My investment choices are no different than my friends’ investment choices, and my friends don’t work in finance. Haas School of Business–I demand a refund!

Getting Started

1) Why should you care about the difference between a stock and a bond?

When a company like Apple needs money, they will ask people like you and me if we want to give them money in return for a small ownership stake in their company. If you like Apple, you’ll buy a sliver of their company for say, $10.

If Apple continues to take over the world, that sliver that you bought could grow to be worth $15. If you want your money back, then you’d sell your sliver of Apple to someone else who is willing to pay $15 and you’d pocket the difference of $5 dollars. The sliver of money that you bought is “stock” in Apple.

Another way for Apple to get money is to “borrow” money from people like you and me. Apple borrowing money from you is like you taking out a student loan for college: someone gave you money to pay your school tuition and you pay them interest on that loan until you’ve paid it back. So when you buy a bond, you’re giving Apple a loan; the bond is representative of the loan.

So why does everyone make such a big deal about the difference between owning a sliver of Apple (“stock”), or you just loaning money to Apple for a period of time (a “bond”)?

If you decided to buy stock in Apple, Apple now owes you nothing. The sliver that you bought for $10 could go down to $0, and it’s not Apples’ problem–it’s yours.

If Apple is borrowing money from you, they pay you interest and they have to pay you back the amount they borrowed from you; just like you’d have to pay back your student loan.

Stocks are more risky than bonds for this reason. But you’re usually paid more for taking on extra risk, which is why investing in stocks can generate higher returns than investing in bonds over the long run.

Why should you care? Because when you invest you’ll buy “funds” that consist of individual stocks or individual bonds. You’ll have to choose to buy more stock funds than bond funds, or vise versa.

2) Why should you invest in “funds” instead of individual stocks or individual bonds? The same reason why you should be going on a lot of dates.

If you’re single, are you just going on one date every month? No, you’re probably going on as many dates as possible–because if you go on just one date and it sucks, you don’t have any others lined up to make up for it! You’re diversifying, and that’s good.

I don’t invest in individual stock and bonds, and I don’t go on just one date per month. I only invest in stock and bond “funds” because within the funds there are many individual stocks and many individual bonds, so if one does poorly, it shouldn’t matter, since I have exposure to a lot of others.

3) Why should you invest in “index funds?”

Imagine you had 1,000 dates in one year (oh man, that sounds brutal) and someone asked you to tell them how your dates went. You’d probably take a smaller sample set and base your answer off that since you can’t remember all 1,000 dates, particularly if you like to drink on the first date to ease the awkwardness like me (I’m so mature, I know).

The S&P 500 is an index consisting of 500 large US companies, but it’s supposed to represent the entire US stock market, just like your “sample set” of dates you’d use to describe your dating experience, which represents all of your 1,000 dates.

I buy funds that track an index. So, if I wanted to buy a fund that performs like the S&P 500, I could buy the Vanguard Total Stock Market Index Fund. There are all sorts of index funds available for stock and bond funds, so that’s just an example.

I like index funds because they’re cheap. Index funds charge around 0.20% while funds that don’t track an index charge a lot more, like 1% or 2%. The fee they charge is called the “expense ratio.” When you buy index funds, you shouldn’t be paying any other fees, or “loads,” you should only be paying the “expense ratio,” which is usually around 0.20%.

Index funds outperform most non-index funds because they have lower expense ratios. You can save hundreds of thousands of dollars over the long run by investing in index funds.

4) How much money should you invest in stock funds and how much in bond funds?

The general rule of thumb is to buy your age in bonds. So if you’re twenty-five, 25 percent of your portfolio would be invested in bond index funds. The older you get, the less risk you should be taking (remember, bonds are less risky than stocks).

Maintenance

1) Why it’s good to leave the party early, and rebalance

Picture this, you’re at a party and you’re talking to some hottie you’ve had your eye on. The conversation is going great, really great. You’ve been chatting for about 20 minutes; do you stay, or, do you walk away and tell them it was nice to meet them and you hope to see them again soon?

Most people are losers, and they stay, till the very end when it’s awkward and you’ve run out of things to talk about.

And that’s why most people aren’t good at rebalancing their portfolio. Say you’re twenty-five years old and you have 75 percent of your portfolio in stock index funds, and 25 percent in bond index funds. If the stock index funds increase in value, you have more than you want in stocks for your age, and you’d want to pull some of your money out of your stock index fund and put it in your bond index fund.

Don’t be the loser at the party who’s over staying their welcome. When something is going great, or increased in value, pull back. It’s hard to move away from something that’s working but it’s the only way to make sure your ratio of stock funds to bond funds stays in check (aka your “asset allocation”).  Review your asset allocation every six months and you’ll be set.

2) Why do you need to review the expense ratios ratios on your investment funds?

Funds do raise the fee they charge from time to time so it’s good to look at the expense ratio you’re paying once per year. Low expense ratios save you hundreds of thousands of dollars in the long run.

Things to Avoid

1) Don’t listen to people who tell you to buy stocks. Most people have no idea how to pick stocks, including me–I don’t go near them. Instead, I stick with index funds because they’re cheap, they’re diversified, and they will most likely deliver 7 percent over the long run, which is fine for me.

2) Don’t performance chase funds. Over the long run, picking an index fund that has good performance comes after you’ve figured out your asset allocation and after you’ve found index funds that charge around 0.20%. Past performance is not indicative of how a fund will do in the future.

And this why my finance career is a JOKE! I don’t pick stocks, I buy index funds, I review my fund investments every six months to see if I need to rebalance, and I review my expense ratios once per year. You don’t need to be a finance wiz to make your money grow; you just need to get started. So get started!

Article written by Kathryn C. for Moxy Magazine, June 2011. Photo credit: flickr.com user eschipul.