Once a person has their debt under control, the next thing that they want to do with their money is figure out ways to maximize it, and most of the time the potential gains of the stock market look like a great place to put money.
But how? For the average person, the diversity of options for investing in stocks are overwhelming. Should I buy a mutual fund? Should I buy individual stocks? How do I even get started when I’ve figured out what I want to do? What are my investing goals? How do I even describe those goals?
I used to feel overwhelmed by such questions until I sat down and did the research, but I discovered that for the beginning investor, there’s really only a handful of simple steps that you need to follow to make smart investment choices. If you’re at the point where your debt is under control, your savings account is getting quite fat, and you’re looking for better options, here’s how you get started.
1. Figure out your goals.
When you first start thinking about this, it seems nebulous. It’s often hard to tangibly state what your goals are, especially if you’re young and single. However, you often find that they day you get married, it feels like a flood of goals hit you at once – buying a house, having a child, and so on.
Here’s what to do to get started. Take out a sheet of paper and list every financial goal you have in your life right now. What are you saving for? What would you like to be saving for? Things that might wind up on this list are retirement, your children’s education, a house down payment, complete debt freedom, a car, “walk away from your job” money, money to start a business, and so on. Some of those will be important to you, some won’t, and you may have some that aren’t even listed there.
Then, take that list and rank them by importance to you (or to you and your spouse). Don’t worry about what society says, but I will say that younger people tend to undervalue the importance of retirement. Other than that, it’s really about what’s important in your own life – not in what society thinks or what someone else sees as being important in life.
I tend to argue in favor of focusing on the top two to four goals. This way, an average person can actually reasonably accomplish those top goals in a reasonable timeframe. Figure out that time frame for those top goals. How much time is it before you reach that goal?
This doesn’t mean that your goals are set in stone. Everyone’s life changes over time and your goals may in fact change. The point is that your investment decisions are led by your goals, so before you even start investing, you should have a good grasp on what your goals are.
In my own life, I have several goals: retirement (targeted for age 60), my children’s college education (targeted for about seventeen years down the road), a new minivan (targeted for 1-2 years from now), and a new house in the countryside (targeted for about twelve years from now). Each of these have a different investment strategy, which we’ll get to in a minute.
2. Know your risk tolerance.
One major piece of the puzzle that people don’t address before they start investing is their risk tolerance. Often, they overestimate their risk tolerance, then find themselves in an investment situation that leaves them feeling very nervous about their financial position.
Spend some time thinking about this. Would you not worry if you woke up and found out that you had lost 5% of your investment if you knew in the long run it would build up in value? How about 20%? If you had $10,000 in stocks, and then over a very bearish month, $2,000 of that vanished, how would you honestly react? Would you take your money out?
The reason this is important is that it is extremely dangerous to be invested in something that exceeds your risk tolerance. If you find yourself waking up in the middle of the night nervous about where your money is, you’re likely to make an emotional move, like taking your money out when it’s about to rebound.
As a general rule of thumb, if you feel nervous about losing money at all, you probably shouldn’t be invested in stocks. Keep it in cash, in either your bank account or in certificates of deposit. Don’t feel weird – my best friend is in this camp.
On the other hand, most people have some degree of risk tolerance, though, and if you find that losing 10% or so won’t make you scared and ready to pull out, then you should dip your toes into stock investment. We’ll get to the specifics later.
3. For short term goals (less than two years or so), keep the money in cash.
That means store it in a savings account or perhaps buy a short term certificate of deposit at a bank – whichever option gets you the best interest rate and enables you to have cash in hand on the day you need it.
Why? Keeping it in cash means that it won’t be exposed to the up and down nature of the stock market. Quite often, over short term periods like two years, it’s quite possible that not only will you not turn a profit, but you might actually lose a piece of your invested money.
4. For medium term goals (two to ten years), diversify at your comfort level.
If your investment window is more than two years, the odds that you’ll come out ahead on the stock market start to get better, but it still comes with some risk. The stock market is never a guarantee, and past performance is never a guarantee of future returns.
Another factor to consider: how much is your life relying on this money? It makes sense to be more conservative with retirement money than with, say, money you’re saving for a new car. That’s because a downturn in your retirement can force you to work for years longer, while a downturn in your car savings just means you might have to continue to drive an older car for a year longer. The more vital that money is to your life plans, the more conservative you should be with it. If you’re not sure, be more conservative than less – keep plenty in the savings account and just dabble in the stocks.
5. For long term goals (ten years or more), stocks are a pretty good place to put your money.
Over the history of the stock market, almost every period longer than ten years has seen a profitable return in a broad stock investment. Even better, during many ten year stretches, the returns are quite impressive. Because of that (even though past performance isn’t a guarantee of future returns), it generally makes sense to put long term money heavily in the stock market.
6. The best place for first-time stock investors to put their money is in a low-cost index fund.
There are several reasons for this.
First, an index fund allows you to be invested in a lot of stocks at the same time. That way, you’re not affected by the ups and downs of a single company just as you are getting your toes wet in stocks.
Second, a low cost fund means that the investing house isn’t eating much of your money. Look for a fund with a cost less than 0.2%. That way, the gains go into your pocket, not in the pocket of your investing house.
Third, an index fund will introduce you to the ups and downs of stock investing. While they’re nowhere near as volatile as individual stocks, they are volatile. Many index funds can go up or down 3% on a single day. In other words, it’s a great way to find out where your risk tolerance really is without a deep risk of losing a lot of your money.
Personally, I only invest in index funds, for reasons I’ve specified in the past.
How can I get started with these? The best way is to get an account with a large investment house and transfer your money in online – the interface is often like online banking. I personally use Vanguard when I invest (though I’m currently focused on eliminating debts), as Vanguard offers a wide array of low-cost index funds.
Once you sign up with an account, the best first fund to buy is an index fund made up of a huge number of domestic stocks. If you sign up with Vanguard, take a serious look at the Vanguard Total Stock Market Index. It has a total expense ratio of 0.15% – in other words, when you invest, each year Vanguard charges only 0.15% for managing the fund, which is very cheap – and includes virtually every significantly large company on the New York Stock Exchange.
Once you’ve started, set up an automatic investment plan so that you put in a certain amount each week or each month. Not only does this make it incredibly easy to keep up with your savings, it essentially automatically follows the investment strategy known as dollar cost averaging (which reduces investment risk).
Just sit on that for a while. Watch it. See whether you’re comfortable with the ups and downs of it. Learn more over time, and then you’ll figure out on your own where to go next. Maybe you’ll find that the volatility is too much for you and you’ll move the money to savings. Maybe you’ll want to diversify and buy an international index fund. Maybe you’ll have no problem at all with the volatility and dip your toes into individual stocks. It’s up to you.
Remember, though, that today is always the best day to get started.