A Few Key Terms to Know Before You Start to Invest

When considering how to invest, first thing’s first: For the average American family or single person, the most important thing is to prepare for retirement. Starting this year, to max out your accounts, you can put $18,500 into a 401K if that’s offered at work, and $5,500 into an IRA, if your finances allow for it. That is one of the absolute best places to invest because there are tax benefits, and your retirement funds have the opportunity to grow. Depending on your income, there may be a limit on the IRA amount you can deduct, so ask your financial advisor or your financial services company.

After that is taken care of, I give you permission to think about investing outside your IRA and 401K accounts. Understand that, generally speaking—and I’m not giving specific investing advice here—the most important things to know are your risk tolerance and time horizon.

Let me explain.

When you’re investing money, you need to know when you’ll need it. There’s a big difference between a 10-year and a five-year or one-year time horizon. If you need the money in one year, you shouldn’t be investing. Remember 2008? If you had needed money you had invested within a year, you would have been in very big trouble. Given that the markets naturally—and sometimes, catastrophically—fluctuate, you have to be ready to ride those waves.

We call it the rule of five: If you need the money in the next five years, it should not have major stock market exposure. It should be invested in more conservative things. This rule applies to you if, for example, you planned to buy a home in two years where you need a $200,000 down-payment and you currently have $175,000. It’s better to continue saving and put that money into something less risky than the stock market, because you cannot afford to weather any movement.

You should also understand the investment products that are available to you. Here’s what you could put your money in, in ascending order of risk:

Bank Certificate of Deposit (CD)
Think of this as a supercharged savings account that offers low rates for various short-term periods. (The current rate for a 2-year CD, for example is around 2.4 percent, though that figure will fluctuate).

Bonds
When you buy a bond, you’re becoming a lender to, for example, the government or a company. The return tends to be lower, but usually so is the risk. Bonds come in several durations. (Average return for a 10-year US treasury bond—the most common that people will buy, though there are others—is around 2.84 percent).

Equities
Buying into equities (i.e. the stock market) means you own shares of either an individual company or a basket of stocks. (Average return: Hard to say, but the average market return over the last 100 years is just under 10 percent).

As you move up the ladder from CDs to bonds to equities, your risk profile is going up. So while equities have the potential for better returns, they often have more risk, which is why you generally should consider investing more in equities when your time horizon is much longer.

In short, a longer time horizon has potential to yield better returns because you can take on more risk. But remember that all investments carry risk including potential loss of principal.

Another trend to keep in mind: Generally speaking, Index Funds and Exchange-Traded Funds (ETFs) tend to have lower costs—and are increasingly embraced by newer investing firms, like Betterment—than, say, actively managed mutual funds. The difference for you could be 2 percent versus 0.25 percent in fees. Those numbers sound tiny, but spread the difference in those fees over a decade, and it really adds up. Keep in mind, of course, that choosing the right investment is not only about finding the lowest fee. A good financial planner—and if you’re high-earning, you should have one—will want to steer you in the direction that’s right for you.

The bottom line is, investing shouldn’t be overwhelming and complicated, though it can feel like it for those of us without deep knowledge of these terms. Whether you’re ready to dive in or just learning the ropes, start with your retirement. That way, no matter what the return, the future should be bright.