It’s intimidating to start investing in the stock market. There’s tons of financial jargon casually being thrown around, lots of different acronyms, and sudden market swings that create chaos. All of this can make it seem like you’ll never be able to understand investing or make money doing it.
The good news is that the basics of investing are actually quite simple and if you master the basics, you can become a successful investor. To build your investing confidence, I’m going to tell you why stock market investing is just like a simple task that you do all the time, grocery shop.
Your Investment Account Is Your Grocery Bag
When it comes to stock market investing, the first thing you need to consider is the type of account you’re going to invest in. Each account has different advantages and disadvantages, but all of them do the same thing, hold your stocks.
Think of it like choosing between plastic, paper, or reusable grocery bags. All of these bags will hold your groceries, but each one has some pros and cons. Plastic bags are the most convenient and can easily be stuck under the sink to use as a dog poop bag later, but overall, they’re not very environmentally friendly. Paper bags are better for the environment, but they aren’t always available, and reusable bags are great for the environment, but you have to remember to bring them with you every time.
Some people prefer the convenience of single-use bags, while others bring their own bags to try and cut down on the waste they generate. The grocery bags you use reflect your individual goals and priorities, and so should your investment accounts. Regardless of which bag or account you choose though, all of them are designed to do the same thing, hold your groceries or investments.
To help you choose the account that’s right for you, here is a breakdown of the pros and cons of the most popular investment accounts.
Retirement Accounts
Retirement accounts are by far the most popular type of investment account. These are your 401ks, 403bs, and IRAs. All of them provide some sort of tax benefit, but they also have restrictions on how much you can contribute and when you can withdraw your money. Let’s get into the specifics of the main three.
401k/403b
401ks and 403bs are employer-sponsored accounts, which means you sign up for them through your job. Their main advantage is that their contributions are tax-deferred, which means that you don’t pay income taxes on any money you contribute to them until you withdraw the money later in retirement. This lowers your taxable income now, which means you pay less in taxes today.
Because of this benefit, there is a limit to the amount you can contribute to your 401k/403b each year. The limit for 2021 is $19,500. In addition to your contribution limit, you also can’t withdraw your money without paying a 10% penalty until you’re 59 ½.
Traditional IRAs
Traditional IRAs are very similar to 401ks, but they aren’t employer-sponsored. Like 401ks, they take tax-deferred contributions, and you aren’t able to withdraw your money until age 59 ½ without paying a penalty. However, IRAs have a much lower contribution limit at $6,000.
Roth IRAs
Unlike 401ks and traditional IRAs, Roth IRAs take after-tax contributions, which means that you’ve already paid income taxes on the money you put in them. Later, when you withdraw your money after age 59 ½, you pay no additional taxes. The contribution limit for Roth IRAs is the same as traditional IRAs at $6,000.
The main difference to consider between the two IRA accounts is how you pay taxes. Because your contributions are tax-deferred in a traditional IRA, you end up paying income taxes on your earnings and contributions when you withdraw your money in retirement. Since your Roth IRA contributions are after-tax, you only pay taxes on your contributions and pay no taxes on your earnings.
Taxable Brokerage
Taxable brokerage accounts offer none of the tax benefits that retirement accounts do, but that means they also have far fewer restrictions. There is no contribution limit or minimum withdrawal age, which means you can put as much money in them as you want and take it out whenever you want.
Your contributions to a taxable brokerage account are after-tax, just like in your Roth IRA, but your earnings are taxed at the capital gains tax rate, unlike in your Roth IRA.
Your Stocks Are Your Food
Once you’ve chosen your desired grocery bag, aka investment account, then you have to fill it up. Just like the food you buy at the grocery, some stocks are “healthier” for your portfolio than others, and those stocks should make up the bulk of your “diet”.
Index Funds/ETFs
Index funds and ETFs are the health food of your investment portfolio. Many people avoid them because they don’t have a lot of brand recognition or get a lot of flashy advertising but they should make up the bulk of your shopping list.
These funds are so good for your portfolio because they’re cheap and well-diversified. Their low price tag is due to the fact that they’re set up to track an underlying set of investments, which means they require minimal upkeep and research.
One of the most popular indexes they track is the S&P 500, which is made up of 500 US companies. When you buy an index fund or ETF that tracks the S&P 500, you buy a partial share of all 500 companies in the index. It’s like buying a variety pack at the grocery so you can get a sampling of everything.
Owning 500 companies instead of 1 gives your portfolio diversification, which reduces your risk. If you only own one company and that company does poorly you risk losing all of your money, but if you own 500 companies and one does poorly, you have 499 that can still make you money.
With so many companies working for you, it’s nearly impossible to lose money if you invest in a market tracking index fund like the S&P 500 for several decades. That’s why these are the healthiest stocks for your portfolio. Over the long term, they’ll keep your earnings up at an extremely low price.
Actively Managed Mutual Funds
Actively managed mutual funds are the name brands that charge you more for their products because of their name recognition. Unlike index funds and ETFs that track the market, actively managed funds try to beat the market. They do this by hand-selecting a group of stocks they think will perform better than all the rest.
To find these superior stocks, fund managers need to do a lot of time-consuming research, which is expensive. They then pass this expense on to you by charging you a high administrative fee called an expense ratio.
The problem is that most of the time, these funds underperform the market. That means you end up paying more to invest in them but earn less. Just like the brand names at the grocery store that charge a higher price even though they’re not any better than the generic.
Individual Stocks
Just like all food is fine in moderation, the same is true for buying individual stocks. As long as you maintain a healthy long-term investment strategy for the bulk of your money, it’s ok to treat yourself every now and then.
With food, you might splurge on your favorite ice cream or some cake and cookies. With money, you might buy the latest stock market gem. I’m looking at you, Tesla and GameStop. I’d recommend keeping your individual stock picks to less than 10% of your overall portfolio but it can be beneficial to indulge in individual stock picking from time to time to avoid FOMO.
Just like it’s tough to stick to a strict diet and eat only healthy foods for a long time, the same goes for investing. The constant chatter about people getting rich on the latest hot stocks can make it seem like your long-term investing strategy isn’t working. Allowing yourself to get in on a small piece of the hype can help you avoid feeling like you need to dump all of your money into GameStop or Tesla to try and get rich quick.
So while investing may seem intimidating on the surface, it’s actually as simple as a trip to the grocery. You should choose a shopping bag that fits your investment goals, fill it with mostly healthy food, save money by buying generic brands, and splurge on some of your favorite treats every now and then.