Everyone needs to invest. In terms of classic pearls of wisdom in the personal finance sphere, “invest your money” is right up there with “have an emergency fund” and “make a budget.”
Despite the fact that putting some portion of your savings to work in stock and bond markets is almost universally acknowledged to be sound advice, a 2018 survey conducted by GOBankingRates found that almost half of Americans aren’t investing. Given how powerful a tool investing can be, that’s downright tragic.
Case in point: Imagine that at age 35, your long-lost uncle dies and leaves you $10,000. You’re trying to decide between just parking that money in your savings account — one of the safest options imaginable — and investing money in shares of an S&P 500 exchange-traded fund, an investment designed to match the performance of the index. How would your decision play out after 10, 20 or 30 years?
Take a look at the table to see how that $10,000 could grow:
|What a $10,000 Investment Would Be Worth Over 30 Years|
|Investment||Estimated Annual Return||After 10 Years||After 20 Years||After 30 Years|
|S&P 500 ETF||10%||$25,937.42||$67,275||$174,494.02|
Whereas the average interest rate paid on a savings account is 0.1%, the average annual return on the S&P 500 has come out to roughly 10% over the years — about 100 times more. That means an average savings account will yield about $100 a decade for every $10,000 while the S&P 500 should more than double the value of your money over the same time period if returns are in line with historical norms.
So if you’re among those Americans who still aren’t investing, it’s time to get yourself into the game. Although investing can feel intimidating from the outside looking in, understanding a few basic topics can help you get started even when you don’t have a lot of money to spare. Whether you’re starting with $5 or $5 million, some simple strategies can help keep your risks low and your money growing.
Here’s what this guide to investing your money will cover:
- What Is Investing and Why Is It Important?
- What’s Your Investment Strategy?
- Deciding What To Invest In
- Investment Accounts
- Choosing a Broker To Manage Your Investments
- Common Investing Mistakes
- More Resources on Investing
On the most basic level, investing is about letting other people use your money. Everyone has to save, be it a rainy day fund or for a major purchase. At the same time, businesses need to spend: on staff, on R&D, on repairs. And most businesses need to spend more than they can get their hands on, even if only temporarily, to keep growing.
Investing is the brilliant compromise that makes the money people save temporarily available to businesses that need to borrow.
In many cases, you aren’t putting money directly into the hands of a business owner, but almost every transaction involved with investing echoes back to this basic principle at some point — even your savings account. The reason your bank pays interest on your savings account is that it takes a certain percentage of deposits and uses them to make loans, creating profits it shares with you. Not only is your savings account a way to keep your money safe and growing, it’s also playing some role in helping local small businesses get the loans they need.
Compounding interest refers to the fact that the longer you invest, the faster your money grows. That’s because gains from the money you make from your investments become part of the new basis from which new returns grow. That makes your returns bigger, which makes your investments, and thus your future returns, even bigger. Over time, that can have an exponential effect that’s surprisingly effective.
Say you find a high-yield savings account offering a 2% interest rate and park $10,000 there. At the end of the first year, your initial $10,000 will have grown by 2% and you’ll be sitting at $10,200. In that second year, you collect 2% of $10,200, so your interest payment goes from $200 to $204. In year three, you get 2% on $10,404, so you collect $208.08.
Over a long enough period, your original $10,000 keeps gathering momentum, like a snowball rolling downhill.
Compound Interest Means the Earlier You Invest, the Better You’ll Do
Thanks to compound interest, every additional year you leave your savings untouched means an even bigger payout than the year before.
Take a hypothetical example of two sisters: Ruth and Erica. Erica had the good sense to take her $10,000 graduation present from grandma, park it in an S&P 500 ETF and then completely forget about it.
Ruth, on the other hand, spent grandma’s $10,000 graduation gift on a car, but she started saving 10% of her income a year at age 45 and matched the $10,000 Ruth stashed away each and every year for 20 years.
Clearly, Ruth wound up with the larger retirement fund, correct? After all, by age 65, she had invested 20 times as much money as Erica had, and in the exact same investment vehicle.
Guess what? Despite failing to save a penny aside from that one investment early on, Erica’s fund is now worth $881,974.85 after compounding at 10% a year for 47 years. Ruth’s fund, despite her investing $200,000 to Erica’s $10,000, is worth $640,024.99.
Alas, you can’t travel back in time and invest $10,000 as a teenager, but you can take to heart just how important it is to start investing as soon as possible if you haven’t already.
Learn: How To Invest in the S&P 500
Getting the right investment strategy isn’t about having an encyclopedic knowledge of investment products. It’s about what matters the most to you. What are your plans for the future? What are your financial goals? Before you even begin to think about what to invest in, you should have a strong sense of what it is you’re investing for. Here’s what to consider when figuring out your investment strategy:
A crucial step in formulating an investing strategy is to figure out what sort of risk profile you want as an investor. Every investment involves risk, and generally speaking, more risk means higher returns and vice versa.
In every portfolio, few things matter as much as that dance between risk and return. It’s a careful balance that’s ultimately going to be different for every person.
2. Time Frame
Another essential factor in developing an investing strategy is when you plan on using your money. Before you can buy a house or start funding your retirement, you’ll need to sell off investments to convert them back into cash. In some cases, selling them at the wrong time can mean you wind up with a lot less. Knowing when you will need to turn your investments into cash, to the degree that’s possible, will help you maximize your earnings.
Short Term: Most short-term investments focus on minimizing risk. But the investments that might produce a large gain over a short period of time often have a strong chance of producing a large loss. If you’re going to be cashing out in the near future, you don’t want to be forced to sell at a loss. That’s part of why most financial advisors tell people to begin shifting into more stable investments as they near retirement.
Intermediate: With a little more time comes more flexibility to assume risk with less chance of having to sell something before the right time. You might even be able to put a small portion of your money into higher-risk investments because you have a little more time to ride out any ups and downs. But you should start shifting away from that risk the closer you get to needing your money.
Long Term: Long-term investing can mean taking on a bit more risk. Because you’re not going to sell any time soon, you can just wait out the ups and downs and stay focused on the trends that play out over years and decades rather than weeks and months. But, once again, keep an eye toward when you will eventually be cashing in so that you can keep shifting into more stable investments over time.
Eventually, the rubber meets the road and you have to make some choices about what to invest in. Don’t worry if you find that terrifying. There are a great many investment products built precisely with you in mind, giving you a chance to make simple, easy-to-understand choices without taking unnecessary risks.
Stocks often get the lion’s share of public attention, due in no small part to their volatility. Stocks are among the riskiest investments you can go for, but how much risk you actually take can vary widely depending on your approach.
Simply put, a stock is a tiny little piece of a company. The more successful the company, the more valuable its stock becomes. As such, investors buy stocks because they expect to be able to sell them for more later — if they’re particularly good at predicting which companies outpace market expectations, maybe a lot more than they bought it for.
That does mean stocks are one the riskiest and most volatile investments. The prospects of a single corporation, even a big one, can be a veritable crapshoot. Even a casual observer of the stock market is probably aware that there’s a crash every decade or two that can send values diving across the board and take years to recover from.
Although the short-term perspective on stocks can be chaotic, the long term can be remarkably stable. Whereas the S&P 500 has had individual years where it lost a third of its value, the good years and the bad still average out to a gain of about 10% a year — a return that’s hard to match elsewhere. And it’s also important to remember that there’s a whole range of risk levels when it comes to stocks. Smaller companies, or “penny stocks,” are incredibly risky, but established, “blue-chip” stocks are more stable and less risky by orders of magnitude.
When a corporation or a government needs to borrow money, it does so by issuing bonds. The bonds are essentially a promise to pay back the face value of the bond at a later date — when it “matures” — and to pay regular interest payments until that point.
Buying bonds and holding them to maturity results in a much more stable, steady return than you can expect from stocks. If you buy stock in a company that then reports plummeting profits, you can almost immediately lose a big chunk of your investment. If you buy the company’s bonds, you’ll get the same rate regardless of what’s in the quarterly reports. Unless things get so dire the company has to declare bankruptcy, your returns are essentially locked in.
That stability makes bonds valuable for short-term and intermediate investors. Not only do you know in advance exactly what sort of return you’ll get, but you have a set date on the calendar when you’ll receive your initial investment back in cash.
You can even bail out prior to the bond maturing if you need to. There’s a massive secondary market for bonds, and depending on the prevailing interest rates, you might get a pretty fair value. The one thing to understand is that whereas buying bonds and holding them to maturity is usually a very stable investment, that goes right out the window when you start trading bonds. Bond markets can be quite volatile, moving up and down based on the performance of the stock market and changes in interest rates.
As with stocks, there’s a range of risk levels out there for bonds. German government debt might be incredibly safe, for example, but high-yield junk bonds come with a distinct chance that the issuer could go under and you could lose most or all of your investment.
A fund is a collection of stocks and/or bonds that have been broken up into millions or billions of shares to be sold to investors. When you buy a single share of a fund, it represents shares in hundreds or thousands of different companies packaged in one bite-sized piece.
Funds make it easy for investors to diversify. The more different stocks and bonds you own, the less damage a single failure can do to your portfolio. Diversifying also mitigates how much you benefit from a single incredible success, but for the average investor, it’s worth it to reduce risks.
Mutual Funds vs. ETFs
The two types of funds used by most investors are mutual funds and ETFs. The primary difference between them is that mutual funds only sell after the market closes, and they can be “marked to market,” or have the day’s market movements factored into the share price. ETFs, on the other hand, trade throughout the trading day, just like stocks.
Passively Managed Funds vs. Actively Managed Funds
Conventional wisdom used to say that the way to build a fund is to hire a fund manager who selects stocks and bonds for the fund — i.e., actively manages its contents. But the companies putting these funds together charge a fee, usually in the form of an “expense ratio” that’s a tiny slice of the fund.
Alternatively, if you create a fund that doesn’t actively try to pick stocks and just matches market returns exactly — i.e., is passively managed — managing the fund is almost automatic. You know what’s in the index you’re trying to match, so you just need to keep rebalancing to keep the proportions right. You give up any chance of “beating the market,” but you pay lower fees.
It might seem defeatist to simply accept market returns, but over 90% of fund managers don’t outperform the market with consistency, so the additional money you pay for active management might end up being for nothing in most cases.
Nearly all ETFs are passively managed, and most mutual funds are actively managed, so you’ll often see that noted as the primary difference between the two. But there are a great many passively managed mutual funds known as “index funds” that can serve essentially the same purpose as most ETFs.
Check out: The Complete Guide to ETFs
4. Real Estate
Branching out into real estate can be another way to keep your assets spread among many different places.
Real estate investing can take a lot of different forms. If you have a mortgage, for instance, you’re essentially investing in real estate. Over the years, your house is probably going to appreciate in value just like stocks or bonds might. When you reach retirement, the equity you have in that house can be an important piece of your plan for living easy in your golden years.
Although most people never invest in real estate other than their homes, an enterprising investor can also invest in rental properties or flipping houses. Or you can use a real estate investment trust, or REIT, which is essentially a mutual fund for real estate. REITs package a certain type of real estate investment — say, apartment buildings in the upper Midwest — into a single fund you can invest in.
Stocks are pretty risky compared with bonds or a savings account, but they’re bumper bowling compared with cryptocurrency.
Cryptocurrencies — the most famous of which is Bitcoin — are digital assets based on computer code. Adherents see cryptocurrency as being the money of the future because of its open structure and ease of transfer, and some portions of the underlying technology are being developed into a variety of cutting-edge financial products.
But at present, cryptocurrencies are speculative. The rising and falling prospects of the various cryptocurrencies mean there are fortunes to be made — or lost — betting on the outcomes.
Investing used to be expensive, but online trading and artificial intelligence have reduced the cost over the years. Whereas commissions in the 1980s were about $45 a trade, today many online brokers are charging just $5. And a new generation of investing apps is challenging the idea that you should charge a per-trade commission at all.
These apps might help even the playing field for a new generation of investors by allowing them to get started with less. In some cases, you can sign up and get started with just $5 or automate contributions to keep you saving even when you’re not consciously thinking of it.
Not all microinvesting apps are created the same, so do your research. At the very least, understand how the app makes its money and how that might affect the service it provides.
Once you have a sense of what sort of investments you want to make, you’re ready to open an account, deposit some funds and start making investments. Before you do, though, you should understand a little about the types of investment accounts you might consider.
1. Taxable Accounts
Taxable accounts include individual brokerage accounts, bank accounts and any other type of account that’s taxed normally.
2. Tax-Deferred or Retirement Accounts
Although taxable accounts are the simplest, most investors likely make use of one or more tax-deferred accounts, also known as retirement accounts. Saving for retirement is important, and the government knows it. That’s why it has provided a few different avenues to save on taxes when you invest for your retirement.
401(k): A 401(k) is a retirement plan offered through your employer, allowing you to direct money straight from your paycheck into an account where you can invest it. The important benefit is that 401(k) contributions aren’t subjected to withholding taxes. You will pay taxes on your eventual withdrawals, but you can invest the full amount in the meantime.
IRA: An IRA has many of the same benefits as a 401(k). Any money you deposit into your IRA is tax-free, so you can reduce your taxable income by the amount of your IRA contributions every year. And whereas a 401(k) is administered by your employer, an IRA is a personal account you control.
Roth IRA: Like a traditional IRA, a Roth IRA is a personal retirement account you can open on your own. But you make contributions to your Roth IRA with money you’ve already paid taxes on. Unlike a 401(k) or traditional IRA, your eventual withdrawals aren’t taxed, so any growth you get from investing constitutes tax-free income. You essentially trade a benefit now for a benefit later.
Limitations on Retirement Accounts
There are limitations to the benefits provided by these accounts. For starters, annual contributions to your 401(k) are capped at $19,000, and you can only add $6,000 a year to an IRA or Roth IRA. Although it’s your money, you’ll pay a hefty tax penalty for pulling it out before you’ve reached retirement. There are some important exceptions — like when you use it for the down payment on your first house or to cover college costs — but you should otherwise expect not to use that money until you retire. In addition, traditional IRAs and 401(k)s have “required distributions” that require you to start drawing down the accounts or pay a tax penalty.
Contributing to both a Roth IRA and a traditional IRA can create a lot of flexibility to limit your taxes in retirement, so don’t be afraid to open a few options and make investments in each.
Buying a stock isn’t like buying a stick of gum. You need a broker who can execute the trade for you. Here’s what you should know about the different types of investment brokers.
1. Full-Service Brokers
A full-service broker offers money management services beyond just buying and selling stocks for you. They usually have their own research team making stock suggestions to clients, and they take an active role in helping you build your wealth. They’re also very expensive and usually require initial deposits in the thousands or tens of thousands of dollars. Unless you have a pretty sizable sum of money to invest, a full-service brokerage might not be for you.
2. Discount Brokers
A discount brokerage will do just fine for most investors. Discount brokers aren’t there to make suggestions about which stocks you should buy — you tell them what you want to buy or sell and they get you the best possible price. They usually charge much lower commissions and have much lower minimums to open an account.
3. Online Brokers
Online brokers make trading easy by using the internet to streamline the investment process. Their rise is a huge part of why commissions have plunged from almost $50 to $5 in just a few decades.
4. Financial Advisor
If you’ve gotten to this point and you’re still feeling queasy about just how little you understand, don’t worry: you can hire someone to handle this for you. A good financial advisor can listen to your financial goals and help you achieve them. Granted, it comes at a fee, but you might decide that it’s worth the money not to have to make any investment decisions on your own.
Just be careful about who you hire. In particular, look for someone who is open about being a “fiduciary” and has the initials CFA, for certified financial advisor, after their name — certifications that mean you can rely on them to provide you with the best possible advice.
In much the same way that online brokers have helped reduce the cost of trades, robo-advisors are helping actively managed funds close the gap with passively managed ones in terms of cost. Using algorithms based on certain investing principals, robo-advisors can execute a top-tier selection of assets without needing a person to approve every decision.
Robo-advisors are still relatively new, but they can be a great way to get solid returns without paying excessive fees. Just be clear on what sort of performance the advisor has produced in the past and what fees it’s charging for use. If your robo-advisor is charging more than an ETF or index fund without beating its benchmark index, you’re better off without it.
Attention, New Investors: Choose a Robo-Advisor
Many inexperienced investors are terrified of making a huge mistake that will cost them most of their savings. Fortunately for you, as long as you stick to basic, steady investing strategies that rely primarily on a savings account and a mixture of stock and bond funds, there aren’t a lot of big mistakes for you to make.
But there still are some basic missteps to look out for.
Panic Selling: There’s probably no more common mistake among the average investor than freaking out when markets are crashing and trying to sell. Sell at the market bottom, and you lose big and won’t be in the market when it starts coming back. You can’t time the market, and the only real strategy for dealing with market crashes is to take a deep breath and hold on until the inevitable rebound.
Speculating Instead of Investing: Once you start to get into investing, it can be easy to watch the daily stock returns and lament missing out on every big shot. At this point, you’re mostly speculating on tickers rather than investing in companies. In the long run, chasing the next hot stock rarely works out as well as investing in companies because of the strength of their underlying business.
Impatience: Time is your best friend in investing, but it can be hard to be patient enough to let it work. Even a return of 10% a year can seem painfully slow growth when you’re in year five or 10. But making big changes to accelerate the process can ultimately do more harm than good.
Investing Is a Tool That Can Work for Anyone
The financial system isn’t nearly as closed off as it can feel, and more so than ever before, almost anyone can get started investing even when they have very little to stash away.
There are plenty of ways to keep your risks low and your money growing even when your knowledge about finance is almost nonexistent. So instead of letting the process intimidate you, commit to finding and using the best way to invest your money.
Learn more about investing by checking out the following:
- Consider whether you need a financial advisor even if you aren’t rich.
- Learn where to find the best robo-advisors.
- Find out what you need to know about IRAs with this beginner’s guide.
Joel Anderson is a business writer who has been writing about investing topics for over a decade. His work has been featured on a number of investing sites, including CNBC, MSN and Equities.com.