Set Goals and Start Investing
The most important first step of any investment plan is goal-setting. Think of investing as a road trip: Your goal is your final destination, while your investment plan is the route you’ll take to get there. Many people start investing as a way to save for retirement. But you can also invest to save for other big goals like your child’s college education, future medical expenses, or the down payment on your dream home.
When you’re just getting started, simple is better. In fact, you’ll hear plenty of finance experts argue that the best investment strategy is a boring one.
Let’s talk about some of the tools and assets that might be a part of your investment strategy.
Stocks
A stock is a piece of ownership (“equity”) in a publicly traded corporation. Companies sell stock as a way of raising capital for operating and capital expenses. Those who buy stock in a company can make money in two primary ways:
- Dividends: When the corporation periodically passes on some of its profit to the shareholders.
- Capital appreciation: When the value of your stock grows over time, and you are able to sell it for more than you bought it for.
Bonds
A bond is a type of debt security that allows companies and government agencies to borrow money from investors by selling them bonds. Bonds usually come with a predetermined interest rate, which the issuer pays over the life of the bond (often twice per year). Then, when the bond reaches maturity, the issuer pays back the principal amount to the bondholders.
Investors can make money investing in bonds both through regular interest payments and by selling a bond for more than they paid for it.
Funds
Some of the most popular investments on the market are actually funds, which are a combination of many stocks or bonds (or both). Here are the primary types of funds:
- Index funds: A pool of investments that passively tracks a particular market index, such as the S&P 500 or the total stock market.
- Mutual funds: An actively managed investment pool where a fund manager hand-picks holdings, often in the hopes of beating the overall market performance.
- Exchange-traded funds: These are similar to an index fund or mutual fund, but ETFs can be traded throughout the day, while index and mutual funds can’t.
Manage Your Risk Levels
Anytime you invest, you take on a certain level of risk. As you begin investing, it’s important that you understand the risk that each asset brings with it and how you can set up your portfolio in a way that reduces your risk exposure.
The first thing to consider when choosing your asset allocation is your risk tolerance, or your comfort level and willingness to lose money in exchange for a greater possible reward. In most cases, there’s a correlation between the risk and return an investment brings. The higher the risk, the greater the return often is. Similarly, lower-risk investments generally have a smaller potential return.
Everyone has a different risk tolerance, and it’s important that you build an investment portfolio you’re comfortable with. Keep this in mind as you choose your assets. And if you’re using a robo-advisor, it’ll likely ask you about your risk tolerance and make investment decisions that reflect it.
Let’s talk about a few steps that everyone can take to help mitigate risk in their investment portfolio.
Diversification
Diversification is when you spread your money across different investments. The more diversified your portfolio, the less impact the performance of a single investment has overall.
The first way you can diversify is across asset classes. For example, you might invest in stocks, bonds, real estate, and cash equivalents to ensure that your money isn’t all in a single class. That way, if the stock market is doing well but the bond market is doing poorly, your overall portfolio isn’t negatively affected.
The other way you can diversify is within asset classes. For example, instead of buying stock in just one company, you would invest in many different companies—or even a total stock market index fund—to help reduce risk.
Dollar-Cost Averaging
Dollar-cost averaging refers to making recurring contributions to your investments no matter what’s happening in the market. Many people use dollar-cost averaging without realizing it by making monthly contributions to a 401(k) plan at work.
Core-Satellite Strategy
Core-satellite investing is a strategy designed to reduce costs and risk while also attempting to outperform the market. This strategy involves having a “core” of your portfolio, which would typically be passively managed index funds. The rest of your money goes into actively managed investments, which make up the satellites. The core of your portfolio helps to reduce volatility, while the satellites are intended to achieve higher returns.
Cash on Hand
No matter what your investment strategy, experts generally recommend keeping at least some of your money in cash or cash equivalents. Cash isn’t susceptible to downturns in the market. And if you’re saving for a goal that’s just a few years away, you won’t have to worry about losing your investment just before you need it.
Take Advantage of Compounding
There’s a common investing phrase that says, “time in the market beats timing the market.” In other words, you’re better off consistently putting money in the market and letting it grow versus trying to time the market for bigger returns. This concept fits hand-in-hand with the dollar-cost averaging strategy above, where you invest consistently regardless of what’s happening with the market.
The reason that time in the market makes such a big difference is that your returns compound, meaning they are attended to your principal investment and also earn money.
Let’s say you invested $200 per month from the ages of 25 to 35. After the age of 35, you never contribute another dollar, but you let your money continue to grow. We'll assume a return of 10%, which is the average for the stock market, according to the Securities and Exchange Commission (SEC). Your investment of $24,000 will turn into more than $676,000 by the time you reach age 65.
But what if you invested the same amount of money later in life? If you contribute the same $200 per month over 10 years but don’t start until age 55, your investment would grow to just $38,768. As you can see, time in the market can make the difference of hundreds of thousands—or even millions—of dollars.
Minimize Your Taxes and Costs
The more of your investment that goes toward taxes and fees, the less you have left to help you reach your goals. And while the percentages may seem small, remember that your investments compound. And money that goes to taxes and other expenses isn’t compounding, costing you a lot more in the long run.
The first investment expense to watch out for is taxes. Taxes are unavoidable and arguably have a purpose, but that doesn’t mean you should pay more than you have to. One of the best ways you save money on taxes is to invest in tax-advantaged accounts. 401(k) plans, individual retirement accounts (IRAs), 529 plans, and health savings accounts (HSAs) all provide tax savings.
The other types of expenses to be careful of are fees that you pay on your investments. Common fees include those you pay to a financial advisor and expense ratios on individual investments.
Luckily, it’s easy to reduce these fees. Many investors opt for a robo-advisor or stock trading app to manage their investments. These generally come at a lower cost than a financial advisor.
You can also pay attention to the fees attached to each investment. Mutual funds often come with higher expense ratios. They’re actively managed, meaning there’s a person running them who has to make money. But index funds are passively managed, meaning they don’t require anyone to hand-pick the investments. As a result, they often have significantly lower expense ratios.
Check on Your Money
Even the most passive investing strategy isn’t entirely set-it-and-forget-it. It’s important to review your investments on a regular basis to check their performance, adjust your strategy for your goals, and rebalance as needed. Rebalancing is when you adjust your investments to return to your intended asset allocation. Because certain investments grow at a faster rate, they’ll eventually expand to take up a greater percentage of your portfolio. For example, you might decide to allocate your portfolio to 75% stocks and 25% bonds. Stocks usually have a higher return, meaning as they grow, they’ll make up an increasingly large percentage of your portfolio. To rebalance, you would sell off some of your stock and reinvest that money into bonds.
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