As I’ve mentioned multiple times the last few weeks, only about half of all Americans are investing — and only 10% of those have investments outside of their work’s retirement plan. The biggest reason is a shortage of money but another, less excusable reason, is a lack of knowing where to start or how investing actually works.
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I remember the first time I learned what a 401(k) was in my Introduction to Personal Financial Planning class in college. I had always heard people talk about these magical 401(k)s but had no idea what they were. After hearing a simple explanation, I felt like I was part of an exclusive club; the “we know what 401(k)s are” club.
I felt empowered. Investing wasn’t some mysterious process anymore.
Through conversations I have with people trying to get into investing, I’ve become much more aware of the confusion around the basic differences between custodians, investments, and accounts.
When asking people about what they invest in I often hear, “I’m invested in my 401(k)” or “I’m invested in my Roth IRA.”
While these statements aren’t completely inaccurate, they demonstrate the confusion many people have with investing. 401(k) and IRAs are not investments. They are different types of investment accounts. An investment account is like a car and actual investments are like the passengers inside.
So, here’s my attempt to simply explain the basic mechanics of investing and bring you into this exclusive club.
Custodian/Broker
When you want to buy stock in a company, you can’t simply call up the company and buy shares, nor can you walk into your local bank and invest. You have to open a special investment account through a broker or custodian.
A custodian is a financial institution that holds and safeguards customers’ financial assets. In that way, they’re like a safe; much like your everyday bank. Custodians protect your assets from theft, loss, and unauthorized access.
A few examples are of custodians/brokers are: TD Ameritrade, Charles Schwab, Fidelity, Vanguard, Edward Jones, E*TRADE, Robinhood.
There’s no straightforward answer to which platform you should use. They all essentially perform the same function. Most, if not all, allow you to open accounts online with no fees, don’t have account minimums or trading costs, and offer a similar array of investment options. Your decision mainly comes down to your personal needs and preferences. Some people may want a complex, full-feature trading platform while some would prefer a simple user-friendly app.
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Investment Account
After choosing a custodian, you can then open an investment account. An investment account is where you hold your investments.
There are many different types of investment accounts you can open; below is a list of a few of the most popular:
Brokerage Account - standard investment account. There are no tax advantages and they’re available to everyone. You can pull your money out any time for any reason and you can invest as much as you’d like.
IRA (Individual Retirement Account) - pre-tax retirement account. When you put money in you don’t pay taxes on it. The taxes are incurred when you take money out in retirement. Because you’re getting a tax benefit, there are limits to the amount you can contribute and penalties if you withdraw early.
Roth IRA - after-tax retirement account. This is the inverse of a traditional IRA. You pay taxes when you put money in, you don’t pay taxes when you take the money out in retirement. It has the same contribution limits as an IRA.
401(k) - pre-tax retirement account offered through an employer. Functions similarly to an IRA but with a much higher contribution limit. 401(k)s usually include a match amount your employer contributes to your account.
Deciding which type of investment account to open depends on your current financial situation and is a conversation for another day.
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Investments
How much your investment account balance grows or decreases each year depends on the investments within the account.
Investments such as stocks, bonds, and mutual funds are not tied to a certain type of account, nor are they tied to a certain custodian. While many custodians sell their own mutual funds, you don’t need an account with that specific custodian to buy those mutual funds. For example, you can buy Vanguard index funds with an account held at Fidelity or Robinhood.
Below is a list of common investments found in an investment account:
Stock - an investment that represents ownership in a company. When you buy a stock you buy a small piece of that company, which is called a share. If the stock price goes up, you can then sell it for a profit.
Bond - a loan made by an investor to a company or government. Bonds are used by companies and governments to raise money and finance projects. The issuer of the bond promises to pay back the price of the bond plus interest, usually with fixed payments.
Mutual Fund - a collection of stocks or other investments. Instead of having to buy 100 stocks individually, you can just purchase a single mutual fund that contains all of those stocks. There are stock mutual funds, bond funds, real estate funds, etc.
ETF (Exchange Traded Fund) - very similar to a mutual fund. The main difference is ETF prices change throughout the day which is different from a mutual fund which only trades once a day after the market closes.
Deciding what to invest in is also dependent on your current financial situation and is also a conversation for another day.
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Phew. That was a lot of definitions, but I hope it was helpful. The actual process of opening an investment account and starting to invest is pretty simple but rarely explained. I’ve run into people who are knee-deep into infinite leverage options trading (very complicated trades) but don’t understand the basics of how an investment account works.
Starting with a basic understanding of how investing works is the first step towards making logical, smart decisions on your way to wealth. Join the club.
Thanks for reading!