This is a question that pops up over and over again, both in reader questions to me and in questions I see on countless personal finance forums.
A person has stabilized their finances and has a solid job. They’re spending a little less than they earn, don’t have a whole lot of debt, and are starting to build up some money in their checking and/or savings accounts. They’re aware that people can get better returns on their money than they can get in their savings accounts by investing, but they don’t know where to start.
What should a person do in that situation?
X steps to take before investing for the first time
1. Cover your bases
Before you consider investing your money, you should make sure you have several financial basics in place first.
First, you should be up to date on all of your bills. If you are currently making late payments on any bills, you shouldn’t be thinking about investing. Rather, your goal should be to get up to date on all of your bills.
Second, you should have an emergency fund that covers at least one month of lean living. You should have enough in there to cover minimum payments on all of your bills and keep food on the table if you’re unemployed for a month. Ideally, you have more than that and you have a small automatic weekly contribution set up to slowly build up your emergency fund.
Third, you should not have any high-interest debts. By this, I mean that you do not have any debts that charge you an interest rate of above 7% or so, and won’t switch to such a rate any time soon. The definition of “high interest” changes a bit as time goes on, but 7% is a safe number in this era of low interest rates. This should include things like credit card debts and some personal loans, but exclude things like car payments, student loan payments and mortgage payments.
If you have those three bases covered and you’re spending less than you earn, then it’s time to consider investing for the future. If you ever find that those bases aren’t covered, you need to dial back your investing until those bases are securely covered again.
There are other options to consider at this stage, like doing small energy efficiency improvements to your home, getting into a bulk buying cycle for your household goods and some of your food, replacing major appliances that are about to fail and so on, but deciding amongst those options is more of a matter of personal preference than a clear financial priority.
2. Figure out why you want to invest
The first thing you should think about when you’re thinking about investing isn’t dollars and cents or investment portfolios. Rather, you should start with the why. Why do you want to invest? What exactly are you hoping to achieve with it?
The easy answer that many people give is to “make more money,” but that doesn’t really cut it. Why do you want to make more money? What do you hope to do with it?
Answering those questions gets a lot tougher for many first time investors, because it’s not a question of money, but a question of purpose. It’s also not a question that many first time investors expect to be thinking about when they first start considering investing.
So why ask why?
The reason is simple: defining the goal of your investment helps you figure out the timeline of that investment, the amount of liquidity it must have, and the amount of risk you can tolerate in that investment. Both of these factors are vital in figuring out what kind of investment is necessary.
For example, the longer the timeline of your investment, the more short-term volatility you can accept. For example, stocks can go up and down in value rapidly over the course of a few days or a few weeks or even a few years, but over a long period of time (more than a decade), the U.S. stock market has consistently gone up in value and virtually always produced a nice return for investors. So, if you’re investing with the intent to use it in six months, the stock market might not be a good idea, but if you’re investing with the intent to use it in 25 years, it might be a great idea.
Another example: the more time you have between deciding that the time is right for your goal and when you actually need the money in hand, the less important liquidity becomes. What’s liquidity? Liquidity simply means how easy it is to turn something into cash. Money in a savings account is very liquid — you can get cash at an ATM. Money in the stock market is fairly liquid — you can usually sell it pretty quickly and have proceeds in a few days. Real estate, on the other hand, is usually not all that liquid (unless you’re willing to sell at a big loss), because it takes time to find someone to buy that land.
What you’re looking for when you define your “why” for investing, then, is how long will it be before you need that money, how fast you may need it when the time comes and whether or not you’ll feel okay losing some of that money in an effort to get a better average return. If you’re young and saving for retirement, then you won’t need the money for a long time and you don’t mind taking on some risk right now to get a great average annual return in the coming years.
On the other hand, if you’re saving for a house down payment and you expect to buy property three years from now, you don’t want your money in anything that has significant risk of losing money over that timeframe and you want to be able to access that money quickly when you find the right house.
What should you do if you don’t have a goal? If you don’t have any sort of goal, you should be investing your money in a way that enables you to get that money quickly — meaning it’s pretty liquid — and in a way that doesn’t put your balance at much risk. Honestly, I suggest using a savings account or a money market account at a local bank or credit union. That way, when you do decide what your goals are, you can get that money quickly and move it into whatever fits that new goal.
3. Decide in what and where you want to invest.
For example, if you decide that you want to invest in collectibles, you’ll likely own those collectibles yourself. You’ll have them in hand and have to store them. If you buy real estate directly, you’ll have the deed to that real estate.
If you want to buy things like stocks, bonds, mutual funds, or things like that, you’ll usually open an account with some financial institution. You’ll deposit money into that account, and then within that account, you’ll use that money to buy various investments. When you want to sell your investments, you’ll do the reverse – within that account, you’ll sell the investments, which will turn back into cash within that account, and then you withdraw it and move it back to your checking account.
An important thing to remember: when you buy anything you’re investing in, keep track of what you initially paid for it, because most of the time, you will owe taxes on what you earned on those investments. For example, if you buy something for $100 and then sell it for $500, you owe taxes on the $400 you gained. You will need to keep careful track of what you bought, when you bought it, how much you paid for it, when you sell it, and how much money you brought in when you sold it. All of that will be necessary when you file taxes the following year after your sale.
4. Find out if there’s a tax-advantaged way to invest for your goal.
Some goals that people save for are encouraged by the government in the form of offering tax advantages for savings earmarked for that goal. Basically, if you’re saving for that goal, you simply sign up for a particular type of account with a few special rules, usually involving limiting how much you can contribute.
The benefit of that kind of account is that there’s usually some benefit on your income taxes for using it. Some accounts allow you to deduct how much you contribute.
For example, if you contribute $10,000 a year to your 401(k) for retirement and you make $50,000 a year, then you get a $10,000 tax deduction, meaning you only have to pay income taxes on the remaining $40,000 (this usually transforms into a pretty nice tax return).
Another example: if you put money into a Roth IRA, you don’t get any tax benefits right now, but when you take money out of that account when you are of retirement age, you don’t pay any income taxes on the money earned in that account. So, if you put $20,000 in your Roth IRA when you’re in your twenties and it grows to $100,000 by the time you retire, you don’t owe any income taxes on the $80,000 in investment growth. You can take it out and it won’t impact your taxes at all!
In general, there are tax benefits if you are saving for your own retirement, if you are saving for your own education or that of a child in your home, or (in some cases) if you are saving for future health care expenses, like a surgery you know you’ll need in the near future. If your goals are in one of those groups, then the government will actually help you get there by requiring you to pay less on your income taxes, either now or later.
I’m going to discuss the three most common types of accounts that this applies to for most beginning investors: 401(k)s (and its very similar cousin, the 403(b)), Roth IRAs, and 529 college savings plans.
If your workplace offers a retirement account, it’s usually a 401(k), a 403(b), or something very similar offered by a government entity. This type of plan is one that’s deducted straight from your paycheck and put into that plan for you. At the end of the year, your total taxable income is reduced by the amount that you saved throughout the year, which means you’ll get a nicer tax refund. However, when you retire, you will have to pay income taxes on the money you take out of that account. Usually, at that point, you’ll be paying at a lower rate, but future tax rates are absolutely not a guarantee.
Sometimes, these are available in a “Roth” variation. What that means is that you won’t get the income tax savings now, but when you actually retire, the money that comes out of that account will be tax free then.
Regardless of whether your workplace offers a retirement plan, you have the option of signing up for an individual retirement account, often abbreviated IRA. These are also available in traditional and Roth variants. In general, if you qualify for a Roth IRA, that’s the option to choose, because the tax benefits are quite nice. You put money in the account directly from your checking account and, if you wait until retirement, all money you withdraw from that account – including the money you gained – is income tax free.
If you’re saving for an educational goal, whether it’s your future education or that of a child, you’ll likely want to use a 529 college savings account. The money you deposit into this account comes from your checking account and offers minimal tax benefits right now (in some states, you can deduct 529 contributions from your state income taxes for a small benefit), but the real benefit comes when you use the money from that account. If you use that money for educational expenses, you owe no income taxes on the money gained from investing in that account.
So, what do I do?
Before we go any further, let’s make one thing perfectly clear.
This information is being presented for food for thought for you, not as investment advice. If you are thinking about making an investment decision, consult a financial planner before making a move to make sure it’s right for you. This is true for any financial information you read. The writer cannot know your situation specifically, so it is impossible for any article or book to give great advice that’s catered to your specific situation. Consult a fee-based financial planner before making any financial moves; the information here is just food for thought to help you develop the right questions to ask.
Let’s dig in.
If your investment goal is retirement-based or education-based, you should consider investing in an account designated for that purpose to take advantage of the tax benefits for that specific goal. For example, if you’re investing for retirement, you should strongly consider using your workplace retirement account or a Roth IRA. If you’re investing for college education, you should strongly consider using an account designed for educational purposes, like a 529 college savings plan. The tax benefits of those accounts are well worth taking advantage of if your goal is in line with them.
If your investment goal is a short term goal, such as something where you’ll need the money within a year, you should strongly consider keeping your money somewhere where it has little risk of losing any value and is easily accessible. The best place for this is a high-yield savings account or money market account, which you can sign up for through a bank or credit union. Here’s The Simple Dollar’s current savings account recommendations. Yes, a savings account seems pretty unglamorous, but it serves quite a few purposes. It provides a very safe place to keep your money where there’s essentially no risk of losing value while giving you a small return, plus it’s easily accessible whenever you want it. You just go to the bank and withdraw it, and you can feel extremely confident that the money you deposited will be there (plus a little bit more). That is exactly what you want in a short term investment.
If your investment goal is a long term goal, meaning more than 10 years, you should strongly consider opening an account with an investment firm and purchase investments with short-term volatility and long-term returns, like stocks. The investment advice within this category is like drinking from a fire hose. If you’re uncertain about what to do, strongly consider spreading out your risk by investing in an index fund. An index fund is basically a way to buy a tiny bit of everything. For example, the Vanguard Total Stock Market Index is a big collection of shares of every single publicly traded company in the United States. When you buy a share of the Vanguard Total Stock Market Index, you’re actually buying little tiny slivers of shares of every single publicly traded company, all at once. That way, if one goes bankrupt or goes into steep decline, you barely notice it, but the same is true if one company goes up in value rapidly. Rather, it tends to track with the overall health of the stock market, which tends to go up at a nice clip over longer periods of time (there are definitely some bad years, though).
If your investment goal is a medium-term goal, you should strongly consider opening an investment account and invest in a mix of things. A “medium-term goal” would be something you expect to need within one to 10 years. With this goal, it really depends on how much you can tolerate losing some of the balance. If the entire plan falls apart with any losses, you’re going to want to be very conservative with the money and, in fact, a high yield savings account or a money market fund might be the best option. If you can accept a little risk of losses and perhaps a delay in your goals if it means very good chances of a solid return, you’ll probably want to mix in other things like a bond index fund (which usually offers a little more risk and a little more reward). If you’re okay with significant risk, then you could mix in a stock index fund or a real estate index fund.
The goal is to create a mix of these things that’s tuned to your goal. The more risk you can tolerate (meaning the less vital it is to have an exact dollar amount on an exact date), the more you can lean toward bonds and stocks. The less risk you can tolerate (meaning that it’s really important to have an exact dollar amount on an exact date), the more you should lean toward ordinary savings with some bonds mixed in.
What about real estate? You can definitely buy index funds of real estate. The way they work is that each share of that index fund represents a tiny sliver of ownership of a lot of different real estate. That’s usually a good way to begin investing if you don’t have a lot of money to start with.
You can, of course, also buy real estate yourself. People who do this often borrow money to get started, taking out a mortgage to buy a house or an apartment building to rent. That generally involves quite a bit of risk, as you have to have good renters in order to be able to make your money back on those kinds of investments. (You can also buy investment real estate, but that usually requires having a lot of money to invest.)
What about gold or Bitcoin? Those investments have extreme levels of volatility, meaning the value of those investments swing rapidly from day to day or week to week, let alone year to year. They both have a history of going through long low periods, followed by enormous spikes in value. You can earn enormous returns in a year or enormous losses. They can be used as a small part of a mix of other things, but if you invest in them alone, you have an enormous amount of risk and run a good chance of never achieving your goal. In general, if I’m saving for a goal that is really important to how I want to live my life, I would not put money into something as volatile as gold or Bitcoin. Treat it as either a small part of your investments — the really risky portion that makes everything else riskier as a whole — or as something you do for entertainment’s sake.
What about collectibles? Many people have an interest in investing in particular collectibles. Although you can make money in this way, you have to simultaneously have a thorough knowledge of a particular type of collectible while also managing to not be emotionally attached to those collectibles (so that you don’t blind yourself to the realities of the market for that collectible). Again, I would not suggest investing in collectibles for anything that you intend to need in your future, though it can be a hobby when you have the important things in your life covered.
Many investment accounts offer “targeted” funds that help out if this seems overwhelming.
If you’re able to figure out the timeframe of your goal and how much risk you can stomach, most investment firms already have some type of index fund or other fund designed to match both of those things for you.
For example, let’s say you’re going to retire in 2045. Pretty much any company operating a Roth IRA or a 401(k) plan offers some sort of “target retirement” fund matching that year that balances risk and return for people who are intending to retire them. It’s pretty aggressive now, but as the years pass, the fund will gradually move from riskier things to safer things to preserve what you’ve built and avoid short term ups and downs.
If you have a daughter who will graduate in 2028, her 529 college savings plan likely has some sort of fund that’s intended to balance out risk and reward for people who are graduating then, gradually moving away from risk as the target date gets closer.
Even if you’re saving for other goals, investment houses generally have funds that match up well no matter how much time there is before you’re ready to use the money and how much risk you can tolerate along the way. Your best opening move is to find an investment that matches what you want and put your money there.
Never stop learning, and never forget that you can change things as you learn more.
One thing that holds people back from beginning to invest is the fear of doing something wrong. What if you invest in something that only earns 5% this year when that other option might have earned 10%?
Remember, no matter what the returns, you’re better off having invested than not having anything at all. Money put aside for that goal, even if it’s not perfectly invested, is far better than having put it off and not put any money aside at all.
Another thing to remember is that if you later decide you want to do things differently, you can change it up. You’re very rarely locked in stone. There are some situations where you might have to pay a fee to undo a choice — for example, if you put money into a 401(k) and then later want the money back before you retire – but for the most part, everything you might do can be undone and changed.
Even more important, investing is something you can always keep learning more about. There are countless books out there on all types of investing; I usually point people at The Bogleheads’ Guide to Investing, which is my favorite single book on investing topics. If you ever feel uncertain about anything regarding your investments, you can learn by reading books, by reading documentation about your investment, by reading and learning about other investments. In general, people tend to come to an overall strategy after some learning and then stick with some version of that strategy thereafter, adjusting a little here and there as they learn more.
As I suggested earlier, before you make any big moves on our own, you should talk to a financial advisor, preferably a fee-based one. A fee-based advisor will charge you a fee, but doesn’t have financial incentive to steer you toward any investments; rather, they merely want to see the best outcome for you (because a happy customer is one that will recommend new clients). If you’re uncertain at all about what to do in your case, talk to a fee-based financial advisor about your situation and your goals. Make sure you clearly understand what your goals are before you have that conversation.
Investing for your future is an incredibly empowering step to take in your financial journey. It can be a scary step, too. The purpose of this article isn’t to answer all of your questions, but to give you enough guidance so that you know what questions to ask next.
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