Posted by Gradual Millionaire on November 27th, 2016

Stocks, Mutual Funds, and Retirement Accounts: A Beginner’s Guide

Often, I believe, the greatest barrier to entry into investing is not knowing quite where to start. There are all these different kinds of accounts and acronyms with their own advantages and disadvantages. It all seems overwhelming and everybody recommends doing different things. So, where to begin?

Let’s take a step-by-step approach and work our way through all the basics. By the time you reach the end of this post, the goal is that you’ll feel confident enough to actually open an account somewhere and start investing.

First, let’s start with stocks. When you put money into a stock, you’re buying some number of “shares” in that company. When you buy shares, you really own a small piece of that company. And by small I mean a tiny fraction of a percent of that company. But it’s yours. If the company does well, earns profits, and grows, so does your piece of the company pie. On the flip side, if the company tanks due to a scandal or bad performance, the value of your shares decreases along with it.

For example, let’s say you own shares in Apple. Apple owns factories, store buildings, inventory, patents, a reputable brand, etc.. All of these things, combined with the assumption of future profits, is what makes Apple valuable. When you own shares in Apple, you essentially own a small fraction of all these things. The value of your shares is partially based on all of these, but is ultimately determined by what other people are willing to pay for it.

Companies will usually pay out to shareowners some portion of their profits each year to keep investors interested. These payouts are known as dividends and they also play a part in making a stock valuable.

Putting all of your money in one company can be really risky, though. On the risk-reward spectrum, buying stock in one company is near the farthest end of “High Risk, High Reward.” If you were lucky enough to have bought stock in Google back in the ‘90s, you’d probably be rolling in piles of money as you read this sentence. However, if you’d bought another web company like Pets.com or any of the hundreds of others that went bankrupt during the tech bubble of the early 2000s, you’d have lost all your money.

This is where mutual funds come into play. Instead of buying one company’s stock, you can pool your money with thousands of other people and invest in a “mutual fund” comprised of hundreds of different companies. Some of the stocks in that fund will do really well, and some will do poorly, but the idea is that because you’ve spread your money across all these companies, you’ve also greatly reduced your risk. Overall, the goal is that the fund will slowly but reliably increase in value over time.

This goal isn’t some pie-in-the-sky, unsubstantiated dream, either. If you look at a graph of the Dow Jones Industrial Average, which represents the average performance of stocks over the last 100+ years, you’d see that there’s no single 15-year period where the stock market has lost value. You’ve got your spikes and valleys, to be sure, but note that none of them seem quite so bad when you look at them in context. Notice that big drop near 2008 when the housing market fell apart, banks were being bailed out, we entered a big recession, and everybody lost their minds? Did you notice that about a year later, the market blazed right on past its previous high and continued to go for a huge climb for the next 5 years?

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There are two kinds of mutual funds: actively managed mutual funds and passive index funds.

As the name suggests, an actively managed fund is run by a portfolio manager with a team of analysts and researchers who try to select which stocks will outperform the average return of the stock market as a whole.

The other kind of fund is an index fund, which bases the stocks it holds on some standard list of stocks rather than a person selecting stocks. To understand what an index fund is, we should take a step back and look at what an index is. In the investment world, an index is a list of stocks that meet some criteria. The S&P 500 (Standard & Poors 500) index contains 500 large companies. The performance of this index is closely correlated with the performance of the stock market as a whole. An index fund invests in the stocks that make up the index on which it’s based. So, an S&P 500 index fund is a mutual fund that holds the 500 stocks that make up the S&P 500.

Now you’re probably asking, “which is better, an actively managed fund or an index fund?” You might tend to think a portfolio manager with a PhD in finance, decades of experience, and a team of researchers all devoting their careers to studying companies would be able to pick out a portfolio of stocks that performs at least slightly above average. The problem is that research tends to find that the majority of actively managed funds actually underperform the market average. In addition, actively managed mutual funds charge much higher fees than index funds because you’re paying for the salaries of dozens of people. Essentially, you’re paying more for less in most cases. Picking a portfolio manager who can consistently outperform the market average is as difficult as picking an individual stock that can do that.

Personally, I invest all my retirement money in an S&P 500 index fund. The fees are incredibly low and the performance is best-in-class. In fact, one of the world’s greatest investors of all time, Warren Buffett, recommends this kind of index fund for the average investor. If it’s good enough for Warren Buffett, it’s good enough for me!

Since we’ve got the concept of stocks and mutual funds under our belts now, we’ll want to take a look at the different kinds of retirement accounts you can choose from. For this post, we’ll consider the 401k, Traditional IRA, and Roth IRA. If you’re a teacher or government worker with a 403b, substitute 403b in anywhere you see 401k, since they effectively work the same way.

Think of these types of retirement accounts as buckets inside of which you invest in mutual funds. They aren’t really “accounts” at all, but they simply designate how your invested money should be treated from a tax perspective. The government wants to incentivize people to be responsible citizens who invest for their own retirement, ultimately requiring less outside support in the future. They create these incentives  through tax-advantaged accounts.

A 401k is a retirement account that’s run through your employer. If you invest in your company’s 401k, you get to take a tax deduction at the end of the year on any money you put in (up to $18,000). For example, if you earned $50,000 this year and contributed $10,000 to your 401k, you only have to pay income taxes on $40,000 at the end of the year. Often, employers will match some portion of what employees contribute to their 401k as a benefit, but this is gradually becoming less common.

A Traditional IRA is similar to a 401k, except that it is not through your employer and you can only contribute up to $5,500 per year to it. The tax advantage works exactly the same way, though.

There’s another type of retirement account called a Roth IRA, which is different from the 401k in a couple of key ways. First, this account is not tied to your employer in any way. It’s your own personal account, just like a Traditional IRA. This means you have more freedom in terms of what you invest in, and what financial institution you go through. Secondly, and most importantly, instead of getting a tax deduction in the year you invest in your Roth IRA, you get a tax deduction when you withdraw the money in retirement. So, if you make $50,000 in a year, and you contribute $5,500, which is the maximum you can contribute per year, you will still pay taxes on the whole $50,000, However, once you reach 59.5 years of age, you can start withdrawing from your Roth IRA and you won’t have to pay any taxes on your earnings at that point like you would with a 401k.

A general rule of thumb is that if you’re early in your career and will be making significantly more in the future, a Roth IRA is a good way to go. If you’re nearing retirement or are on the later end of your career, a traditional 401k and/or traditional IRA can make more sense. It all depends on your plans for the future, so it’s worth doing some thinking and research about your specific situation.

15% of your gross income is generally a good number to shoot for, although you can bump that percentage down a few points if you’re young and can’t quite make 15% work. I’d personally try not to go lower than 12% if you can help it. Conversely, you might want to push that percentage up if you’re getting a later start in life. The most important thing is that you’re putting some amount away for retirement, you’re building the habit of investing, and you’re shifting your mindset to be more future-oriented rather than paycheck-to-paycheck. If you can do this, you’re already ahead of the vast majority of your fellow Americans.

I hope this has all been helpful. If you have any questions at all, please don’t hesitate to drop a comment and I’ll answer it to the best of my ability.