Investing for Beginners: How to Make Passive Income That Lasts
We all need to make money, and most of us do that through working a job of some sort. Jobs are nice in that they pay you the money you need to live, but they do have their downsides. The major downside is that if you stop actively working, you stop earning money.
This sounds obvious, but it’s important for understanding the other type of income: passive income. With passive income, your earnings are not attached to your time. That is, you’ll earn more or less a fixed amount per month regardless of how much work you put in.
Passive income may sound like an impossible goal for the average person, but there’s actually a rather straightforward way to earn it: investing. This way, once you reach an age where you can no longer work (or just don’t want to), you can still have a reliable source of income.
Investing can be an intimidating topic, but it’s not as hard as you might think. With just a few basic principles, you too can start investing your money and growing your wealth (all without having to do any extra work). So come along as we explore the basics of investing for beginners, including why you should invest your money, key investment terms, and how to get started investing.
What Is Investing?
To start, what exactly is investing? It’s a term that lots of people use without really understanding what it means.
While investing can be quite a complex topic, the basic premise is quite simple. When you invest, you put your money towards something in the hopes that you’ll get out more money than you put in.
The details of this are where things start to get more complex. After all, you can invest your money in a wide variety of things, and all of them have the potential to earn you a return. Therefore, the main thing to learn with investing is how to invest your money (and, even more importantly, how not to).
Below, we’ll cover some of the different ways to get started investing, but we should first include a brief disclaimer: We are not brokers, financial advisors, or finance professionals. The information in this article simply explains some ways of investing that tend to work well for most people. You should not take any of this as advice — it’s for informative purposes only.
Having said that, what makes investing so great, anyway? Why should you invest your money instead of just keeping it in a savings account (or under your mattress)? Read on to find out.
Why You Should Invest Your Money
While we can’t tell you what to invest in, we can say with confidence that you should invest your money. To understand why, we need to touch briefly on a few key finance concepts.
The first is inflation. Without getting into lots of complicated economics jargon, inflation describes how the price of things tends to increase over time. What’s more, economists have even figured out that inflation occurs more or less at a predictable rate. While inflation can fluctuate from year to year, it averages about 3%.
So why should you care about this? Simple: if you put your extra money in a savings account and just let it sit there, you’re going to earn around 1% (and likely less). Even the highest-yield savings accounts have interest rates of only 2.5%, which is still less than inflation.
What this means is that, over time, you’ll actually lose money if you keep it in a savings account. Therefore, you need to find a method of growing your money that will outpace inflation. This is where investing comes in.
Now, of course, it’s possible that if you invest poorly, you could lose all your money and be in a worse position than if you had just kept it in a savings account. However, if you invest well and over the long term, you have a very good chance of doing better than inflation.
On average, if you invest your money in the stock market for a period longer than 10 years, you can expect to earn an annual return of 7% to 10%. This is far better than a savings account, and it’s also enough to make sure your money grows faster than inflation. If you’re curious where these numbers come from, we recommend reading this guide.
Key Investment Terms You Should Know
Now that you understand why investing is beneficial, we need to cover some key terms that you’ll run across when reading about and making investments. You don’t have to have majored in finance to get started investing, but you should understand these basic terms so that you can protect yourself from bad investments and questionable advice.
Stock — A stock is a portion of ownership in a company that’s available for public purchase. When you own a stock, you own a very small amount of a company.
Bond — If a stock is owning a piece of a company, then a bond is owning a piece of debt. Both companies and governments can issue bonds in order to raise money. In exchange for purchasing a bond, you receive payments over a set period of time. Bonds tend to be less risky than stocks, but they also tend to have lower returns.
Stock market — The stock market refers to the collection of all stocks currently being bought and sold. When people talk about “trading” stocks, what they mean is buying and selling pieces of ownership in companies.
Exchange-traded fund (ETF) — This is just a collection of stocks, bonds, or other assets that gets traded as one unit. Purchasing ETFs can be advantageous because it spreads out your risk over a variety of assets instead of concentrating it all into just one company.
Mutual fund — A mutual fund is similar to an ETF in that it’s a collection of stocks or bonds that are pooled in order to decrease overall risk. However, the difference is that a mutual fund is managed by professionals. This can help boost returns, but it also means that you’ll need to pay fees in order to invest in one.
Index fund — An index fund is a particular type of mutual fund that seeks to invest in a particular segment of the overall financial market. Basically, the idea is that you pool money from a bunch of investors, spread it over a broad range of companies, and then (hopefully) earn a better return than if you just invested in one specific company.
S&P 500 — Short for “Standard & Poor’s 500,” the S&P 500 represents the performance of the 500 largest corporations in the United States. It’s the basis of lots of index funds, and it’s also a common tool that people will use to measure the overall performance of the U.S. stock market and broader economy.
Brokerage account — This is a tool that allows you to purchase stocks and other investments through a licensed brokerage firm. Brokerage accounts encompass a wide range of companies, from ones that focus on individual stocks (such as E-Trade) to ones that focus on helping you retire (such as Betterment). Brokerage accounts are also sometimes called “investment accounts.”
Retirement account — This is a specific type of investment account focused on helping you have enough money invested to retire by a given age. Retirement accounts come with special benefits, including helping you save on your taxes. They also often come with advice to help you meet your retirement goals.
IRA — Short for “individual retirement account,” an IRA is a type of retirement account that can help you save on your taxes. IRAs come in two types: traditional IRA and Roth IRA.
With a traditional IRA, money you contribute is tax deductible (within limits set by the IRS). You won’t have to pay taxes on traditional IRA contributions until you withdraw money (generally when you retire).
With a Roth IRA, on the other hand, the money you contribute isn’t tax deductible, but you can withdraw it tax-free when you retire.
Financial advisor — This is a person who specializes in advising you on what to do with your money. It can be helpful to consult with one when you start investing, are putting together a retirement plan, or are making any other sort of major financial decision.
If you decide to hire a financial advisor, make sure they’re a CFP (Certified Financial Planner), as that helps ensure that they’re giving you unbiased advice.
Robo-advisor — This is the computer equivalent of a human financial advisor. Robo-advisors are typically discussed as part of an automated, online investment account such as Betterment or Wealthfront.
Robo-advisors use artificial intelligence, machine learning, and statistics to give you the best investment advice. Plus, they’re also substantially cheaper than hiring a financial advisor.
How to Start Investing (Even If You Don’t Have Lots of Money)
Okay, so we know we just threw a lot of financial terminology at you, and it may have left you wondering, “But where do I start?”
While it’s important to understand basic financial terms even as a beginner investor, it isn’t that hard to get started with investing. In fact, it only takes 3 simple steps.
1. Determine Your Financial Goals
To start, you should figure out your financial goals. You can then tailor your investment strategy to help you achieve them.
Here are a few examples of financial goals, as well as how they can affect your investment approach:
- If you know you want to buy a house in a couple years, then that means less cash you can put in other investments.
- If you know you want to retire by a particular age or date, then that will dictate how much you need to invest (and how you should invest it).
- If you have or are planning to have kids, then you’ll need to consider if you want to set up savings for their college education and figure out how they’ll inherit your money after you’re gone.
2. Figure Out What You Want to Invest In
Once you have your goals, you need to figure out what to invest in. We’ve covered lots of the options already, but there are also many we didn’t discuss due to their complexity (such as real estate).
When choosing investments, you need to figure out something called your “risk tolerance.” This describes how risky of an investment you’re willing to make. For instance, investing in a single company is highly risky, as all your money is tied up in its performance. In contrast, investing in bonds will be far less risky.
This doesn’t mean that higher risk is necessarily a bad thing. While you risk losing more money, higher-risk investments can also potentially have higher returns than a safer investment. The trick is to balance risky investments with safer ones so that you can spread out your risk and earn the highest possible return.
How much risk you want to take on is ultimately up to you. In general, it makes more sense to have your money in riskier investments while you’re younger, as you have a longer amount of time to recover from losses and benefit from gains. When you’re closer to retirement, on the other hand, it makes sense to move your money away from riskier stocks and into more stable bonds, as you have less time to recover from a loss.
Having said that, every situation is different, and you’ll need to decide what kind of risk you’re comfortable with.
3. Make Your Investments
Now, it’s finally time to make your investments. There are lots of ways to do this, but the basic difference between the methods is how active you want to be in managing your investments.
If you just want something that you can set and forget, then robo-advisors are a good place to start. They generally don’t require you to put in a lot of money upfront; some, such as Betterment, don’t even require a minimum contribution. Bear in mind, however, that you will pay management fees in exchange for this simplicity.
If you want to take a more active approach, then you can set up a brokerage account and buy your own investments directly. If you’re going to do this, we recommend consulting with some kind of financial advisor, or at least doing a lot of research. Otherwise, it can be easy to lose a lot of money very quickly.
Investing for Beginners FAQ
To conclude this guide, here are answers to some common questions that new investors have.
1. How much money do I need to get started investing?
These days, you can get started investing with any amount of money thanks to robo-advisors. Many traditional brokerage firms do require large initial investments, but that doesn’t necessarily make them better than newer, tech-enabled companies like Betterment and Wealthfront.
2. Should I start investing if I’m in debt?
This is a tricky question. In general, it’s better to pay off debt first. This is especially true if you have high-interest debt such as credit card debt. For this type of debt, the interest rates are so high that they’ll outpace the growth of your investments.
If you have lower-interest debt (such as a mortgage, auto loan, or student loan), then it will generally make more sense to invest, as your average returns will tend to be greater than the interest you’re paying on your debt.
3. Should I be concerned about the daily performance of the market?
If you’re investing for the long-term, then short-term market performance shouldn’t concern you. This information matters to people who are day traders or work in other branches of finance and economics, but it’s of little use to the average investor who plans to invest for decades at a time.
4. What kind of investments can make me money quickly?
In general, there’s no such thing as an investment that will make you quick money. Anyone who tells you otherwise is either lying or giving you bad advice. The best way to win in investing as an average person without a finance degree is to invest steadily and consistently over a long period of time. Investing is not a “get rich quick” pursuit.
Investing Doesn’t Have to Be Difficult
Learning how to invest your money is an aspect of personal finance that everyone should understand. Once you know how investing works at a basic level, you can start putting your money to work instead of letting it languish in a low-interest savings account.
We hope this guide on investing for beginners has helped you understand how to get started, and we wish you the best with achieving your financial goals!