How Do I Start Investing?
Investing your money is the most reliable way to grow your wealth and secure your future. Warren Buffet defines investing as “…the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future”. In other words, you are giving up the chance to purchase something now in order to have increased income and security down the line. If you are a first-time investor, the sheer number of investment options can be paralyzing. Specialized language and abbreviations tossed around by investment professionals make it difficult to sort through your options and get started. Luckily, you don’t need a finance degree or large income to begin investing.
Why Should You Invest?
Investing allows for wealth creation and, depending on the investment vehicle, may include special benefits like building on pre-tax dollars, reducing your taxable income, and qualifying for employer-matching programs. Investing can help you reach financial goals, including saving for college, purchasing a home or vacation home, and of course securing your retirement. One of the most compelling reasons to invest is the financial cost of not doing so.
Money kept in a savings account will lose value over time due to interest rates well below inflation. According to Bankrate, the national average interest rate for savings accounts for the week of December 30, 2020 was a paltry 0.07%. If you parked $10,000 in a savings account with the national average interest rate and made no additional contributions, you would have $10,007 one year later and $10,283.86 after forty years. If you had put that same money in an index fund in the stock market, assuming an average return of 7%, you would have $10,700 after one year and $149.744.58 after forty years. While there is more inherent risk to the stock market, the reward is significantly higher.
Investing in the stock market lets you become a business owner without being an entrepreneur. When you purchase stock, you are purchasing fractional ownership in that company and your wealth can grow as the company does. Imagine having bought Amazon shares at $18 each during their May 15, 1997 IPO. Amazon now trades well over 3k a share. While few companies will be the next Amazon, the overall stock market return has been about 10% a year for the last century. Investing in the stock market lets your money earn money while you do other work.
What Do I Need to Consider First?
Most financial experts recommend establishing an emergency fund prior to investing. An emergency fund will ideally cover 6-9 months of expenses. If you do not have a fund yet, start with a goal of $1000 and increase your goal by 1 month’s expenses each time you reach it. You can consider beginning to invest once you have about 3 months of expenses saved, although you will want to continue increasing your emergency fund until you have at least 6 months of expenses on hand. An emergency fund needs to be easily accessible, such as in a high-interest rate online savings account. Having an emergency fund keeps a job loss, surprise home repair, or medical problem from derailing your financial life.
If you carry high interest debt, such as a personal loan or credit card balance, you should consider paying it off before investing. Even solid stock market returns of 9-10% can’t offset paying 16% interest on a credit card balance. Lower interest debt (typically with 2-6% interest), such as a mortgage, car payment, or student loans, does not need to be paid off before beginning to invest as you will likely get higher returns from your investments than you are paying in interest. If you are paying 2% interest on a mortgage and earning 10% in the stock market, you are essentially losing 8% by directing extra funds towards your mortgage instead of investing.
Once you have decided that you are ready to invest, you will need to decide how much time you have to spend on investing, what your investing style is, and how much risk tolerance you have. Active investing requires large amounts of time dedicated to research and constructing your portfolio. You need plenty of time and investment knowledge to actively craft and manage your investment portfolio. On the other hand, passive investing has historically produced strong returns and allows you to set it and forget it. Investing in investment vehicles managed by someone else, such as mutual funds, is considered passive investing. For the vast majority of new investors, passive investing will make the most sense.
You can always take more control of your portfolio in the future as you learn more about investing and have the time and knowledge to do so.You will also need to be honest with yourself about your tolerance for risk. A well-crafted portfolio will strike a balance between maximizing the returns on your money and keeping the risk level in a range you are comfortable with. Lower risk investments generally also yield lower returns. For examples, government bonds offer predictable returns with very little risk. However, the current yield for the 10-year U.S. Treasury note is around 1.15%, well below the rate of return available from other, higher-risk investments. The stock market on average returns around 10% per year, a much higher return. Owning individual stocks in a company exposes you to more risk if that company does poorly while index funds spread your investments over a large swath of the stock market, lessening the effect of individual stock fluctuations. You can still lose money if the market declines but keep in mind your investment timeline – if you leave your money in the market, it will likely regain its value and continue growing again within a period of months or years.
Where Should I Start Investing?
Once you have an emergency account funded and have eliminated high-interest debt, you are ready to start investing. You can begin with a small amount – say $100 per month – and contribute more over time as your income increases.
For many people, the best place to begin investing is in an employer-sponsored retirement plan such as a 401(k). Most employer-sponsored plans deduct your contributions from your paycheck before taxes are calculated, reducing your current tax burden. Some employers will match all or a portion of your contributions up to a certain percentage of your salary. Be sure to contribute at least enough to get the full match – otherwise you are passing up free money. If your employer does not offer a sponsored-plan or you are a non-traditional worker, consider opening a traditional IRA or Roth IRA. Self-employed individuals can look into a solo 401(k) or SEP IRA. Regardless of what plan you are using, consider increasing your contribution by 1% each year or each time you get a raise. You will hardly miss the difference and the increased contributions will make a significant difference at retirement time due to the magic of compound interest.
If you have a retirement fund that is well-funded, you may be ready to explore other investment options. Know your investment goals – money you will want to use in the next couple of years to buy a house may need to be more liquid and in less risky investments than money you plan to keep invested for 10 years or longer. If you are doing it yourself with your investments, you will want to choose an online broker. Shop around and check out broker reviews before deciding where to open an account. Many financial institutions have minimum deposit requirements. If you are beginning with a small initial investment, you will want to seek out an online brokerage with a low (or no) minimum deposit. Look into fees like low balance fees or commissions on trades. If you are trading frequently with relatively low dollar amounts, commission fees can become cost prohibitive. Luckily, it is possible to find zero-commission brokers today.
Certain investments have extra fees. Mutual funds are professionally managed pools of funds that invest in a focused manner, for example in small-cap stocks. One fee charged by mutual funds is the management expense ratio each year – the higher the management expense ratio, the more it will lower the fund’s overall returns.
You can protect and grow your portfolio using two tools: diversification and dollar cost averaging. Diversification is investing a range of assets in order to reduce the risk of one investment’s poor performance hurting your overall investment return. Mutual funds or exchange-traded funds are helpful for diversification, particularly for a beginning investor whose total investments are too low to spread across sufficient assets. Both mutual funds and exchange-traded funds typically invest in a large number of stocks and other investments within the fund.
Dollar-cost averaging is an investment strategy in which an investor makes periodic purchases of a target asset, dividing the total amount to be invested over a long period to reduce the impact of volatility on the overall purchase. When you invest a set percentage of your salary in predetermined investments in your 401(k) each month, you are taking advantage of dollar cost averaging. Dollar-cost averaging is a simple and effective way for new investors to invest in mutual or index funds.
What if I Need More Help?
Whether you are just beginning to invest or are ready to branch out into other investments, you do not have to go it alone. Robo-advisors are a low-cost option for investors who just need a little help to craft and maintain their portfolio. You typically answer a short questionnaire about your goals and risk-tolerance and, using an algorithm, the robo-advisor recommends a portfolio and asset allocation that’s appropriate for your age and investment time horizon. Robo-advisors will rebalance your portfolio over time and invest your monthly contributions accordingly. However, robo-advisors are limited in scope. A robo-advisor cannot help with issues like forgetting to contribute, not increasing your contributions over time, or avoiding financially ruinous investment decisions like pulling your money out of the market after a crash.
If you want a more personalized, hands on approach, seek out a financial advisor. A financial advisor can provide the experience, broad knowledge, and personalization that an algorithm just can not match. If you have a steady, reliable income and have the ability to save or invest 20% or more of your income, it may be time to consider a financial advisor. The right financial advisor for you will depend on the value of your assets and what you are willing to pay in fees. Some financial advisors specialize in servicing affluent professionals while others prefer to work with middle-class families. Shop around and talk to different financial advisors to find the right person for you. The right financial advisor can be a long-term partner to grow your wealth and achieve your financial goals.
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About the Author
Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.
Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.