I get many questions from people who are interested in becoming investors but don’t know how to get a foot in the door. And while that is a general question, I find myself struggling with an easy way to explain “how to get started.” Many are expecting the answer to include direction on specific investments to get into, but because the American Association of Individual Investors (AAII) is a nonprofit organization, and because the answer really depends on the individual, I can’t give advice to any one investor on which investments to choose or what their risk level should be. But I can point you in the right direction, especially as to resources on AAII.com and other websites that can teach you how to make the right decisions for yourself when starting out.

There are a couple of things to consider.

To answer some of the general questions you may have as a beginning investor, “Investing Basics FAQs” is a great place to start. We also have an online classroom that can introduce you to many basic topics, like “What Is a Mutual Fund?” or “Making Your First Investments.”

The first thing any financial adviser would do is ask you to create your Investment Policy Statement (IPS). “The Art of Creating an Investment Policy Statement” from the November 2016 AAII Journal goes over some of the basic concepts included in this.

It may seem like an investment policy statement goes beyond the question of “how do I get started”; however, I think it’s a great concept to understand when you want to take control of your own investments. Your choices should consider your overall financial goals in life, particularly when it comes to risk and reward.

Determining how you will invest has a lot to do with how much time you want to spend on investing. Are you going to be someone who is looking for new stocks weekly? Do you want to learn how to go through company financial statements and read their annual reports? Or do you simply want to just put some money away each month and leave it alone? This is important because it will dictate your approach to investment selection.

If you want to be able to fully understand a company’s financial statements and analyze their annual and quarterly reports, you’ll definitely have to do a lot of reading beyond this article. That’s okay, though! AAII has plenty of resources to help you, and there are other excellent resources online (and books of course). Two books you probably will have to read eventually are by Benjamin Graham, “Security Analysis” (McGraw-Hill, 1934) written with David Dodd, and “The Intelligent Investor” (HarperCollins, 1949).

I want this article to be somewhat of an outline, a precursor of articles to come. There will be a second part to this article that will discuss more on how to select securities when you are getting started. Here, I summarize some of the basics and link to additional articles that cover the topics more in-depth.

If you have a suggestion on what topics to cover for beginning investors, please email me directly at jaclyn@aaii.com. Some of the views expressed in this article are unique to me and do not necessarily represent AAII or AAII’s views.

Investment Risk Basics

Risk is a funny thing to me. It can be measured in many ways, but I am in the same school of thought as AAII founder and chairman James Cloonan. In his recent book “Investing at Level3,” he states that risk is the likelihood that you won’t have enough money when you need it. There are two aspects of risk: your ability to take risk and your willingness to take risk. As a beginner, an important concept to understand is how your investing time horizon plays into your ability to take risk. The longer the time horizon, the higher your ability to take risk. When your time horizon is longer, you will have a longer time to invest and recoup your money if you suffer a loss. If you needed your money within the next couple of years, it may be good to be a little bit safer or risk averse. Riskier securities decline more when the general market declines.

I have helped some of my friends set up their retirement accounts, and when they got to the point where they were selecting the mutual funds that would be in their accounts, they saw some labeled with the words “high risk” and thought that meant they were funds to avoid. However, high risk is generally accompanied by higher return. Stocks have historically been riskier than bonds, but stocks have also had a higher return.

Here are a few articles that can help you understand investment risk:

• “Assessing Different Measures of Risk”—Retire Happy blog
  
• “How Investment Risk Is Quantified”—Investopedia
  
• “For Long-Term Investors, the Focus Should Be on Risk”—AAII
  

Asset Classes and Asset Allocation

There are many different asset classes that you’ll often here about in the “investing world” and while some are more popular than others, it’s a good idea to have a basic understanding of your options. Once you understand the available asset classes, your next step is to determine your desired asset allocation. Asset allocation simply involves deciding what percentage of your overall portfolio will be invested in which asset class. Asset allocation can be generalized based on age, but it is also based on your risk tolerance, your required return and your unique circumstances.

To understand more about asset classes, I suggest checking out “Selecting Asset Classes for Retirement Investments” written by John Zhong and featured in the July 2017 Computerized Investing. While the title implies it’s only for retirement accounts, he also gives a great description of the different asset classes, and this knowledge applies to different types of accounts.

Here are the main asset classes to familiarize yourself with:

• Equities (stocks)
  
• Bonds
  
• Cash and cash equivalents
  
• Real estate
  
• Commodities
  

To start, you will probably focus on equities, bonds and cash.

Equities

There are many different ways to slice and dice the equities asset class.

One way to break it down is by geographic location. As an investor in the United States, we say, “domestic equities” to refer to stocks traded in the U.S.; this is separate from “foreign equities,” which are stocks traded on non-domestic exchanges.

You can break equities up by “market capitalization,” which is calculated by multiplying a stock’s price by its outstanding shares. Generally, the higher the number of outstanding shares, the larger the company. Would a really small company have as many shares traded as Apple Inc. (AAPL)? Probably not. Having more shares outstanding isn’t necessarily a good thing, but that’s a discussion for another day. The three main breakdowns by market capitalization that you’ll hear are: small-cap, mid-cap and large-cap. Think of it this way: small-cap companies are small companies, mid-cap companies are medium-sized companies and large-cap companies are large companies.

Large-cap companies will be most of the ones you hear about on the news: Apple, Facebook, Google, Caterpillar, etc. In general, small-cap companies are riskier than larger companies. Small-cap companies have historically outperformed larger companies.

Here are some useful articles that explain these breakdowns of equities in more detail:

• “What Is Market Cap and Why Is It Important?”—The Balance
  
• “Investing in U.S. Stocks Vs. International Stocks in 2016”—Investopedia
  

Bonds

Bonds are generally considered less risky than stocks, but they can actually be more confusing. A bond is like a loan. For example, if a company issues a bond and I purchase the bond, they are saying, “Jackie, we need $1 billion dollars, can you buy this bond with a 5% coupon rate and we will pay you back over the next 20 years?” By purchasing the bond I am saying, “Yes company XYZ, I accept these terms.” Each year the company will pay me 5% of the original bond value until the loan expires in 20 years, then they will repay me the full amount of the loan ($1 billion in this case).

If you are interested in learning about how bonds work, I suggest checking out some of these articles:

• “Getting a Handle on the Bond Market”—AAII Classroom
  
• “Why Bond Prices Go Up and Down”—AAII Classroom
  
• “What Is a Bond?”—The Wall Street Journal
  

Bonds are generally categorized by maturity or credit risk. Maturity is the length of time until the bond is paid off—in my example above, that was 20 years. You can break these down (broadly) between short term, intermediate term and long term.

Credit risk is the risk of default: What is the chance that the bond issuer won’t be able to make payments on the loan? Generally, the higher the credit risk, the higher the coupon payment (or interest payment) you will receive. You must be compensated for taking on additional risk.

I will say that investing in an individual bond is probably not your best option if you are a beginner. You should look for a “bond fund” that invests in many different bonds at once, as this helps to spread out some of the risk.

I don’t want to get overly bogged down on breaking down the asset classes and the definitions of each, because this could easily turn into a book; however, it’s important to get a general understanding of your options.

Asset Allocation

Asset allocation is how these different “categories” of investments are apportioned inside your portfolio.

This may be an unpopular opinion, but again I agree with James Cloonan that you should be fully invested in equities until retirement. Many people will say that as you approach retirement, you should shift more of your assets into bonds. This is because as you near retirement, you are less willing or able to take on more risk. But moving more of your allocation to bonds comes at a price.

Table 1 shows the historical returns from 1926 to 2016 for several different asset classes and sub-asset classes. (To read more about the difference between geometric average and arithmetic average click here). You can see that historically equities (large-cap and small-cap stocks) have significantly outperformed the bond categories. While past performance is not indicative of future performance, it is hard to ignore the difference between the returns received by equity investors and those of bond investors. However, that doesn’t mean that at times bond investors won’t outperform equity investors and vice versa.

Table 1. Summary Statistics of Annual Total Returns (%) 1926–2016

So, when I say moving more of your money into bonds comes at a price, the price is through (potentially) receiving a lower return.

The overall goal of asset allocation is diversification—a word you will hear quite often. It follows the idea of not putting all of your eggs in one basket. If you put all of your money into one stock, you are heavily dependent on that one stock. If the stock’s price goes down over time, you don’t have other stocks to help offset the decline. Not being diversified is risky. If you’re interested in the math behind diversification, check out “What is Correlation and Why Does it Matter for your Portfolio?” from the StockRover blog. In the article, the author discusses how correlation affects your portfolio and also shows you how to use StockRover’s correlation table.

There is no “right answer” to asset allocation, but AAII and other sources offer asset allocation models as a guideline. Here is a link to our asset allocation page.

There are many tools online that help you analyze your asset allocation, such as Personal Capital. This company offers a free tool that allows you to integrate all of your brokerage accounts into one, then it shows your asset allocation based on the accounts you’ve linked. If you’re interested in learning more about how to analyze your asset allocation once you have investments, check out Computerized Investing’s Best of the Web. You’ll see a link to “Portfolio Tracking, Analysis & Optimization” on the side of the page.

More asset allocation articles:

• “How to Achieve the Right Asset Allocation”—AAII Journal
  
• “Basic Truths About Asset Allocation: A Consensus View Among the Experts”—AAII Journal
  
• “Minimizing Taxes With Asset Allocation”—AAII Journal
  

Before Worrying About Asset Allocation

Keep in mind that nobody expects you to be able to build this massive, diversified portfolio overnight. Everyone has to start somewhere, and many of us just don’t have an extra $100,000 lying around when we are ready to get started in investing.

If you simply want to invest in stocks here or there for “fun,” that’s okay too. But I will say that having some extra cash on hand is really important. If you don’t have at least a couple months of your current salary/income in cash, then you may want to consider working toward that before “investing for fun.”

Aside from having cash set aside in case of an emergency, it’s a great idea to set up a retirement account if you don’t have one. Check out this CI article: “Setting Up a Retirement Account Online.” If your employer offers a retirement plan, make sure to join it. If your employer doesn’t offer a retirement plan, you should really consider setting one up yourself. It is not very difficult to do, and you will thank yourself later. Whether it’s offered through your employer or not, you should automate the savings that go into the account. This way, the money is regularly withdrawn from your bank account and invested without you having to remember to transfer money every month. I personally tell people to invest at least 10% of their income into their retirement account, but you should select a percentage that you are comfortable with. The benefit of an employer-based retirement account is that the employer usually contributes to your account also, matching your contribution up to a set percentage.

From there, your next safe bet is to buy a “total market” stock mutual fund and just let that accumulate over time. This is something you can slowly add money to over time. If you’re also investing for fun, you know in the back of your head that you have a total market fund accumulating money in the background. Here is an article about some total market fund options. That article points to mutual funds, but if you don’t have the minimum investment that some of them require, don’t get down about it! Your next option is to select an exchange-traded fund (ETF) that follows a similar investment methodology. Some investors may argue that ETFs are better than mutual funds, but this is a topic we will cover in a different article, along with how to go about analyzing ETFs and mutual funds.

ETFs don’t have minimum investments; you purchase shares of an ETF the same way you would purchase a stock—share by share. If you have a couple hundred dollars to use for an initial investment, you would just have to calculate how many shares you can buy with the money you have available. For example, if you have $500, and an ETF share is $65, you can buy roughly seven shares. A couple of shares here and there are better than nothing! Just keep in mind that every time you buy shares through your brokerage account, you will pay a commission cost. We will discuss commission costs in the “Selecting a Brokerage” section below.

A popular total stock market ETF is the Vanguard Total Stock Market ETF (VTI). Click here to see the analysis page for this ETF on ETF.com.

I also recommend that you consider looking at an application called Acorns. Acorns lets you round up your spare change, and it invests it in ETFs for you. This is a fun and easy way to automate your savings and get started with investing. Click here to see our original write up on Acorns.

Lastly, if you have kids, your next step would be to set up a 529 Plan for them. These are tax-advantaged accounts that help you save for college. Many of the plans require a very small monthly contribution (some have no minimum requirement, but I’ve seen some as low as $10 a month) and many of them don’t require a large deposit to get started. If your child doesn’t attend college, there are options on what to do with the money—it’s not all lost. This is a topic I intend to expand upon in another article.

To summarize, your first steps before even worrying about asset allocation and picking individual stocks are:

1. Make sure you have an emergency fund
   
2. Set up a retirement account and automate your retirement contributions
   
3. Invest in a “total market” stock mutual fund or ETF
   
4. Set up a 529 Plan for your children
   

… and then invest!

Selecting a Brokerage

In order to be able to buy and sell securities, you will need to open a brokerage account. There are many different “discount brokers” that allow you to easily buy and sell securities online (or even on your phone) for a low fee. Brokers act as intermediaries between you and the exchanges.

There are a few things to consider when selecting a broker:

• Fees
  
• Commission-free ETFs and mutual funds
  
• Resources available
  

NerdWallet’s article “How to Choose the Best Online Broker” notes several things to consider when selecting a broker.

I generally hear good things about Charles Schwab, Fidelity and TD Ameritrade. Charles Schwab and Fidelity charge $4.95 per trade, while TD Ameritrade charges $6.95 per trade. A “commission” fee is what the company charges you to place trades. It generally pertains to equity trades, so be sure to read the fine print. For example, if you want to place a trade to buy five shares of Apple, you will pay the $4.95 commission cost when you place that trade. It is not per share of stock, it is per trade; it doesn’t matter if you buy five shares or 500 shares when you click “purchase,” you will pay $4.95. If you come back to the platform later in the day or the next day to buy more shares, you will again pay the $4.95 fee. This is the same for selling: Every time you place a trade to sell shares, you will pay $4.95 per trade.

For more information on fees you may encounter, read “Understanding Investment Fees: From Brokerage Commissions to Sales Loads,” by NerdWallet.

If you are only going to be placing a couple of trades a year, the commission cost doesn’t matter as much as it does for someone who is trading constantly. However, if you could pay a couple bucks less, why not? For those who want to trade often, I recommend checking out Folio Investing.

I also tell people to take a look at how many commission-free ETFs and mutual funds each brokerage offers. The more the better. Be careful though, just because an ETF is commission-free doesn’t necessarily mean you should buy it. Wealthfront had a good article about this topic: “Commission-Free ETFs Aren’t What They Seem.”

Another thing to consider is what types of resources the brokerage firm offers. To the best of my knowledge, all of the online brokers let you create a “watchlist” and track individual securities through their platform. This is useful if you want to keep a list of potential investment candidates separate from the stocks in your actual portfolio.

Here is an example of how I went through an in-depth analysis of Scottrade. You should consider features such as what types of analysis tools they offer (screeners for funds and stocks) and if they offer third-party reports (S&P analysis reports, etc.). As I said before, I believe on a basic level that all of the online brokerages will offer you tools, so don’t get bogged down here. If you select a broker to place some trades and find that you don’t like them over time, it’s not the end of the world if you have to switch brokerages.

Also, if you intend to reinvest your dividends, you may want to check out which brokerages make that easier for you in this article, “Tapping Into the Dividend Well: Reinvesting With DRIPs.”

At AAII, we survey our members to see which online discount brokers they use. You can find more information on that survey here.

Conclusion

We covered a lot in this article, but at the same time barely scratched the surface. Unfortunately, before you can get to the fun stuff, you have to learn some of the basics.

With investing, there is no “right way” to get started, and that’s what makes many of these articles challenging. When traveling on your investment path, whether you’re old or young, a seasoned investor or a beginner, you always have to keep learning. Find some blogs you like, tools that work for you, websites you want to check out, books you want to read, etc. You can never know too much about investing. If you don’t want to be hands-on that’s okay, too, but at a bare minimum, learn about what the bare minimum even means!

In the next installment, I intend to go through how to analyze different securities.

As I mentioned in the introduction, if you have suggestions or questions for beginning investor topics, please feel free to email me at jaclyn@aaii.com.