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How to Invest - Basic Investing Strategies

Stocks in this article: VTSMX LEXCX SWTSX BRK.A BRK.B

NEW YORK ( TheStreet) -- Learning how to invest your money is one of the most important lessons in life. You don't need to be college educated to start investing, in fact, you don't even need to be a high school graduate. You just need to have a basic understanding of business and have the confidence to make a plan -- consider it a business plan for your life. You can do it.

Why Investing Can Be Scary

For many of us, money and investments weren't discussed at home. These subjects may even be taboo within certain households -- quite possibly, in households that don't have much money or investments.

If your parents or loved-ones aren't financially independent, they probably can't give you good financial advice (despite their best intentions). And even if your family is well-off, there's no guarantee that their financial advice makes sense for you. Plenty of parents encouraged their kids to buy a house during the peak of the housing bubble, because in their lifetimes, housing only went up.

Having said all of this, the first investment that you make will probably be the hardest.

The Goal of Investing

Of course, everyone has different financial goals -- and the more you learn, the more confident you'll be in determining your own path. But here's a basic financial goal to strive toward:

Over decades of hard work, I would like to make more money than I spend and invest the difference. By the time I retire, I would like my investments to throw off enough cash -- through dividends or interest -- that I can live on this income without having to sell my investments.

Notice the first part of this goal is about hard work. If you're hoping to take a little bit of money and gamble it into a fortune in the stock market, you can stop reading now, this article isn't written for you. But if you plan to work for a few decades, and want to make sure that you don't have to work until life's end, you'll need to spend less than you make and invest the difference.

Also, you'll notice that this goal doesn't recommend selling your investments. Rich people don't sell-off their assets for spending money -- if they did, they wouldn't be rich for long. They stay rich because their assets provide enough cash flow to support their lifestyle. And these cash-producing assets, through careful estate planning, can be passed down from generation to generation.

Enjoying your twilight years by living off your investment income -- and having something left over for your loved ones or a charitable organization -- is something that all investors should aspire to. It may not be possible for everyone, but it's the right attitude.

What Should I Invest In?

The most common investments are stocks and bonds, which most financial advisers agree should be held in some proportion based upon your personal circumstances. Stocks represent partial ownership of a company and bonds are a form of "I owe you." Mutual funds can own stocks or bonds or both on your behalf. (If you are unfamiliar with stocks, bonds or mutual funds, you should bookmark this article and return to it after you've learned more about each of these asset classes.)

There are other ways to invest -- for instance, real estate investment trusts (REITs) -- and these types of investments have their place. But you needn't focus on them if you are just starting out -- sticking to stocks and bonds (and the funds that hold them) is just fine. But if you have debt -- whether, it's credit card debt, mortgage debt or student loans -- it may not make sense for you to own bonds, or, to invest at all.

Should I Invest or Pay Down Debt?

It should go without saying that if you can't make the minimum payments on your debts, you should not be investing at all. But if you have extra money left over from each paycheck, you have a few choices that can each have a positive impact on your finances:

1.) Use all of your extra money to pay down debts (mortgage, credit card, student loans).

If you have interest payments that are higher than 10%, you are almost certainly better off paying down debt than investing. The stock market has returned about 11% per year in the long-term ( far less if you consider taxes and fees), but there are no guarantees in stock investing. Your debt, however, is guaranteed -- sometimes, even after bankruptcy.

2.) Use all of your extra money to buy investments (stocks, bonds, funds).

This only makes sense if your debts aren't costing you much, in other words, if the interest rate that you're paying is low. If your debts are costing less than 5% interest, you may be better served (in the long-term) by investing your extra money in carefully chosen stocks or stock funds. If your mortgage is costing you 5%, it makes no sense to buy a bond or bond fund that yields 2%. A bond that pays you less in interest than the interest payments on your personal debt is not worth buying. And even if a bond pays you higher interest than what you owe, that doesn't mean it's always a good investment.

3.) Use some of your extra money to buy investments and some to pay down debts.

Benjamin Graham -- Warren Buffett's teacher -- once suggested that investors should hold no more than 75% of their investment money in a single asset class (he was referring to stocks vs. bonds). You can apply this same logic when deciding how much of your extra money should be used to make investments.

If you treat your low-interest debt like a bond, then, at minimum, you'd use 25% of your extra income to pay this debt off -- the remainder could be invested in stocks. If stocks or stock funds became too expensive (remember, the higher the stock market climbs, the more expensive it becomes), then you could use as much as 75% of your extra income to retire debt and the remaining 25% to buy stocks, despite their high prices.

Ultimately, you should pay down your debts with the highest-interest rates first. For more complicated situations, it may be best to consult a fee-only financial adviser who is familiar with your personal situation. A financial planner is only as good as the information that he or she is provided with, so if you consult an adviser, be sure to mention all of your debts as well as your investments and investment ideas.

Know the Difference Between Saving and Investing

There are a few steps before you can become a successful investor: you being employed, having essential insurance coverage, having your personal debts under control and having an emergency savings account in case you lose your job.

Your investments and your savings are very different things. What if the stock market crashes and you lose your job? If you do not have a cash savings account -- and your unemployment benefits do not cover your living expenses -- you'll probably have to sell your investments at the worst possible time. Don't fall into this trap.

Two Strategies for Lifetime Investing

The two investing strategies below assume that you have a very long investment horizon -- in other words, you plan on working for the next few decades. The first strategy requires minimal effort. The second strategy may seem to require minimal effort, but it requires far more investor education than you'll find in this article alone.

1.) Investing in Mutual Funds With a Margin of Safety

Jack Bogle -- founder of The Vanguard Group -- has dedicated half-of his life to demonstrating how no-load low-cost index mutual funds (specifically, those that buy the entire stock market) are the best way for an investor to succeed. By dollar-cost averaging -- the practice of buying the same dollar amount of a fund on a regular schedule -- investors needn't worry about timing their purchases. Their average purchase price will ultimately reflect a "fair" value.

Dollar-cost averaging is a great idea with a big flaw: Investors are most likely to be unemployed when stocks are cheapest.

If you spent 2006-2007 using your leftover paycheck to buy stocks on a monthly basis, then lost your job (and paycheck) during the financial crisis of 2008-2009, you didn't have the money to buy stocks at their cheapest prices in decades. Ultimately, you didn't dollar-cost average -- you timed the market. And bought at the worst time (when stocks were most expensive).

One solution to this problem is to create an investment reserve fund (similar to- but separate-from your emergency savings fund). If you're socking away $100 per week into a total stock market mutual fund, try to accumulate a cash reserve of $2,400. This will allow you to invest for 6-months in the event that you're unemployed.

You may feel uncomfortable to part with your money when fear or instinct tells you to hold on tight, but successful investors are able to detach themselves from their emotions. Try to make smaller investments consistently rather than larger investments erratically.

As a practical example, if you invested $6,000 in Vanguard's Total Stock Market Fund (VTSMX) in Sept. 2007, you'd have $6,290 by August 2012. If you invested $100 per month, in the same fund, from Sept. 2007 to August 2012, your $6,000 of investment would have grown to $7,689 (both of these examples assume that your dividends were reinvested). Slow and steady does win the race.

One last point to consider: Most low-cost index mutual funds require an initial investment in the range of $3,000 - $5,000. If this upfront cost would eat up most of your investment money, you may be better starting off with a fund that has slightly higher expenses and a lower initial investment.

But beware: Many poor-quality funds attempt to attract investors with low initial investments. Before you look elsewhere, see what high-quality fund providers like Vanguard, Fidelity and Charles Schwab have to offer. As of this writing, the Schwab Total Stock Market Index fund (SWTSX) has a $100 initial investment, no-load, and very low expenses.

2.) Buying and Holding Carefully Chosen Stocks

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks," wrote Benjamin Graham in his classic book The Intelligent Investor.

It's true: If you buy a total stock market index fund at regular intervals over a long enough timeline, you will almost certainly have satisfactory results. Yet many investors forgo the financial rewards of simplified investing for the psychological reward of "stock picking."

For small- or beginning-investors, trading stocks is a fool's game. If you buy $500 worth of stock, minus a $10 commission to your stock broker -- then sell the stock after it rises 4%, again, minus a $10 commission, you've gained nothing. If you do make winning trades, transaction costs and taxes will eat away at your returns, not to mention you'll be trading against PhD-level mathematicians and the computer programs they've written to pick your pockets.

But there is long-term value to be had in buying the stocks of great companies and holding on to them for many years. Even more so if your stocks pay dividends (an actual cash payment of the company's profits). The amount of wealth that reinvested dividends can create is simply amazing. What's even more amazing is that many online stock brokers offer dividend reinvestment as a free service. This luxury gives the patient investor an even bigger advantage over the frenetic stock trader.

The Living Proof That Buy and Hold Is Not Dead

There's a mutual fund -- about as old as Warren Buffett -- that has never changed the stocks it holds; not in over 75 years. Had you invested $10,000 in the Corporate Leaders Trust (LEXCX) in 1935, it would be worth many millions of dollars today. Yes, some of the fund's original 30 stock holdings disappeared over the years -- the fund currently holds 22 stocks -- but even so, the fund has outperformed the S&P 500 and Warren Buffett's Berkshire-Hathaway in the past decade (pretty amazing when you consider that the fund was created before the programmable computer was invented) and it has consistently earned a five-star rating from Morningstar.

Kevin McDevitt, CFA wrote the following when highlighting the fund's 75-year birthday:

With the very long term in mind (the fund was originally scheduled to liquidate in 2015, since extended to 2100), the original advisors wanted to find blue-chip, dividend-paying companies that could thrive for decades...When looking this far out, decisions are driven more by enduring factors such as brands and sustainable competitive advantages rather than earnings projections... It's notable that no financials companies of any kind were included originally.

If you can find 30 dividend-paying stocks -- selling at a reasonable price -- that make goods and services that people will use decades from now, you will almost certainly be richer by holding them.

This is easier said than done.

How to Buy Stocks Without Losing Your Shirt

First, you'll need to learn how to value a company. When you're buying a stock, you're buying part-ownership of a company. Therefore, if it makes financial sense to buy the entire company, it would make sense to buy a fractional part of the company. Figuring this out takes a little bit of math, but nothing more difficult than multiplication and division. Don't get scared off.

There are several ways to value a company and its stock -- by all means, read as much as you can on the subject (if you can't make sense of a balance sheet or cash flow statement, you're not ready to invest in stocks). But at the end of the day, the question that you need to answer is:

If I bought this entire company, assumed all its debts and then collected 100% of profits from now until forever, how long would it take to make my money back?

Once you have the understanding and confidence to answer this question, you'll see why a $1 stock is not necessarily cheaper than a $50 stock -- and that's a concept that many folks have trouble with.

But here's where it gets tricky.

If you knew that a company could maintain or grow its profits at a fixed-rate every year in the future, valuing the stock would be an exact science. However, many companies -- especially those that specialize in technology -- can watch their products fade into obscurity and their profits disappear (remember when Nokia was the king of cell-phones and Apple was a $7 stock?).

To find stocks that have a good chance of surviving into the future, think about the products that you use every day. Did your parents also use these products? Their parents?

Also, don't invest in companies that you don't like. If you hate smoking, you will not feel good about owning a tobacco company -- even if the company makes you money.

Some of your stock picks will probably lose money, but one great investment can make up the difference and then some. As long as you are diversified (owning 20-30 stocks that aren't very similar) -- and assuming that you have not overpaid for your investments -- you should do fine in the long run.

Then again, you can save yourself the trouble and buy a mutual fund that owns the entire stock market (see above). Investing in stocks takes a lot of time and research -- it's up to you to determine how much your free time is worth.

Learn More About Investing

Being a successful investor requires money, patience, and just as important, confidence. Having confidence to make- and stand-by your financial decisions requires education. Never stop learning.

If you're looking for a good investing book, you owe it to yourself to read Benjamin Graham's The Intelligent Investor. Graham's writing style isn't for everyone, in which case you may prefer The Rediscovered Benjamin Graham -- a collection on interviews and lectures with the "father of value investing."

Warren Buffett's annual letters to shareholders also make for good reading -- they are free to download on the Berkshire-Hathaway website.

About.com's Joshua Kennon does an admirable job at explaining basic- and advanced-financial concepts -- most importantly, how successful people think about money.

The Motley Fool's Morgan Housel cuts through the noise of investment television; he lays down the bare facts about investing in an inspirational way. Meanwhile, if you're looking for insightful analysis of individual stocks, Eddy Elfenbein's Crossing Wall Street blog is a must-read.

Lastly, TheStreet has been publishing investment guides since 1996 -- if you're just getting started, you may be interested in our glossary of financial terms and articles on investing basics. For more advanced readers, you're free to enjoy daily stock ideas from professional traders and investors.

-- Written by John DeFeo in New York

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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