One of the most popular financial goals people set is to achieve millionaire status. It’s a great goal, and something most people can achieve with enough discipline and time. We have written an entire series on reaching this goal, and this article covers the step of how to invest. By now, you are earning money, spending less than you earn, and saving the difference. But simply saving money will not make you a millionaire – you need to make your money work for you. That means you need to invest your money.
How to Start Investing
The first, and most important step is to create a basic emergency fund before you start investing. Why? Because the last thing you want to do is to have to cash in your investments to pay for an unexpected expenses that may pop up. Even though your money won’t be earning much in interest, you will have those cash reserves available at a moments notice. Once you establish your emergency fund, you should begin investing. There are literally thousands of ways to invest, so this is meant to cover only basic investing principles.
Pay Yourself First
Add investing to your budget, make it automatic, and invest before you ever see the money. This way you don’t ever have to worry about “finding” the time and money to invest. Your system will already be in place and you won’t need to worry about it except when you need to rebalance your allocations once or twice a year, or if you decide to invest more money.
Make Your Investments Automatic
The same principle to automatic saving applies to automatic investing. Set it up so you don’t even think about it. That way, you know it gets done on time, every time. Many people choose to invest through payroll deductions in employer sponsored retirement plans such as a 401(k), the Thrift Savings Plan (TSP), pension plans, and other defined benefits plans. You can also set up automatic deposits to invest in IRAs, mutual funds, single stocks, and many other investments. Automatic investing is a painless way to ensure you invest.
Wait, what about timing the market? I’ve read many arguments about timing the market, and for the average investor, it’s basically impossible to know how and when to invest to beat the market. The average investor (which most of us are) is better off using dollar cost averaging to buy stocks on a recurring schedule. When stocks are priced lower, you buy more shares. When stocks are priced higher, you buy fewer shares. The idea is that over time, your total number of stocks increases and you don’t have to worry about beating the market.
Invest in Tax Advantaged Retirement Funds
The most common retirement funds most people are aware of are IRAs and 401(k) plans. But there are many other tax advantaged retirement accounts such as the TSP, 403(b), 457, and defined benefit plans (such as a pension). There are also multiple variations of IRAs including Roth and Traditional IRAs, retirement plans for small businesses, and more. The good news is that you can have more than one retirement account.
These retirement plans have additional benefits over taxable investments – the investments can grow without taxes dragging down their value every year. For tax deferred plans such as a Traditional IRA or a 401(k), you invest money before taxes and pay taxes when you withdraw the money in retirement. Other tax advantaged accounts may be the opposite – you pay taxes now, only to enjoy tax free growth and withdrawals in retirement.
Find those accounts which you are eligible for, and take advantage of them – especially if you can receive an employer match on your contributions. Contact your HR department to open an employer sponsored plan like a 401k. If you want to open an IRA, then you can do that with a variety of brokerage firms and other investment houses and learn more about the IRA contribution limits you will have. Here is a resource for some of the best Roth IRA providers.
Don’t Withdraw Your Retirement Investments
The best thing you can do with the money in your retirement accounts is leave it in a retirement account. This means not cashing in a 401(k) when you change jobs, not taking loans from your 401(k), and not cashing in IRAs or other accounts before retirement age. The early withdrawal penalties for retirement accounts are steep – you are required to pay taxes on your withdrawals, in addition to an immediate 10% penalty. This doesn’t account for state taxes or penalties. Depending on which tax bracket you are in, the taxes and penalties could amount to almost half of your withdrawal.
You should also take care to account for all your retirement plans when you change companies. There are several options for your 401(k) when you change jobs and it pays to research which option is best for you. In most cases, people will be best off when they roll their old 401k into their new employer’s plan, or into a Rollover IRA.
Pay Attention to Asset Allocation and Diversification
Asset allocation is how you divide your money among your investments. There are many theories to the best asset allocation, but as everyone’s situation is different, there is no way to cover each asset allocation possibility in this article. Try to find a mix appropriate for your time horizon, risk tolerance, and your financial goals. The SEC has an asset allocation primer, or you can start by reading an investment book from your library. If in doubt, start with a life-cycle fund which uses professionally determined investment mixes that are tailored to different time horizons. These are a great place to start until you know more about your investment needs and risk tolerance.
Diversification is also important. If we were certain about a particular stock’s future performance, we could place all our money in it, wait until it rises to the right price, then cash it in and live like kings for the rest of our lives. Unfortunately we don’t know what will happen. That is why it’s best not to put all our eggs in one basket, especially with company stock.
A better solution is to diversify our holdings by purchasing investments in different asset classes and sectors – stocks, bonds, index funds, mutual funds, real estate, precious metals, large size funds, mid size funds, small size funds, growth funds, value funds, international funds, etc. It may seem daunting at first, and for many people it can be. Again, a good place to start is with a life-cycle fund which is automatically diversified for your time horizon. That doesn’t mean you have to leave it there, you can always learn more about other types of investments as you go. The key is to start investing as soon as you can.
Keep it Simple
You don’t need to worry about investing in individual stocks, options trading, foreign exchange, binary options trading, commodities, or other exotic investments. Most people are better ff just matching the stock market, investing as much as they can in tax advantaged funds, and letting the power of compound interest work in their favor. Over time, matching the market will usually be enough to grow your wealth. If you feel the need to have some more exotic or risky investments, then try to limit it to around 10% of your portfolio. That way you don’t run the risk of losing too much of your portfolio at any given time.
Start Investing ASAP and Don’t Stop
Compound interest is one of the most powerful forces in the universe. The longer you let your money grow, the greater the impact compound interest will have. This is illustrated nicely in The First Million Is The Hardest. By looking at the chart on this site, you can see that by starting at age 25 and investing $15k per year at 10%, it will take 20 years to reach the $1 million mark. But by continually investing afterward, it only takes 6 more years to reach $2 million, 4 more years to reach $3 million, 3 more years to reach $4 million, 2 more years each to reach $5-7 million, and one more year to reach $8 million. Compound interest truly is amazing! But the key ingredient to compound interest is time. So get started!