Richard Whelton - Introduction to Index Funds and ETFs--Passive Investing for Beginners

Passive income is the goal that most people have in mind when they begin any sort of investing venture. Whether they are investing just for fun, some extra money, or retirement, passive income is the light at the end of the tunnel.

One definition of passive income is,income that does not require active participation. In other words, you set up a system that makes money, regardless of any continuing effort you put into the system.

Some examples of passive income include: real estate rental properties, dividend paying stocks, money lending, and long term investing in index funds, or ETFs. Some people would argue that none of these methods are purely passive, but some do come closer than others.

In this book we are going to cover two main forms of passive income within the stock market, along with a few alternatives that still produce amazing results.

Both of the stock market investment vehicles are uniquely suited for beginner investors and will make a responsible addition to any investment portfolio.

Lets go ahead and dive right in!

While we prefer to stick with index funds and ETFs for the majority of our passive investing, you will need a good working knowledge of different components of the market. So lets do a quick overview of three main players.

Stocks

There are three categories in which you may place stocks; they are income, growth, and value.

-Income Stocks have a huge potential to create passive income for the purchaser. Income stocks pay higher dividends than most other equity stocks. Income stocks are also considered safe investments, without a lot of risk. When you are shopping for income stocks, choose the stocks that regularly increase their dividend pay out, which will help you to stay ahead of inflation. Many investors have a portfolio filled with income stocks, and focus primarily on dividends as a retirement investment.

-Growth Stocks are stocks that generally grow quickly and yield a high return on investment after being sold. Growth stocks do not generally pay out dividends however, the company profits are reinvested into the company, which will continue the growth cycle. Technology stocks are mainly classified as growth stocks. This category of stocks are fantastic for short-term investing, but without the enormous volatility that comes with penny stocks.

-Value Stocks are the stocks for bargain-hunters. These stocks are usually priced below the current market value for other comparable stocks trading in the same industry. Value stocks are not necessarily risky investments; usually the companies have solid fundamentals. These stocks are just flying under the radar of most investors. Always be searching for value stocks, they will fill out your portfolio nicely.

Bonds

Bonds are a relatively safe and conservative investment. Most of the time, they are considered a safer investment than individual stocks. But what is a bond?

A bond is basically a glorified IOU note. You can purchase bonds from the government, or even businesses, in order to assist their fund-raising campaign.

One benefit to owning bonds is the repayment of your investment along with an annual return on your investment.

Bonds are stable and predictable, but tend to be dry and boring. If dry and boring appeals to your present investment portfolio, these will make a great addition.

Mutual Funds

Mutual funds are large groups of stocks and bonds purchased by a group of investors. The group appoints a fund manager, who then oversees the fund. Each investor in the group pays the fees to cover payment to the manager in charge of the mutual fund. The fund manager is responsible for purchasing and selling the stocks and bonds, while timing the market just right in order to get the highest return on investment (or ROI) for the members of the mutual fund.

Four different types of mutual funds exist with varying levels of risk, so there should be a fund that is just perfect for your own comfort level.

The money market fund is the most conservative fund in terms of risk. The money market fund is mostly used in place of a savings account. This fund is not risky at all, and your money is as easily available as it currently is in a regular checking or savings account.

Bond funds are only slightly more risky than money market funds, though some may argue that U.S government bonds are one of the riskiest investments available. These funds buy U.S. government debt, corporate debt and municipal debt in the form of bonds. Bond funds offer a small increase in earnings over money market funds; however, the returns are still minimal and should only make up a small portion of your portfolio. If however, you need to balance out an otherwise risk-filled portfolio, bond funds will accomplish your goal.

Balanced funds combine stocks and bonds with money market accounts. When you purchase a balanced fund, you are getting a great balance in risk, along with a better ROI than just purchasing bonds or money market funds alone. These funds will go up and down in value, because of the stocks, which are less stable.

Stock mutual funds are most common and also have the highest ROI. These funds carry the greatest risk, but will give the greatest reward. Although these funds are considered the riskiest type of mutual fund, they are still less risky than investing in single stocks. The risk is spread over many different stocks within the fund. There are funds on both ends of the spectrum of risk from which to choose. So, evaluate your investing goals and choose the fund that best aligns with those goals.

The main principal to consider with risk is that the more risky the investment, the greater the return. In other words, if you are hoping to make a substantial amount of money with investing, then you need to have a good amount of risk built into your portfolio.

In contrast, the more conservative an investment, the lower the return. So, if you are just planning to park your money to keep it safe, and are not as concerned with the growth of your portfolio, then the majority of your investments should be very conservative.

The risk return theory is a general principal, however, and we all know there are exceptions to the rule. Your main goal will be to spread your risk around by having a combination of risky higher yielding investments, and conservative lower yielding investments, and this is called diversification.

When you diversify your portfolio, you are spreading out your risk. This gives you the freedom to try out a risky, potentially high paying investment, because you know that you have plenty of safe investments that will not be going anywhere.

When seeking to diversify your portfolio, think about a house analogy. When you are building your home, you absolutely must build a strong foundation. In the finance world, a strong foundation translates into dividend paying stocks, ETFs, and index funds.

After your foundation has been built, only then can you begin thinking about other additions like a great kitchen, fancy bathrooms, and vaulted ceilings. These fancy additions can be compared to growth stocks, value stocks, and even some penny stocks thrown in for fun.

The point is, until you have a solid foundation, you should not even think of adding in all of the extras that require more skill and expertise to invest in unscathed.

Diversification means owning a wide enough variety of investments that if one completely collapses, you have not lost everything. This does not mean that you should jump in feet first and buy five different types of investments without truly understanding how each works. Learn the ins and outs of one investment first. After you know how the investment works, well enough to thoroughly explain it to a friend, then you are ready to enter into the investment.