You went out for lunch today at Chipotle. You spent about $10 for a burrito, chips, and a drink. Ten dollars doesn’t seem like much, but imagine if you could turn that $10 into more than $100 in 25 years just by letting it grow. With investing, you can.
If you’re willing to cut back in small ways today so you can invest money instead of spending it, the future payoff will be significant. Although investing might seem like a completely foreign concept to you, it’s fairly easy to grasp with just a little bit of time and effort. Read on for everything you need to know about how to start investing.
Grow Your Money by Investing
You might be wondering what the term “investing” actually means. In the most basic sense, investing involves purchasing an asset with the goal of generating steady income or a profit when you sell that asset. Investments can be tangible items, like real estate or gold coins, or they can be intangible items, like stocks and bonds.
One common misconception about investing is that you have to be wealthy to get started. But by no means is that true. Countless people who would not be considered “wealthy” invest. In fact, over half of Americans invest in the stock market, and these investors come from various age groups and income brackets.
One of the easiest ways to start investing is by opening a money market account or a certificate of deposit (CD) for your emergency fund savings, both of which give you the benefit of compound returns. Compound returns means you earn interest on top of your interest. Albert Einstein called it the eighth wonder of the world.
Confused about how compounding works? Take this example: You invest $1,000 that earns 2.5% interest a year and compounds monthly. That 2.5% gets earned on the principal of $1,000 plus any interest accrued. Assuming you don’t spend any of your returns, this means that after the first year, you’ll earn 2.5% on the $1,025, and so on.
Below, you can see just how much money compounding earns you over time:
Ready to get started? Below, you’ll find a simple five-step guide for how to start investing.
Step 1: Save Some Money
The first step in investing is saving money. After all, you can’t invest if you don’t have any money to put to work! Your income is the gas in your investing engine. Get started by spending less than you make each month and putting that remainder into a bank savings account for emergency savings.
If you’re on a tight budget right now, don’t worry. Even the smallest savings can make a difference. For example, if you cut out a $2.75 latte each morning, you can save $1,000 in one year. If you invest that $1,000 in a CD with 3% interest, you’ll have $2,116 in 25 years.
One great way to begin saving money is by tracking your expenses. After all, there might be areas where you can cut back without even realizing it.
We love these expense tracking apps:
If you’re not super tech savvy, you can keep track of your spending using a pen and paper or Excel. Consider using this weekly budget worksheet.
Step 2: Know Your Risk Tolerance
With risk comes reward. That’s why every type of investment has some element of risk to it. Risk depends on the potential returns — the greater the risk, the greater the potential returns; the lower the risk, the lower the potential returns. That’s why there’s no such thing as a low-risk, high-return investment.
For perspective, stocks, stock mutual funds, and stock ETFs have the highest average long-term returns, but there can be wild swings in value over the short-term. Bonds, on the other hand, are more stable, but they won’t yield as high of returns. Money market accounts and bank savings accounts have the lowest risk.
One way to think about your risk tolerance is to put a dollar amount to a potential scenario. Instead of thinking, “Am I OK with a 20% risk of loss,” ask yourself, “Am I OK if my $100 investment turns into $80?”
To figure out your risk tolerance, try taking this Morningstar course.
Step 3: Identify Your Financial Goals
The third step for beginner investors is to figure out your financial goals. What are you saving money for? A down payment on a home? Retirement? Your child’s college education? This determines the type of account to set up. Once you’ve identified your goal and the timeline for that goal (i.e. short-term versus long-term), you can open the right account for your investing needs.
If you need the money in less than five years, you’ll likely want a low-risk option, since you’ll need the money fairly soon. If you don’t need the money for five to 10 years, you could choose an investment with moderate risk. And if you won’t need the money for 10 years or longer, you can choose a higher-risk option, as the longer your investment horizon is, the less vulnerable you will be to short-term market fluctuations.
Below are some examples of common investment options depending on your timeline.
Anytime: Retirement Accounts — 401(k)s and Roth IRAs
Regardless of your financial situation, you should always contribute to a retirement account. If you’re traditionally employed, you should put as much in your 401(k) as your employer will match each month — even if you’re paying off debt like student loans. After all, that 2% or 3% match is free money that you’d otherwise be leaving on the table. Depending on your employer’s plan, you might be able to make pre-tax or Roth IRA contributions.
Because 401(k) retirement accounts can’t be accessed until you’re 59 1/2, they’re considered a long-term investment option. This means they have ample time to compound, making your potential future returns even greater. In 2019, you can contribute up to $19,000 per year in a 401(k).
If you are self-employed or your employer doesn’t offer a retirement plan, you can open your own retirement account. We recommend a Roth IRA. (This option is also great if you maxed out your employer 401(k) and would like to save more money for retirement.) With a Roth IRA, all contributions are made post-tax, and they will grow tax-free as long as they’ve been in the account for at least five years and you don’t withdraw them before age 59 1/2.
Roth IRAs are a worthwhile way to invest your money, and here’s an example that shows why: If you put $100 in a Roth IRA at age 35 and it grew 10% each year, by age 60, you could take out the entire $1,080 without any income tax.
Although there is a penalty to withdraw your 401(k) funds before 59 1/2, there is no penalty with a Roth IRA. Roth contributions (but not growth) can be withdrawn at any time without tax or penalties. In 2019, you can contribute up to $6,000 in a Roth IRA.
More Than 5 Years: Taxable Brokerage Accounts or Mutual Fund Accounts
If you’re looking for a long-term investment option for an intermediate term goal that’s not retirement, you could consider starting a side hustle as an investment, or opening taxable brokerage accounts or mutual fund accounts. Although these accounts don’t have tax protection, they also don’t have penalties for withdrawing your money.
When it comes to these accounts, do your due diligence. Don’t overpay! The last thing you want is for your small investment to be taken over by exorbitant fees. Make sure you choose a financial services firm that has no fees or low-cost fees, and allows you to get started with a small amount of money. Check for firms that offer low-fee index mutual funds and exchange-traded funds. (This tool allows you to check mutual fund fees.)
Less Than 5 Years: Bank Savings or Money Market Accounts
Maybe you’re looking to start an emergency fund, finance the down payment of a home, or create a vacation fund. Because you know exactly when you’ll need the money by, you’ll want to pursue a short-term investment option.
Consider short-term investments like a high-yield bank savings account, a certificate of deposit (CD), a Treasury Bill or a money market account. These are all safe, low-risk options that will earn steady returns.
The chart above explores types of accounts you can explore for your goals, depending on when you need the money and your risk tolerance.
Step 4: Figure Out Your Investing Style
Now that you’ve saved money, determined your goals, and assessed your risk tolerance, it’s time to figure out what kind of investor you are. Ask yourself the following questions to get started.
Am I Hands-On or Hands-Off?
If you’re hands-off, this means you like to delegate to investment professionals who have a pre-set, diversified strategy for investing your money. You’re not the type of person who thrives off of watching the stock market on a daily basis. You want more of a “set it and forget it” strategy.
If you think this applies to you, look for a target date fund that is close to your target savings date. You can also consider using a robo-advisor, which offers automated investment management advice based on computer algorithms and can be less expensive than a human advisor.
If you’re hands-on, that means you like the idea of following the stock market each day, checking up on how your investments are doing and rebalancing them when needed. This also means you have the time and knowledge to manage your investments strategically.
If you’re hands-on, you can choose investments by yourself without the help of a professional. Create your own investment portfolio that fits your needs and preferences.
Am I a Passive or Active Investor?
Passive investors are those who are happy to match market performance. Their primary goal is to keep fees low. Active investors, on the other hand, want to try to beat the market.
If you’re more passive, you might prefer a passively managed index fund. If you’re more active, you might prefer an actively managed mutual fund. Just keep in mind that more actively managed funds will likely have more fees, which can add up over a lifetime. One or two percent might not seem like a lot, but here’s a calculation for perspective: A 1% management fee for a mutual fund, when compared with a 0.1% management fee for an index fund, could cost you nearly 30% of your retirement savings over a 30-year period.
Feel like you’re a mix between passive and active? No problem. Your best bet would be to make index funds the bulk of your portfolio with a small allocation for actively managed funds.
Step 5: Put Your Investing Strategy on Auto-Pilot
If you’re learning how to start investing, the final step is to put your entire strategy on auto-pilot. Let’s be realistic, if you had to manually write a check or make a deposit each month, you’re less likely to do it. Put technology to work so you don’t have to think about it.
If you have a 401(k) retirement account, automation is easy, as your contributions are likely taken from your paycheck and invested in the mutual fund you’ve chosen each month. If you have a Roth IRA, you can set it up so that an automatic deposit is made from your bank savings account to your retirement account each month. If you have mutual funds or brokerage accounts, you can also set up automatic payments to go into these accounts.
Grow Your Investing Savvy
Now that you’ve learned about how to start investing, you might want more detail on the types of investments out there. Consider reading about fixed-income investments and how to invest in stocks to grow your knowledge of investing.
Congratulations on taking the first step! You’ll be well on your way to making decent returns in no time.