You’ve probably been in one of these conversations, before. Someone who’s older, maybe a teacher or a family member, encourages you to start investing as soon as possible. It’s well-meaning advice.
On an academic level, you know that the younger you get started, the more you can allow the magic of compounding investment returns to work in your favor. You’re also committed to prioritizing your own financial health, and you feel inspired to work towards your own personal financial freedom.
Every new investor has to start somewhere, and there’s no better time than this year.
So, you’ve got the right idea, but you don’t have a playbook. No one taught you how to invest. You’ve heard of Roth IRAs and mutual funds, but how do you know that you’re doing the right thing?
Further, there are a lot of people with divergent opinions on the best way to invest. It’s hard to know where to go and who to listen to.
Much of learning to invest means learning to navigate the options and the conflicting advice and then distilling that down into a portfolio that makes the most sense for you and your goals.
Here are some suggestions for how to start investing in five easy steps.
1. Understanding the Options
While the universe of investment options sometimes feels limitless, it’s not. With knowledge of the core building blocks of investing, you’ll be better able to navigate the available options with ease.
Investors have a variety of options available to them, including: stocks, bonds, cash or money market funds, real estate, private equity, investment partnerships, and natural resources, like gold. These are assets, essentially, things that have economic value and can store wealth. Beginner investors may focus largely on stocks and maybe bonds.
A stock represents a share of ownership in a company. Shareholders can make money in two ways: through the value of shares appreciating, and through dividend payouts. Although this is an oversimplification, the success of a stock will generally be correlated to the success of the underlying business. This is highly unpredictable, which leads to the volatile nature of stock prices overall.
Bonds, on the other hand, are investments in the debt of a company or government. In this case, the bondholder is the lender, collecting a rate of interest on that debt. The terms of the contract are agreed upon at the outset. Therefore, they are typically less volatile as stocks, although they can lose value.
An investment portfolio generally includes a variety of assets, including both stocks and bonds, for diversification. The purpose of diversification is to minimize risk, especially over the long-term.
Exchange-Traded Funds (ETFs)
What about mutual funds and exchange-traded funds (ETFs)? Funds are pools of investments. It may be helpful to think of a fund as a basket that holds a bunch of investments, such as stocks, bonds, or real estate holdings. For example, an S&P 500 index mutual fund or ETF holds the 500 leading stocks in the US. Therefore, an investment in this fund is really an investment in the US stock market.
Funds are a popular and easy option for investors looking to get broad exposure to whichever market it is that you’d like to invest within. Depending on the fund, this could also be an affordable way to invest. It is a common misconception that you need to invest in individual stocks to be a good stock market investor.
2. Creating a Goals-Based Investment Plan
The decision on which asset class to be invested in, and in what proportions, is an important one. It is called asset allocation. Although it is tempting to dive right into trying to pick out the “best” stocks, it may be appropriate to first take a step back and ask whether stocks are appropriate given your goals.
The next logical question is this: How does one determine asset allocation? Start by determining what the goal or intended use of the money is. To determine your personal investment mix, conduct an examination of your financial goals, risk tolerance, and investment time horizon.
At its core, the asset allocation decision is one regarding your comfort level with the tradeoff between risk versus reward. In investing, risk and reward are intrinsically connected. In order to have the potential for more reward, you have to take more risk. Be leery of investment options that tout “all reward and no risk.” Unfortunately, such an investment may be too good to be true because risk is an inherent part of investing.
A couple of questions worth asking yourself are: What is my goal with this money? When do I need the money? Last, what kind of risk am I willing to take with this money? Then, take these answers and match them up with one or a handful of the available investment options.
It’s may be easier to wrap your noodle around when we consider two different examples of two investors:
Our first investor is saving up for a down payment on a home. They plan to use that money within one year. For them, the risk of losing any money in a potentially volatile investment outweighs the possibility of earning investment returns. Instead of investing, they decide to keep this money in cash, in a savings account.
Next, our second investor. They’re new to investing, with plans to begin investing in a retirement account. They want to focus on growth over the long-term. Because they have a long time horizon for their investments, they have the time to ride through any short-term volatility, so they are more comfortable with the risks of the stock market. They may build out a portfolio that is primarily invested in the stock market, and for diversification purposes, they may decide to include some exposure to bonds as well.
As you can probably tell, there’s no one “right” asset allocation for any one individual, nor is there a universal formula for determining asset allocation. Investors who are learning how to start investing may want to take some time thinking about what allocation makes the most sense for them.
3. Opening an Account
Here’s another common misconception about investing. A Roth IRA and a 401(k) are not investments. These are accounts, just as a brokerage account, that hold investments. Retirement accounts, such as a Roth IRA or 401k, simply have special tax treatment.
Which account you decide on depends on a few factors. First, what are you investing for?
If you are investing for the long-term, then a retirement account may be most appropriate. Retirement accounts can either be opened individually or through your employer. If your employer offers a plan, this could be a good place to start. (And yes, picking funds or a strategy within a 401(k) or 403(b) counts as investing.)
If you are self-employed or do not have a plan through work, you may want to open an individual retirement account. Some options include a traditional or Roth IRA, Solo or Individual 401(k), and SEP IRA.
Because these accounts come with some tax benefits, they also have their own special rules, like when you can withdraw money and limits on how much money can be contributed each year. To determine which type of account that makes the most sense for your personal situation, you may want to speak with a tax professional.
If you would prefer to invest with more flexibility, you may want to open a brokerage or other general-purpose investment account. Though those accounts do not have the tax benefits of a retirement account, they also don’t have restrictions on when the money can be accessed and no penalties for withdrawals before retirement age.
No matter which account type you choose, remember: this is just an account. After opening the account, it will be funded with cash, likely by hooking up an existing checking or savings account. Once the account is funded with cash, that money can be used to buy investments.
If you are opening your own investing account (as opposed to using your workplace retirement plan), you will have to choose a brokerage account or online investing platform. When choosing your account, it helps to pay attention to the fees charged by the platform. Investing costs can dig into your potential returns. SoFi knows that new investors don’t want to pay a bunch in fees just to get in the game. There are no commissions on the SoFi Invest® platform.
4. Deciding How Much to Invest
This may sound oversimplified, but start with whatever you’re comfortable with, knowing that this money will be subjected to some amount of risk. Generally, this should be money that you won’t need in the near-term. That said, one of the greatest features of investing in the modern era is that you can get started with any amount.
There are a few ways to look at this. The first is to consider where you’re at in your own financial journey. It is often recommended that people first work on saving up an emergency fund and paying off credit cards and high-interest debt. And if COVID-19 has taught us anything, it’s that having a firm financial foundation is incredibly important. If you have yet to build up a sufficient safety net or maintain expensive debt on your personal balance sheet, this could be a good place to focus.
It’s easy to get hung up on the “invest versus pay off debt” decision. Here’s a simple place to start: compare interest rates. On debt, it’s the interest rate that you’re paying. On investing, it’s on the interest that you could potentially earn. So for example, if you’re deciding between aggressively paying off a private student loan with a 12% rate of interest or investing at what you expect could be a 7% rate of return, perhaps this makes your decision for you.
That said, it’s not as if you have to be completely debt-free in order to start building wealth. Instead, take some personal inventory. If you feel like you’re missing out on achieving investment and compound returns, then perhaps you’ll want to make investing a priority. If you feel like you’re being weighed down by debt, then maybe you’ll want to give expedited debt pay-off your energy.
If you have arrived at a place of debt repayment that feels manageable, you may want to consider investing as a piece of your overall budget. (Ever hear someone say, “pay yourself first?” This is what they are referring to.) One popular budget, called the 50/30/20 budget, recommends allocating 20% of income towards saving and investing. If you’d like to reach a place of financial freedom sooner than this, then you may want to consider saving more, as a percentage of your overall income.
5. Selecting Investments
Now the fun part of learning how to invest; choosing the actual investments in a portfolio.
Hopefully, you’ve given some thought to which asset class you’d like to invest in. For example, stocks. Then, there are lots of different options to invest within the stock market: You could pick out individual stocks, or stock-based funds, whether mutual funds or ETFs.
With funds, it is possible to invest in categories of the stock market that are very broad, such as the entire global or US stock market, or that are narrower, such as technology stocks. Building simple portfolios of just two or three broad, diversified funds has been a popular method for investors. This is called “passive” or “set it and forget it” investing.
It is also possible to build a diversified portfolio with narrower funds or even individual stocks, but this may require substantial research and curation.
When purchasing funds, investigate whether they are actively managed or indexed. An index fund, as it sounds, mimics some index that measures the performance of the market. For example, a “total US stock market index fund” may be built against the Russell 3000 index, which measures the performance of all stocks in the US. The point is to return whatever the returns of the broader US stock market. Because there is no active manager, the management fee embedded within index funds tends to be lower than the fees on actively managed funds.
Investors opting to buy individual stocks, may want to consider businesses that they believe will produce some sort of future stream of income, either by an increase in the share value or through the dividend payment. Consider reviewing the following: a stock’s price-to-earnings ratio, industry competition, strength of balance sheet, the company research and development, and product pipeline. These factors can help investors determine the value of an investment.
New investors may want to consider buying stocks or ETFs on a platform that offers zero-cost trading, like active investing with SoFi Invest. Fees can eat away at the potential performance of an investment and act as a barrier to entry. Luckily, there are lots of low-cost options for new investors just getting started.
The last option is to use an automated investing service that buys funds for you. This may be an especially compelling option for new investors who want some help building out their first portfolio in a thoughtful, diversified, and goals-driven way. SoFi Invest also offers an automated investing platform.
Be proud of yourself for starting the journey. Invest in a strategy that makes sense for you, starting with any dollar amount.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.