There’s no getting around it. If you want to build wealth, you need to invest. However, many Americans may not have confidence in their ability to navigate through all that intimidating investing jargon. While it may seem daunting at first, investing is actually attainable, especially with this guide for investing for beginners.
In fact, Wall Street would like to have you think that investing was difficult and complicated — but it doesn’t have to be. While there is a healthy amount of financial terminology that can distract you, in reality the basics of investing can be easily understood and put into action. Just follow our guide to learn how you can start investing, and keep in mind the wise words of Helen Hayes: “The expert in anything was once a beginner.”
Step 1: Determine How Much You Can Afford to Invest
As a beginning investor, before you dive into any investing strategy, you need to determine how much you can afford to invest every month. While some personal finance experts recommend putting at least 10-20% of every paycheck toward your savings goals, that amount will depend on your personal financial situation, as well as how much money you take home each month.
There are a variety of tools available to help you organize your financial life, but one of the most useful places to start is the 50/30/20 budget, as it provides a simple, structured plan for your money:
- 50% Needs: Half your monthly income — although less is acceptable — should go toward essentials such as rent, groceries, car payment, insurance, and prescription medications. If you have debt, this is also where you should bucket any minimum debt payments — whether student loan or credit card debt — as those will severely impact your credit score if you don’t pay on time each month.
- 30% Wants: About one-third of your income — and no more — should go toward non-essential items that make life more fun. For example, expenses in this category might include things like entertainment, eating out, shopping, and traveling.
- 20% Savings: About one-fifth — although more is fine — should go toward your savings and investing goals. Ideally, this 20% should be saved before any other expenses, and your needs and wants categories should be made to fit into the remaining 80%.
Remember, these categories are broad guidelines. If you can’t manage to save 20% of your take-home pay every month, don’t give up. Whatever you can save — just save something.
Step 2: Define Your Financial Goals
Once you’ve determined what percentage of your income you can save or invest every month — hopefully it’s at least 20% — you now need to define your goals, as this will inform your investment strategy.
While your goals will obviously vary based on your circumstances, in general it’s a good idea to ensure you’ve ticked off an emergency fund and a bit of retirement savings before you leap into a more involved investment strategy. Most financial advisors recommend you save for the following goals, in this order:
If you don’t have an emergency fund, this should be the first goal to tick off your list. Life stuff happens, and it can cost you money that you weren’t expecting to spend. If you don’t have savings in place to deal with those unforeseen expenses, you can quickly fall into debt, derailing any investment strategy you might have had.
With an emergency fund, the goal is to accumulate at least three to six months of living expenses — 12 if you’re self-employed — in order to cover an emergency. If you were to lose your job, have a health emergency, or any other unexpected disaster, this fund would help you get through your rough patch without having to take out a personal loan or go into credit card debt.
Now, three to six months of expenses is a lot, and it doesn’t happen overnight. However, by just saving a few dollars a day, you might be surprised at how quickly you can tick this goal off your list and move on to the next.
|Savings Per Day||Annual Savings|
Next on your path to wealth, you should capitalize on any 401(k) match your employer offers. (This would be a 403(b) or 457 plan if you work at a nonprofit or in the public sector.) For example, if your employer matches up to 3% on its retirement plan, make sure you’re contributing at least 3% of your pay so you’re not leaving compensation on the table. After all, that’s a 100% return on investment, which you won’t find anywhere else.
Roth or Traditional IRA
Once you’ve topped off your emergency fund and put enough aside to capture your company’s 401(k) match, you should think about opening an Independent Retirement Account, or IRA. These accounts generally have lower management fees than employer 401(k)s, while offering tax advantages.
That said, there are two types of IRA available: Roth and Traditional.
A Roth IRA offers the opportunity to save up to $6,000 per year ($7,000 if you are 50 or older) in an individual retirement account if your income is within the IRS income limits, e.g., your modified Adjusted Gross Income is no more than $137,000 if you are filing single for 2019. The money grows completely tax-free if you withdraw anytime after age 59 1/2, and if the money has been in the account at least five years.
Your contributions — but not the capital gains — can also be withdrawn at any time without taxes or penalty, which can make a Roth IRA an attractive option for a back-up emergency fund or college savings. If you’re able to add more savings even after you’ve maxed out your contribution to the Roth IRA, consider adding more into your employer’s 401(k) up to its contribution limits.
Another retirement account type is the “Traditional” IRA which provides immediate tax savings by reducing your taxable income when you contribute. Traditional IRAs are also subject to IRS income limits. Your contributions grow tax-free until you start to withdraw the funds at retirement, no earlier than age 59 1/2. When you withdraw your money, however, the withdrawals are counted as taxable income at your tax rate in effect at the time of withdrawal.
Review more retirement savings details, including a comparison of Roth vs. Traditional retirement accounts, with our helpful guide to 401(k)s and IRAs.
Open a Taxable Brokerage Account or Mutual Fund Account
If you have a decent emergency fund and are contributing enough to your 401(k) and IRA to meet your retirement goals, now is when you might want to set up a taxable brokerage or mutual fund account. These investment accounts are a great complement to your core 401(k) and IRA investments, and a great opportunity to finesse your investing strategy even more.
When it comes to brokerage and mutual fund accounts, you can choose the types of investment — or asset class — that best suits your personal goals. This can give you the opportunity to experiment with trading individual securities, but not jeopardize your financial health if it doesn’t work out. Additionally, because these are not retirement accounts with age-related withdrawal restrictions, you’ll also be able to access that money at any time.
Whatever your goals might be, there are three factors you need to consider before you begin examining your investment options:
- What is your goal? Common goals include: preparing for emergencies, buying a home, saving for a wedding or kids’ college, starting a business, and retirement. Determine if your goal has a fixed monetary amount (e.g. $20,000 for a home down payment) or if it’s more flexible — for instance, $2,000-$2,500 for a vacation.
- When do you need it? This is called your “time horizon” in investing terminology. In investing, under five years is considered a short-term time horizon, five to 10 years is considered an intermediate term, and anything more than 10 years is long term.
- What is your risk tolerance? “Risk” means unpredictability and uncertainty of expected returns for a particular investment (but many investors understandably equate risk with “risk of losing money”). Risk is expected to correspond with reward — there is no investing reward that is without risk. If you’re not sure what your risk tolerance level is, take an investing risk tolerance assessment to figure out whether you are a conservative, moderate, or aggressive investor.
Step 3: Know Your Options
The next step in our guide for investing for beginners is to know your options. Once you’ve determined how much you can save each month — and what you’re saving for — it’s time to examine the choices available. While there are a variety of different types of investments (or asset types), you can determine the right asset allocation for you based on the three factors you explored in Step 3 — the amount you need to save, your timeline, and your risk tolerance. “Asset allocation” simply means the diversified mix of funds that reflects your individual strategy. In general, investment assets break down into four main categories:
- Cash and cash equivalent investments
- Stocks (including mutual funds and ETFs)
- Real estate
Cash and Cash Equivalent Investments
Cash is likely the most familiar asset type, as you can physically hold it in your hand, pay bills or purchase something immediately with it. It is also the least risky option available. However, that security comes with a tradeoff: low returns. In general, cash savings will not outpace inflation, and can actually decrease in value if held for too long. As a result, cash is a great vehicle for short-term investment goals.
While cash provides a minimal return on investment when compared to other asset types, there are ways to make your cash work harder for you. For instance, rather than keeping cash in a checking account or run-of-the-mill savings account, store your money in an FDIC-insured high-yield savings account, Certificate of Deposit, or money market mutual fund. You might also consider storing your cash in Treasury Bills, which are very short-term debt securities issued by the U.S. government.
These types of accounts pay you some interest for the cash you store in them, while also ensuring that the money will be there when you need it.
Bonds are fixed income investments that provide income for a predetermined (or fixed) period of time, as well as higher returns than cash savings. As a result, they’re a great option for intermediate savings and investing goals, as well as improving the diversification of your portfolio in the long term.
There are a variety of bonds available, including government bonds, corporate bonds, municipal bonds, convertible bonds, mortgage or asset-backed bonds, and high-yield bonds. Risk also varies from investment grade (lower) to junk bonds (higher). But no matter what type you choose, bonds work more or less the same way. In fact, when you purchase a bond, you’re effectively making a loan to the bond issuer, who is paying you back interest over time, and will then repay the initial amount you invested — or principal — when the bond term comes to an end. Although their values fluctuate when interest rates move, bonds offer a counterbalance to the ups and downs of the stock market, and can help even out the lows you might suffer during a recession with their stable, predictable income streams.
Now, because bonds are typically issued in larger denominations — usually the minimum purchase price is about $1,000 — it’s hard to build a well-diversified portfolio of individual bonds when you’re just getting started with a small amount of money. However, all is not lost. New investors can invest in bonds through bond mutual funds, which offer diversification and professional management. You might also want to consider bond index funds or bond ETFs, which are invested to mimic the performance of a bond index, such as the Bloomberg Barclay’s U.S. Intermediate Credit Index or the S&P U.S. High Yield Corporate Bond Index.
Now we leave behind the relative safety of cash and bonds, and arrive at stocks. If you’re not familiar with how stocks work, in short, when you buy a stock you are taking ownership of part of a publicly traded company. In other words, when you own a company’s stock, you own a very small portion of that business. As part owner in that business, you make or lose money depending on whether or not the company is profitable.
Investing in a company’s stock may not be suitable for a short-term goal, or with money you can’t afford to lose. Over a long time horizon, however, you can participate in the potential growth and value creation of that company by owning its stock.
Typically, investors invest in common shares of stock, but there are other types of stock available such as preferred shares and convertible shares. That said, while you can choose to invest in individual stocks, when you’re just starting out, it may make sense for you to put your money into mutual funds or exchange traded funds (ETFs) that allow you to conveniently invest in hundreds of companies in one investment (and incur only one transaction cost).
When you put your money in a mutual fund, you are pooling your money with investments from a larger group of shareholders. Then, that pool of money is invested in a diversified portfolio — usually a variety of stocks and bonds — either as an “index fund” that mirrors a basket of investments like the S&P 500, or as a fund that’s actively managed by an investment manager. This diversification across hundreds of investments reduces the risk of one company or a set of similar companies performing poorly in a market downturn.
As a note, if you’re looking to invest in a mutual fund, make sure you select one that has low fees and doesn’t have “loads,” which are sales charges. Many mutual funds offer low minimums to invest, such as $25, and share purchases and sales are executed at the end of the trading day.
Exchange Traded Funds
Another way to invest in the stock market without choosing individual stocks is to put your money in an exchange-traded fund, or ETF. This type of fund tracks a group of stocks — most of which are indices but some are also actively managed — and is traded on the stock exchange. The advantage of this type of investment is that the management fees associated are usually lower than mutual funds and can be traded throughout the day. And because ETFs invest in a broad range of stocks, the risk is spread out.
Finally, we come to real estate. If you’re just getting started with investing, you likely won’t want to buy physical real estate since the initial upfront cost can be quite hefty — not everyone has a 20% down payment just sitting in savings.
However, including real estate in your portfolio is still an option when you invest in real estate mutual funds or real estate ETFs. Typically, these funds are similar to traditional mutual funds and ETFs, but rather than investing in stocks and bonds, your money is invested in Real Estate Investment Trusts (REITs). These are publicly traded portfolios of commercial and rental real estate that allow you to enjoy the benefits of appreciating real estate assets and even income, without the need to own a physical building. However, because investors can quickly buy and sell REITs in the stock market, these can fluctuate in value much more than a commercial building would.
The 4 Investment Types At-a-Glance
In sum, there are four primary investment types available. Each has its advantages and disadvantages, and should be chosen based on your time horizon and risk tolerance.
|Investment Type||Pros||Cons||Held In||Best For|
|Cash||Very low risk of loss|
Money is there when you need it
Doesn’t keep pace with inflation
|High-interest savings accounts|
Certificates of Deposit
|Short term (less than five years)|
Low risk tolerance
|Bonds||Return of principal (depending on credit risk)|
Regular interest income
Less fluctuation in values (unpredictability) than stocks
|Bond values fall when interest rates rise|
Limited risk of default for investment grade bonds
|Intermediate term bonds|
Bond mutual funds and ETFs
|Intermediate term (5-10 years)|
Low risk tolerance
|Stock market||Growth potential|
Diversified, low-cost stock portfolios are easy to invest in
Not suitable for short-term goals
Expensive to trade individual stocks
Stock mutual funds
|Long term (more than 10 years)|
High risk tolerance
|Real estate||Diversification and income|
You can own real estate without buying individual properties
|Affected by stock market fluctuations||Physical real estate|
|Long term (more than 10 years)|
High risk tolerance
Step 4: Determine Your Investment Style
You’re in the home stretch now of this guide for investing for beginners. You’ve determined how much you can save, defined your goals and decided what asset class is best for you based on your timeline and risk tolerance. Now, you need to decide how involved you want to be in your investment strategy. In other words, do you want to be a “hands-off” or a “hands-on” investor?
Most people are “hands-off” investors, preferring to delegate decisions about their investments to a portfolio manager who has a pre-set, diversified strategy for maximizing returns. Usually, a hands-off approach is best for passive investors, or those who are happy to match market performance. If you fall into this category, you’ll likely want to consider index mutual funds and Exchange Traded funds (ETFs) with low management fees, as well as index-based Target Date Funds (TDFs) and similar portfolios.
On the other hand, perhaps you belong to the smaller group of “hands-on” investors. These are investors who want to create and monitor their own portfolios, and have the time, knowledge, and resources to do so. In general, hands-on investors are active investors who try to beat the market rather than just match its performance. If you’re game to research investments, able to monitor trading expenses (so they don’t eat into your returns), and have an investment strategy that informs what you buy and sell and when, then you may be ready for active investing.
However, if you fall somewhere in the middle — you want to do slightly better than the market, but don’t want to monitor the NASDAQ and S&P 500 all day, every day — there are investment options available for you, too. As a middle-of-the-road investor, you can choose mutual funds and exchange traded funds with relatively low management fees that match your risk level, while still allowing you to keep pace with or even beat market performance.
|Hands Off||Somewhere in the Middle||Hands On|
|Target date mutual funds||Mutual funds||Individual stocks and bonds|
|Asset allocation mutual funds||Exchange Traded Funds (ETFs)||Does own trading|
|Target risk mutual funds/ETFs||Asset allocation models||Has a buy strategy|
|Robo-advisors||Automatic rebalancing||Has a sell strategy|
|Managed accounts||Core “hands-off” with a side account for dabbling in hands-on investing|
At some point in your financial journey, you might find yourself seeking even more sophisticated investment strategies that can optimize your tax, employee stock and options, estate planning, or other complex situations and goals. If you fall into this category, you will likely be willing to pay the generally higher fees for actively managed mutual funds, as well as the expenses associated with employing a financial advisor.
Step 5: Take Action
You’ve now arrived at the action stage of your investing strategy. You’ve set a monthly investing budget, determined your goals, and chosen which asset class is best for you based on those goals and your investment style. Now it’s time to make a plan and put it into action. Based on your timeline and risk tolerance, the chart below can help you determine what the best asset allocation might be.
In general, your timeline will have the greatest impact on the investment vehicles you should choose. For instance, if you want to purchase a house in three years, you should keep your savings in cash — no matter your risk tolerance. However, if that goal moves out to six years from now, you should consider keeping your savings in a mix of cash, bonds, and even a portion in stocks if you’re willing to take some risk.
Target Asset Allocation Mix by Risk Tolerance
|Risk Tolerance||Less than 5 years||6 to 10 years||11 years or more|
Step 6: Review and Rebalance
Once you’ve chosen your asset allocation, you might think you can just set it and forget it. However, smart investors will revisit their asset allocation at least once a year — but not more than quarterly — in order to ensure the mix of investments they chose is still the best available to meet their goals.
Since time generally has the greatest impact on how you should allocate your assets, it makes sense that as time passes, your allocation should change. When you do review and rebalance your holdings, you should compare your investments to your target investment mix in the chart above. Inevitably, some funds will have done better than others.
While it’s natural to want to keep funds that have increased in value and to sell funds that have fallen in value, that strategy can work against you in the long run. Instead, you should rebalance your investments back to your target mix — as illustrated in the chart in Step 5 — by selling a portion of the funds which have gone up, then buying more shares of your funds that have gone down to maintain your target mix of investments over time. While rebalancing in retirement accounts have no tax consequences, be aware that selling investments that have grown in taxable accounts will. So consult your tax preparer or adviser before making any large moves in your brokerage account.
Step 7: Reap the Rewards
While entering the world of investments isn’t complicated — as we saw in this guide for investing for beginners — it does require a little planning and a lot of discipline. However, if you can stay the course, this is the step that makes it all worthwhile. (If you’d like to put your investing strategy on auto-pilot, check out this guide to robo-advisors.)
Keep in mind that any investment strategy will take time to reap its rewards, and that successful investors use their income as a tool for growing assets over the long run. Just consider: Warren Buffett didn’t become a billionaire overnight — he invested slowly and steadily for decades before that seventh zero showed up on his net worth statement.
While becoming a billionaire might not be a possibility for everyone, financial security is definitely achievable. You just have to make a conscious decision to pay yourself first. That means aiming for a set percentage of your income to save each month, and investing that money in the assets that are best suited for your goals.
As you watch your net worth grow and your financial well-being increase, you come to realize that spending time learning about the world of investment might in itself have been the best investment you ever made.