Investing is a powerful tool that allows you to put your money to work to help you reach future financial goals. But if you’re new to investing, you may be asking yourself some basic questions. What type of investments are available to you? What accounts should you use? And what strategies should you pursue?
Here’s a guide to help you get started.
Investing as Early as Possible
The sooner you can start investing, the quicker you can start taking advantage of compounding interest, which can accelerate your ability to save. Compound interest is the return you earn on your returns, which can help your earnings grow exponentially over time.
For example, say you start with an initial investment of $1,000 and contribute an additional $100 each month. At a 6% return compounded annually you would have $47,349.84 after 20 years. Your total contributions are equal to $25,000 while the remaining $22,349.84 represents your compounded returns over the period.
Over the course of many years, the stock volatility will inevitably emerge, with periods of rising and falling values. Investing early and staying invested for the long run gives you time to ride out periods when the market is down.
How Much You Should Invest
How much you decide to invest will depend largely on your financial goals. As a general rule of thumb, experts suggest eventually investing 10% to 15% of your income each year.
If your employer offers a retirement account, such as a 401(k), with matching funds, save at least enough to qualify for the full match. After all, matching funds are essentially free money. Additionally, retirement accounts offer special tax advantages, so if you can, aim to max out your contributions.
When planning for other investment goals consider how much you’ll need and your time horizon, the amount of time you have before you want to accomplish your goal. Work backwards from there figuring out how much you need to save each month in order to reach that goal.
Types of Investment Accounts
Beginner investors should become familiar with retirement accounts and taxable brokerage accounts. Retirement accounts, such as 401(k)s and traditional and Roth IRAs offer tax-advantaged savings to help you boost the amount you can save. However, there are restrictions about how and when you can withdraw your money.
If you’re saving for non-retirement goals, you may consider a taxable brokerage account. You can make withdrawals from these accounts at any time. However, these withdrawals may be subject to capital gains taxes–levies you pay on profits from investments.
When you open a retirement account or taxable brokerage account, you will decide what types of assets you’ll invest in.
Stocks are ownership shares in a single company that are bought and sold on publicly traded stock exchanges. Stock prices can grow quickly, making them an important tool for building wealth. But it’s also important to understand that they are inherently risky: Share prices may fall, potentially causing you to lose your investment.
At the most basic level, bonds are loans that you make to a company or government entity. They agree to pay you back after a certain period of time, and in the meantime they pay your interest. Generally speaking, bonds are less risky than stock, because you know when you will regain your investment. Though there is some risk you could lose your money if the bond issuer defaults.
An exchange-traded fund (ETF) is an investment fund that pools different assets, such as stocks and bonds, dividing ownership into shares you can buy and sell just like a stock. ETFs are relatively low cost and help give investors diversified exposure to the market.
Once you’ve opened an investment account and you begin to build your portfolio, asset allocation is one of the most important strategies to consider to help you balance risk and return. A typical portfolio might divide its assets among three main asset classes: stocks, bonds and cash. Each asset class has its own risk and return profile, behaving a little bit differently under different market circumstances.
For example, stocks tend to offer the highest gains, but they are also the most volatile, presenting the most potential for losses. Bonds are generally considered to be less risky than stocks, while cash is the most stable. Cash investments in your savings account are insured by the federal government.
The proportion of each asset class you hold will depend on your goals, time horizon and risk tolerance. Your goal tells you how much you need to save. Your time horizon is the length of time you have before reaching your goals. And your risk tolerance is how willing you are to accept losses in the short-term in exchange for potentially greater long-term gains.
Your asset allocation can shift over time. For example, someone in their 30s saving for retirement has a long time horizon and may have a higher risk tolerance. As a result their portfolio may contain mostly stocks. As that person ages and nears retirement, their portfolio may shift to contain more bonds and cash, which are less risk and less likely to lose value in the short-term.
Another way to manage risk in your portfolio is through diversification, building a portfolio with a broad mix of investments across assets, helping you avoid putting all your eggs in one basket.
Here’s how it works: Imagine you had a portfolio consisting of stock from one company. If that stock does poorly your entire portfolio suffers.
Now imagine a portfolio consisting of many stocks, from companies of all sizes, sectors and parts of the globe. Not only that, it also holds other investments, including bonds. Now, if one stock suffers, it will have a much smaller effect on your overall portfolio, spreading out the risk of holding any one investment.
Your portfolio can change over time, shifting your assets allocation and diversification. For example, if there is a bull market and stocks outperform, you may discover that you now hold a greater portion of your portfolio in stocks than you had intended.
At this point, you may need to rebalance your portfolio to bring it back in line with your goals, time horizon and risk tolerance. In the example above, you may decide to sell some stock or devote new investment funds to buying more bonds.
Buy and Hold Strategy for Investing
Market fluctuations are a natural part of the market cycle. However, investors may get nervous and be tempted to sell when prices drop. However, when they do, investors lock in their losses and often miss out on subsequent market rebounds.
Investors practicing buy-and-hold strategies tend to buy investments and hang on to them over the long term, regardless of short-term movements in the market. Doing so can help curb the tendency to panic sell, and it can also help minimize fees associated with trading, which can boost overall portfolio returns.
When it comes to these taxes, whether a holding is a long-term investment vs. short-term one can make a big difference in terms of how much you pay in taxes.
If you profit from an investment after owning it for at least a year, it’s a long-term capital gain. Less than that is short-term. Capital gains tax rates can change, but generally, longer-term investments are taxed at a lower rate than short-term ones.
Dollar-cost averaging is a strategy that helps individuals invest on a regular basis by making fixed investments on a regular schedule regardless of price.
For example, say an investor wants to invest $1,000 every quarter in an ETF that tracks the S&P 500. Each quarter, the price of that fund will vary—Sometimes it will be up, sometimes it will be down. The amount of money the individual invests remains the same, so they are buying fewer shares when prices are high, and more shares when prices are low.
This strategy can help individuals access a lower average share price, and it can also help them avoid emotional investing.
Investing is an ongoing and dynamic process. Your life, goals and financial needs will all change as your circumstances do. For example, may you get a raise at work, get married and have a child, or you decide to retire early. Factors like these will change how much money you need to save and how you invest. Monitor your portfolio and make adjustments as needed.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.