3 Reasons Why You Need To Understand Investing

3 Reasons Why You Need To Understand Investing

None of us can be experts in everything - there aren't enough hours in the day to gain that much knowledge and experience. We rely on the specialized skills and advice of experts in every area of our lives. Few of us manufacture our own cars, diagnose our own illnesses or make our pets' food from scratch. However, we usually take the time to learn about what brands of cars are safe and reliable, what might be wrong with our health and what companies make the most nutritious foods for our animal companions. So when it comes to your money, the medium that makes almost everything you do in your life possible, why would you behave differently?

In this article, we'll explore why you should take the time to learn the basics of investing, even if you plan to hire an investment professional .

SEE: Manage My Own Investments? Are You Kidding?

1. "Basic investments aren't difficult to understand and they are all most people need."
Many people are intimidated by the thought of investing, and that's understandable. However, you'll do just fine if you put together a small, diversified portfolio comprised of low-cost mutual funds and/or ETFs, make regular contributions and leave it alone.

This strategy is called passive investing or couch potato investing. Developed by long-time personal finance columnist Scott Burns, it means investing in just two low-cost index funds: one that tracks the S&P 500 and another that tracks a bond index (such as the Vanguard Inflation-Protected Securities Fund.)

The percentage of your money that you invest in stocks versus bonds depends on your risk tolerance and time horizon. The higher your risk tolerance and/or the longer your time horizon, the more you invest in stocks. Stocks are more volatile but have historically brought higher returns. The lower your risk tolerance and/or the shorter your time horizon, the more you tip the scales toward bonds. Bonds have traditionally been less volatile but yielded lower returns.

Once you've chosen your two index funds, all you have to do is add to your nest egg regularly and rebalance your portfolio annually.

Not only is this strategy easy, it also has an above average track record, and the diversification between stocks and bonds helps keep the portfolio from performing too poorly during market downturns. This strategy also minimizes the investment fees that eat away at many investors' returns.

2. "There are plenty of people who will take your money, if you don't understand what they're doing with it."
There are many excellent financial advisors out there, but if you don't know the first thing about investing, you won't know how to separate the good ones from the mediocre ones and the downright unethical ones. At a bare minimum, you should know how to choose a professional who you can trust to act in your best interest.

For example, according to Jemstep.com, a free online investment guidance and management service, you should know that Registered Investment Advisors are legally required to put the client's interests first, but brokers are not. You should also understand how your advisor is compensated and how they select recommended assets for their clients.

SEE: Paying Your Investment Advisor - Fees Or Commissions?
A problem you could encounter with a broker is excessive trading in your account, since each buy and sell order generates a commission. This practice isn't in your best interest, since it doesn't take your investment goals into account and results in you paying excessive trading fees. Churning can leave you with less money than you started out with.

Another problem with brokers is that they sometimes push investments on clients that are in the brokerage firm's best interest because the firm holds a position in that investment. Brokerage firms can also charge a number of fees that will eat into your investment returns. These fees include inactivity fees, transfer fees, account maintenance fees and minimum equity requirement fees. As if that weren't enough, full-service brokers are expensive. Their commissions are several times what you'll pay to buy and sell stocks on your own through a discount brokerage.

Investment advisors, on the other hand, are not only required to act in your best interest, but they're also more likely to make buy and sell recommendations that are objective because they aren't paid for every transaction you agree to. These advisors also don't have incentives to push you into certain investments, regardless of whether they are your best option; however, their expertise doesn't come cheap. Investment advisors charge an hourly fee for their services.

3. "You can save a bundle by managing your investments yourself."
When you manage your investments yourself, you save money in several ways:
• You don't pay expensive commissions to a full-service broker.
• You aren't pressured into expensive investments that benefit your broker more than they benefit you.
• You don't pay an expensive hourly rate to an investment advisor.
If you adopt the passive strategy described above, your only fees will be the expense ratios charged by the mutual funds and ETFs you invest in. Since these fees are ongoing, you'll want to keep them as low as possible. That isn't hard to do when major players like Vanguard, Fidelity and iShares offer a variety of funds with expense ratios close to zero.
That being said, you can still rack up plenty of investment fees on your own if you aren't careful. When choosing a discount brokerage and selecting investments, make sure to learn what fees you'll be responsible for. Look for a brokerage that lets you buy and sell a broad selection of ETFs and mutual funds without paying a commission. Also, look for a brokerage with low commissions if you plan to invest in individual stocks. Finally, you'll want to seek out ETFs and index funds with low expense ratios.

The Bottom Line
If you're still uncomfortable with the thought of investing your money yourself, go ahead and hire a fee-based investment advisor or financial planner . However, you'll still want to know a few basics so you don't get taken for a ride by an unethical professional.