funds is that they allow you to do automatic reinvestment. You can set up a monthly recurring deposit from your bank account to the fund. This is a free automated feature and goes well with the dollar cost averaging strategy of investing.
Are there any disadvantages of index fund?
The only limitation of index funds is that some of them like the Vanguard 500 index fund VFIAX have a minimum requirement of $3000 for investment.
But a lot of other options like those from Charles Schwab and Fidelity index funds don’t have any minimum constraint.
VFIAX is one of the most popular index funds. As S&P 500 stock market index is a widely recognized benchmark for US stock market performance. Rather than looking at individual companies’ performances, you can simply look at the index direction, whether it’s going up or down.
Here are the top three S&P 500 index funds I found that you can check out. You will find expense ratio and minimum investment requirements, dividend yields, and 5-year trailing return comparison.
Moving on to the newest category of funds, the exchanged traded funds or the ETFs.
Exchange-traded funds have features of both index funds and stocks. They were first created in the 1990s.
ETFs like index funds can mimic a variety of indices such as the S&P500 or medium or small companies indices.
The added feature of ETFs is that they trade on a stock exchange. However, these are still usually passively managed like index funds.
Also, you don’t need a large amount of money to start investing. You only need enough to buy an ETF for the price of one stock, which could be from $50 to a few hundred dollars.
Since ETF trades like a stock, its price can fluctuate throughout the day. Depending on what time you’re buying or selling that’s the price you pay or receive.
So the difference is the option of intraday trading in ETF versus end-of-the-day trading in a mutual fund or index fund.
So is that even worth it?
But this flexibility might not be good for long-term investing. The reason is that when you see the price of ETF going up and down you will be tempted to sell and buy, but this is not what long-term smart investing preaches. Most people just buy once and sell when they retire, so this added feature doesn’t help.
Another downside if you compare them with index funds is that ETFs don’t have the automatic reinvestment feature as index funds do. You manually have to buy more shares of ETF every month which means more fees and more work.
Also, some ETFs could also be actively managed mutual funds. Actively managed ETFs have expense ratios just like mutual funds. So actively managed ETF costs more than a passively managed index ETF.
How do you make money from these funds?
So how do we make money from Mutual funds, index funds, or ETFs? Just like stocks do, through dividends and or capital appreciation. So if you sell your fund for more than what you bought, you’ll make money. You’ll also benefit if the securities in your fund pay dividends or interest.
Which type of fund is the right choice for you?
To summarize, first, we only had mutual funds, which gave everyone this convenience and diversification of pooled investment.
Then came the index funds, which are passively managed mutual funds and mimic an index. Index funds, over the long run, actually perform better than actively managed mutual funds. Also, index funds have much lower expense ratios and fees.
Remember, all index funds are mutual funds, but not all index funds are mutual funds.
Lastly, we have the ETFs which have everything an index fund does with an added option of intraday trading. However, ETFs don’t have an automated option for reinvesting and you have to manually do it every time.
From a tax point of view, mutual funds incur more taxes than ETFs.
So out of three options, my choice would be to invest in an index fund. But I would still recommend you do more research before you make any investment decision.
Last but not the least – Hedge funds
Before closing, I want to quickly go over Hedge funds with you. Hedge funds originally were aimed to hedge risk but now have become high-risk high return types of actively managed funds.
Also, they are mostly meant for institutional investors and rich people. This is because their minimum requirement for investment is a huge amount of money. Most of us will not even qualify for an investment in a hedge fund.
So there you have it, my friends, your must-have knowledge of different types of funds to begin or improve your investing journey. I hope you found this information useful. Please share your feedback in the comment section below.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice on an individual basis.
A fund is a collection of money from many investors. This pool of money can be invested in stocks, bonds, in a specific sector, or a combination of them. The main advantage of investing in a fund is the diversification it provides to us by spreading our risk. So, a fund can invest in places where an individual investor may not be able to.
Depending on how much money you invest in the fund, you’ll get a share in the fund. In investing theory, we call them units. So, the value of your units can go up or down based on the performance of the fund.
Funds can be actively managed or passively managed. In my next post, we will learn about these in more detail.
Where do funds invest?
A fund can invest in a variety of asset classes or in specific assets like only stocks or only bonds. The name of the fund usually states its purpose.
Equity funds, as the name suggests, invest in stocks, while fixed-income funds will invest in bonds – both corporate and government bonds. Some balanced funds invest in both stocks and bonds together.
Growth funds only want to invest in growth companies because they see a high potential for growth in these companies. Most technology companies are growth companies. This is the fast and furious approach to investing, where the fund manager will try to find companies with growing revenue, cash flows, and profits. These companies generally tend to be new companies, with a few exceptions.
On the contrary, Value funds invest in stocks of undervalued companies that pay high dividends. This approach is the slow and steady approach. Value fund tends to invest in companies that are well-established and mature. They usually offer investors a steady stream of income.
Funds could also be sector-specific, like energy funds that only invest in energy companies.
Some funds only invest in large-cap companies like those in S&P 500 index. So, when you invest in those index funds you are investing in many large-cap companies without bearing the risk of owning stocks of individual companies.
Investing in a fund that mimics a broad-based index will save you a lot of money. Also, most large-cap companies’ stock price trade at a very high value, and it will require a lot of money to buy several different stocks of different companies. Something that a lot of us can’t do.
You don’t need a lot of money to invest in a fund!
Did I tell you that you don’t need a lot of money to invest in a fund? Most funds like ETFs and index funds do not have minimum requirements.
A pool of money from many investors
So, hopefully, you got an idea about the purpose of the funds.
There are mainly four types of funds you will most often hear about
Mutual funds (actively managed by professionals)
Exchange-traded funds or ETFs (similar to mutual funds and stocks, could be active or passively managed)
Index funds (passively managed, my favorite)
Hedge funds (need a lot of money to invest in these, so many of us don’t qualify)
I will cover each of these in detail in my next post. So stay tuned if you want to know the advantages and disadvantages of each of these four and which one could be a better choice for a new investor.
In my previous post, I wrote about the various types of assets you can use for investment. To have a diversified portfolio, you should invest in a variety of assets.
Diversification can mean two things:
The first is diversifying within the same asset class.
So, for example, if you are investing in fixed-income securities, you need to invest in different types of those such as government bonds, corporate bonds, CDs etc.
Similarly, if you are investing in stocks, you should invest in multiple companies from different industries and sectors. But when you invest in individual company stocks, you may only be able to invest in 5, 10, or maybe 15 companies.
To achieve diversification using individual stocks, you will need to do a lot of research and invest a lot of money buying stocks from different companies in different industries.
Thus, if stocks comprise a majority of your investment portfolio, then your investment is risky because it is based on the performance of those companies you bought shares of.
So what’s the solution?
For a beginner investor, who doesn’t want to put too much money in several individual stocks, the best way is to start with investing in an index fund or a passively managed mutual fund.
What’s an index fund?
Index fund is a fund whose portfolio are built to mimic the constituents of a stock market index. The most widely used indices in the US are S&P 500 index or Dow Jones Industrial Average, or the Nasdaq Composite index.
Generally, Index funds should give you the same return as the index they follow. These funds buy all the stocks that are part of the index in the same proportion. So, it is like you have invested a little bit in each of those companies that comprise that market index. So yes, that would give you a very well diversified investment portfolio.
Also, index funds are less volatile and therefore are a good investment compared to individual stocks, esp. for long-term investing. So, they are a great option for investment for your retirement.
In my next post, I will argue why I like index funds more than actively managed mutual funds. I feel if you are sticking to read my post this far, you will be interested to know more.
Don’t put all your eggs in one basket!
The main point is to diversify so that if one sector or asset class doesn’t perform well, you don’t lose all your money.
The second key thing for diversification is having different asset classes in your portfolio, such as stocks, bonds, real estate, commodities, etc.
This brings us to the concept of asset allocation. Asset allocation simply means you decide what percentage of your money you want to put into each type of asset class.
Asset allocation will vary from person to person, depending upon their savings, age, risk tolerance and financial circumstances.
Finance theory suggests that generally, your investment in stocks should be 100 minus your age. So, if you are 25 years old, it should be 75% stock and 25% fixed income.
So yes, it means you need to keep changing your asset allocation as you grow older. Later in life, your investment in stocks should be less, and high in other fixed-income assets.
Now comes the million-dollar question.
When should you start investing?
The easy answer is now if you haven’t started already.
You can start investing as early as when you first start earning. Even kids can start investing their allowance money and add to it periodically.
Time plays a huge role in making your money grow, more than the dollar amount you invest. This is due to the power of investing!
Your money grows overtime exponentially!
If you are not convinced, you can take a look at my post here, where I explain this concept by using some simple examples.
How much money do I need to invest?
In the past, you would need a substantial amount of money to start investing. But things are much more simple now. With no minimum, no commission brokerage accounts, and fractional ownership of shares, you can start investing with as little as $10 a month.
You can set aside $1-$5 a day and make monthly contributions of $30-$150 a monthly.
These are some of the top brokerage firms in the U.S. – Charles Schwab, Fidelity, TD Ameritrade, and Vanguard. Stay tuned for my post on how to open a brokerage account!
I hope you found this information useful, I will cover Real estate and commodity investment in another post! But this is useful info to start investing now.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice on an individual basis.
