Investing can be one of the more complex concepts in personal finance. But it’s also one of the key cornerstones to financial independence and wealth building. While it might seem intimidating—from the alphabet soup of terms like IRAs and 401(k)s to keeping track of the latest market movements—understanding the basics can boost your confidence and help you feel comfortable getting started.
How to start investing
On a high level, investing is the process of determining where you want to go on your financial journey and matching those goals to the right investments to help you get there. This includes understanding your relationship with risk and managing it over time.
Once you understand what you want, you just have to jump in. You can decide to invest on your own or with the professional guidance of a financial planner. Below we discuss in detail each of the key steps to help you get started with investing.
1. Decide your investment goals
Before you decide to open an account and begin comparing your investment options, you should first consider your overarching goals. Are you looking to invest for the long term, or do you want your portfolio to generate income? Knowing this will narrow down the number of investment options available and simplify the investing process.
“Consider what your ultimate goal is for this money—is it for retirement, a down payment on a house in the next five years, or something else?” says Lauren Niestradt, CFP, CFA, and portfolio manager at Truepoint Wealth Counsel.
Understanding your goals and their timelines will help determine the amount of risk you can afford to take and which investing accounts should be prioritized.
For example, if your goal is to invest your money for retirement, you’ll want to choose a tax-advantaged vehicle like an individual retirement account (IRA) or a 401(k), if your employer offers one. But you may not want to put all your money earmarked for investing into a 401(k), because you can’t access that money until you turn 59 ½, or you will get hit with penalty fees (with a few exceptions).
You also don’t want to invest your emergency fund in a brokerage account because it’s not easy to access money if you need it quickly. Plus, if you need that cash when the market is facing a downturn, you might end up losing money when you’re forced to sell low.
2. Select investment vehicle(s)
After determining your goal(s), you need to decide which investment vehicles—sometimes referred to as investing accounts—to use. Keep in mind that multiple accounts can work together to accomplish a single objective.
If you’re looking to take a more hands-on approach in building your portfolio, a brokerage account is the place to start. Brokerage accounts give you the ability to buy and sell stocks, mutual funds, and ETFs. They offer a lot of flexibility, as there’s no income limit or cap on how much you can invest and no rules about when you can withdraw the funds. The drawback is that you do not have the same tax advantages as retirement accounts.
There are several financial firms that offer brokerage accounts like Charles Schwab, Fidelity, Vanguard, and TD Ameritrade. Working with a traditional brokerage usually comes with the benefits of having more account types to choose from, such as IRAs or custodial accounts for minors, and the option to speak with someone on the phone and, in some cases, in person if you have questions.
But there are disadvantages: Some traditional brokerages may be a bit slower to incorporate new features or niche investment options like cryptocurrencies. For example, fintech companies like Robinhood and M1 Finance offered fractional shares to investors years before traditional brokerages did.
Another brokerage account option is a robo-advisor, which is best for those who have clear, straightforward investing goals. The advantages of using robo-advisors include lower fees compared to a human financial advisor and automatic rebalancing to name a few.
If you have more complex financial goals and prefer more customized investing options, a robo-advisor may not be the best fit.
One important thing to note: Opening a brokerage account and depositing money is not investing. It is a common mistake for new investors to assume that opening the account and adding money is enough, however the final step is to make a purchase.
3. Calculate how much money you want to invest
As you decide which investment accounts you want to open, you should also consider the amount of money you’ll be investing in each account type.
How much you put into each account will be determined by your investment goal outlined in the first step—as well as the amount of time you have until you plan to reach that goal. This is known as the time horizon. There may also be limits on how much you can invest in certain accounts.
Decide on a percentage of your income that you can dedicate to building your portfolio. The general rule of thumb for retirement goals is to invest 15% of your income each year, but if you started investing later in your career or want to retire early you may want to consider investing a higher percentage. Keep in mind that 15% also accounts for any matches you receive from your employer. This means that you could contribute 10% of your W2 income with a 5% match from your employer to reach a total of 15% to hit this benchmark.
If you live paycheck to paycheck, 15% might seem like a crazy amount to invest. Don’t panic: It’s OK to start small, even just 1%. The important thing is to get started so your money will grow over time.
Plan how you’d like to invest your money. A common question that arises is whether you should invest your money all at once—or in equal amounts over time, more commonly known as dollar cost averaging (DCA). Both options have their advantages and disadvantages.
“For medium to long-term goals, dollar cost averaging is a valuable strategy to ensure that you’re investing consistently toward a goal and hopefully benefiting from purchases at both higher and lower trading prices. As they say, it’s not about timing the market, but time in the market,” says Tara Falcone, CFA, CFP, founder and CEO of Reason, goal-based investing app. Dollar cost averaging, even in small amounts, can be an effective investing tactic.
But DCA has its downsides: Because historically the market rises over time, you’re more likely to see a higher return if you had invested a lump sum at the beginning.
“The data show that investing the sum all at one time is better than dollar cost averaging. By investing the money all at once, you get to your target allocation immediately and, thus, have a higher expected return than if you kept a portion in cash,” says Lauren M. Niestradt, CFP, CFA, and senior portfolio manager at Truepoint Wealth Counsel. Your target allocation refers to the mix of stocks and bonds you should own based on your risk tolerance and how long you plan to invest.
Because most people do not have large amounts of cash to put into the market at one time, dollar cost averaging tends to be the default option. And with investing, it’s better to jump in and not waste time then it is to wait for the perfect moment (when the market is just right, when all your financial ducks are in a row, etc.) that will probably never come.
If you decide to invest with a lump sum, it is still beneficial to continue adding to your investments regularly. Doing so gives your portfolio more opportunities to continue to grow.
4. Measure your risk tolerance
Risk tolerance describes the level of risk an investor is willing to take for the potential of a higher return. Your risk tolerance is one of the most important factors that will affect which assets you add to your portfolio.
“Before deciding on what level of portfolio risk an investor wants to target, they first need to assess the comfort level with risk, or volatility,” says Niestradt. “Does it make them nervous to invest when they see the S&P 500 drop over 24% as it has this year?” she adds. These questions are important because certain assets tend to be more volatile than others.
One way to gauge your risk tolerance is to take a risk tolerance questionnaire. These are typically a short set of survey questions that will help you understand what your risk tolerance is based on the responses you select. Someone with a more conservative tolerance may have more of their portfolio in bonds and cash compared to stocks; someone with a more aggressive tolerance may have a higher portion of their portfolio in stocks .
As you are evaluating your risk tolerance keep in mind that it is different from risk capacity. Your risk tolerance measures your willingness to accept risk for a higher return. It is essentially an estimate of how you would react emotionally to losses and volatility. Risk capacity, on the other hand, is defined as the amount of risk you’re able to afford to take.
Risk capacity considers the factors that impact your financial ability to take risks and would include things like job status, caretaking duties, and how much time you have to reach that goal. Because these other priorities can be capital intensive, your ability to take on risk must fit within those parameters.
5. Consider what kind of investor you want to be
There is no one-size-fits-all approach to investing. The type of investor you want to be is directly tied to your risk tolerance and capacity as some strategies may require a more aggressive approach. It is also tied to your investing goals and time horizon. There are two major categories that investors fall into: short-term investing (also referred to as trading) and long-term investing.
The lure of short-term investing is the potential to replace your current income with revenue made through buying and selling your investments. The drawback is it can be both difficult and risky to see profits consistently because of how quickly the market can move and how unexpected news and announcements can impact an investment in the short term.
Additionally, short-term profits from investments are generally taxed at a higher rate than long-term investments. The IRS defines a short-term gain or loss if an asset was bought and sold in one year or less. Long-term capital gains and losses occur when the asset is held for more than one year.
Short-term investing strategies
There are two types of short-term investing strategies:
Day trading: An investment style that enters and exits an investment between market hours. Day trading is notoriously difficult, especially for new investors and over time has not yielded positive results for the majority of those who have tried.
Swing trading: Investors who take this approach are looking to buy and sell an investment after a few days or months to achieve a profit. The goal is to take advantage of significant swings around seasonal events or trading patterns.
Long-term investing strategies
Long-term investing, on the other end of the spectrum, comes with the upside of allowing more time for compounding interest and more margin for error when the market experiences volatility. One of the drawbacks of long-term investing is that it can become more difficult to catch up with your goals if you’ve delayed your investing efforts.
There are a few different long-term investment strategies to consider. You don’t have to follow just one; it’s OK to try a few different strategies.
Index investing: This method is perhaps the most popular among long-term investors, in part, because firms like Vanguard pioneered index funds in the 1970s, and it’s never really fallen out of fashion. This strategy involves investing your money in entire segments of the market, like the S&P 500. Investors with this style tend to take on less risk than those who buy individual stocks, but often see higher returns when compared to active investing strategies. Index funds tend to charge low fees as well, so you’ll get even more out of your investments.
Value investing: This strategy seeks to identify stocks that are seen as undervalued by the stock market. Warren Buffett is a big proponent of this investment philosophy.
ESG investing: ESG stands for environmental, social, and governance. The Environmental category considers how a company’s actions impact nature. The social category is a measure of how employees are treated and the diversity breakdown of those in leadership roles. The governance category tracks how a company is running and what polices its advocates for. Investors who choose this style of investing try to pick stocks or funds that rank highly for their efforts to become better corporate citizens.
Dividend investing: Dividend investors are those who buy investments for the purpose of generating a regular income stream. Dividends are regular (but not guaranteed) payments that are shared with investors, usually on a quarterly basis. Dividend investing in some cases can require significant capital to generate a modest income.
6. Build your portfolio
Once you’ve determined your goals, assessed your willingness to take risks, decided how much money you have to invest, and what type of investor you want to be, it is finally time to build out your portfolio. Building a portfolio is the process of selecting a combination of assets that are best suited to help you reach your goals.
“I recommend a goal-based investing approach because it allows you to create separate portfolio ‘buckets’ for your investing goals, each of which has a unique goal amount, time horizon, and risk tolerance associated with it,” says Falcone.
This approach to building your portfolio allows you to view your investments through the context of what you’re trying to achieve, which can be a good motivator to keep going. Your first step is to select the right type of account for the goal you’re looking to accomplish.
“Decide what type of account [you] should invest in, whether it should be a brokerage account, IRA, or Roth IRA. There are limitations on how much you can put in an IRA or Roth IRA in a given tax year, so you may need to open more than one type of account,” says Niestradt. With the right account or buckets you can then begin selecting your investments.
Below is a list of common investments to include in your portfolio:
- Stocks: This is an asset representing ownership in an individual company. If the company does well the value tends to rise, but the opposite is also true if the company falters.
- Bonds: These are loans made to a company or government with the promise of repayment plus interest payments. Bonds can provide a steady stream of income but historically do not offer returns as high as the stock market.
- Mutual funds: These assets are investments that are built to pool the collective funds of its shareholders to invest in a collection of stocks and/or bonds. Investors can own large swaths of the market with one fund versus attempting to buy them one-by-one. Mutual funds can either be actively or passively managed. Actively managed funds are run by a team of fund managers, while passively managed funds simply track an index like the S&P 500.
- ETFs: Exchange traded funds are very similar to mutual funds and offer the same benefits but typically with lower fees and more opportunities for trading.
7. Monitor and rebalance your portfolio over time
Once you’ve selected your investments, you’ll want to monitor and rebalance your portfolio a few times per year because the original investments that you selected will shift because of market fluctuations.
For example, if you decide to have 70% of your money in stocks and 30% in bonds this could become 80% stocks to just 20% if the stock market grows at a faster pace than bonds. This is known as portfolio drift and if gone unchecked may result in you taking on more risk that intended and could impact your returns.
Rebalancing is the process of reallocating those funds to match your targeted allocation. A general rule of thumb is to rebalance any time your portfolio has drifted more than 5% from its initial allocation. One advantage of robo-advisors is that this rebalancing process is done for you automatically.
You’ll also want to tread carefully when looking at your investments following a big drop in the market. This can lead investors to make rash decisions and sell their assets when the stock market has a bad week or month or year, potentially losing money on their initial investment and missing out on the opportunity to buy stocks when they are essentially at a discount.
Other key things to know about investing as a beginner
The process for investing does not need to be complex. A best practice is to limit investment decisions rooted in speculation, panic, or fear as these feelings can often lead to significant losses and higher risk. The important thing for new investors is to take things slow and strive for consistency.
“I would recommend looking for low-cost, broadly diversified ETFs as the easiest way to get started in building their portfolio,” says Niestradt. When in doubt, refer to your investing goals as your North Star to keep your emotions and your portfolio on track and remember that investing is a process that happens over time and not overnight.
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