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Here's how beginner investors can build an investment portfolio

Select spoke with an expert to see what people should know about investing for the first time.

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For beginner investors, it can be hard to know where to start. Investment options can seem endless, whether it's cryptocurrency, NFTs (non-fungible tokens), real estate, stocks, bonds or mutual funds.

Knowing how to build an investment portfolio can help you achieve your short- and long-term financial goals, such as having enough money to put a down payment on a house in the short term or, in the long term, being able to max out your IRA each year in order to retire comfortably. 

Below, Select speaks with Douglas Boneparth, president of Bone Fide Wealth and co-author of The Millennial Money Fix, about how people can get started with investing and successfully build their investment portfolio.

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Back to basics

Regardless of what your financial priorities are, investing is a good way to earn passive income — as long as you're knowledgeable about the risks and rewards associated with it — since it allows people to earn compound interest. In other words, they're able to make money on their principal balance as well as the interest they have already earned.

Think about it like this: If you invest $1,000 in year one and earn a 10% annual rate of return on your investments, you'll end the year with $1,100. In year two, assuming the same rate of return, you'll end the year with $1,210 (1,100 x 1.1). This example demonstrates why it's essential to start investing as early as possible if you can. Since interest compounds over time, the difference between waiting a few years to start and doing so now can have a major impact on how much money you earn in the long run.

For example, suppose you started with a $5,000 balance and invested $5,000 each year. If you were to begin doing this at age 22, assuming you earn a 7% rate of return, you would end up with twice the amount of money saved by age 67 compared to what you'd have if you had started investing at age 32.

Before getting started with investing, Boneparth recommends having a solid financial foundation in the form of an emergency fund as well as an idea of what your short- and long-term financial goals are. Short-term goals might be for something fewer than four years into the future, such as a vacation or a down payment on a house, Boneparth says, adding that any money you want to allocate toward short-term goals should not be invested.

Saving for retirement 

Most people start investing through their employer-sponsored 401(k). According to the Pew Research Center, 52% of Americans are involved with some type of investment within the stock market — this is mostly through 401(k)s, with only 14% being directly invested in individual stocks.

Some employers offer a 401(k) match, typically between 2% to 4% of your salary, which is essentially free money. If you were to contribute 3% of your annual salary toward retirement, and your employer offered a 3% match, you're really investing 6% of your salary. Since 401(k) contributions are usually deducted automatically from each paycheck, the money goes straight into your retirement account before you even have a chance to spend it. Plus, those contributions are made pre-tax, which helps lower your taxable income for the year.

401(k) accounts typically offer people the option of investing in mutual funds or exchange-traded funds — having an exchange-traded fund and mutual fund is like having a basket of stocks and bonds from different companies. By being exposed to so many different stocks and bonds these funds help investors diversify their portfolios — if the value of some stocks decreases, it may be offset by an increase in the value of another set of stocks or bonds, for instance.

Fund managers purchase and sell the underlying assets in a fund, while individuals pay an expense ratio or an operational fee for the continued management of that fund. The annual expense ratio — the ratio of the fund's operational expenses to the fund's net assets — is represented as a percentage, for example, a 0.5% expense ratio means that individuals would have to pay $50 for a $10,000 investment.

One of the major differences between exchange-traded funds and mutual funds is that exchange-traded funds can be bought and sold throughout the day on an exchange while mutual funds can only be traded at the end of the day, explains Boneparth. Furthermore, you might get to choose between investing in a passively or actively managed fund.

Most exchange-traded funds are passively managed, Boneparth says, while actively managed funds usually have higher expense ratios since investors are paying for fund managers and researchers to actively pick and choose stocks and bonds in hopes of beating the performance of the overall stock market. He recommends opting for passively managed index funds, which aim to match the performance of the market and tend to have lower fees than actively managed funds. 

"What we certainly want them [people] to know is that most managers don't do a really good job of beating the market over long periods of time," says Boneparth. "So the expense of owning that actively managed instrument or fund is likely going to be higher than its passive invested counterpart."

According to the S&P Dow Jones Indices' annual SPIVA report, approximately 80% of actively managed domestic stock funds failed to outperform their benchmark in 2021.

Some retirement plans also offer target-date retirement funds, which are named for the year an individual plans on retiring and automatically change the allocation of the fund's holdings over time, investing more in conservative assets instead of riskier assets as you get older. Note, however, that this might not always be ideal, especially if you have other investments, as the allocation of your entire portfolio may end up being riskier or more conservative than you want since target-date funds work on auto-pilot.

What to put in your investment portfolio

When it comes to determining the allocation of your portfolio, you'll want to consider your risk tolerance and the time horizon for your goals. Index funds and mutual funds are typically considered less risky investments than individual stocks. And bonds are considered less risky than individual stocks, index funds and mutual funds.

Bonds are considered fixed-income investments. Federal and local governments as well as corporations issue bonds to provide cash flow to finance projects. With bonds, investors know the interest or dividend payments they'll be receiving before they invest. Whereas stocks are a form of equity denoting ownership in a company, bonds are not considered equities.

While Boneparth can't give personalized advice to all investors, he generally advises younger, beginner investors to allocate anywhere from 80% to 100% of their investments to stock funds and the other 0% to 20% in less risky assets such as bonds, with your portfolio allocation becoming more conservative over time. Since younger investors are further away from retirement, they have more time for their portfolios to weather the ups and downs of the market.

Legendary investor Warren Buffet has advocated for a "90/10" asset allocation for his wife's inheritance when he passes away, where 90% of the money is in a low-fee stock index fund and 10% is in short-term government bonds.

And if you do want to invest in individual companies, just make sure that you only allocate 5% to 10% of your portfolio to individual stocks. This strategy allows you to have some fun and invest in companies you believe in, but also helps mitigate risk: if these companies' stocks don't perform well than your overall portfolio won't suffer tremendously.

Where type of account should you place your investments in?

Retirement accounts — 401(k)s, 403(b)s, traditional and Roth IRAs and Roth 401(k)s — are tax-advantaged investment accounts. 401(k)s, 403(b)s and traditional IRAs are considered pre-tax retirement accounts, meaning you don't have to pay taxes on them until you take distributions upon retirement. Roth IRAs and Roth 401(k)s, on the other hand, are after-tax retirement accounts, so you will have to pay taxes on your upfront contributions, which allows your investments to then grow tax-free over time.

It's worth noting that Roth IRAs have an income limit while traditional IRAs do not. Both Roth IRAs and traditional IRAs have a contribution limit of $6,000 each year and offer an option to make an additional catch-up contribution of $1,000 if you're age 50 or older. Like 401(k)s, IRAs offer a variety of different investment options, whether funds or individual stocks or bonds. Select ranked Charles Schwab, Fidelity Investments and Vanguard as the companies offering the best IRAs

If you already have a retirement account, than you can open up a taxable brokerage account which allows you to buy and sell stocks freely. Select ranked TD Ameritrade, Ally Invest and Fidelity as some of the best brokerage accounts with no commission fees.

For investors who prefer a more hands-off approach, a robo-advisor could be a good option, as you'd simply need to fill out a questionnaire to assess your risk tolerance, financial goals, age and other factors that might influence your investing habits. The robo-advisor then uses an algorithm to create a customized portfolio and will automatically buy or sell assets within it to help you meet your financial goals.

Note that many robo-advisors also charge an account fee on top of the expense ratios charged for investing in each individual fund. This account fee is represented as a percentage of the amount you have invested. Select ranked Betterment and Wealthfront as the best robo-advisors.

Lastly, once you feel more comfortable investing and want to buy or sell individual stocks and bonds, you might want to consider opting for a brokerage account — many of these offer $0 commission trading, meaning you won't have to pay the brokerage to execute trades for you. Select ranked TD Ameritrade, Ally Invest and Fidelity as some of the best $0 commission trading platforms.

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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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