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This post was originally published on The Money Mix and is republished here with their permission. Adding to that, this is a great guide on how to build wealth and ensure a wealthy future for your family. I am excited to share this with you!
(Photo courtesy of Steve W.)
You have a great job and make a good income. You’ve paid off your student loans and credit card debt. Now you’re ready to save and invest. But you’re not sure how to invest your money. I have good news.
I’m going to introduce you to six basic steps on how to invest your money. It will be unlike many of the other “how to” articles on investing. Before you think about investing a dime, we need to set the foundation. Without it, it will be difficult, if not impossible, to have a successful investment strategy.
I’ll list the steps first and then get into some detail to help you navigate each one.
- Work from your budget
- Determine how much you can save
- The best accounts to start – taxable vs. tax-deferred
- Find the best investment options
- Monitor and rebalance
Now let’s get into the details for each to get you started.
Principles to build wealth
These are common sense things. Living within our means, being disciplined about saving and investing and minimizing debt will allow us to build wealth over time. There are no get rich quick schemes that work. There are no short cuts. Doing these three things over a long period will give you the best opportunity to build wealth.
Here’s where to start.
1. Work from a budget
I know, I know. Talking about budgets is about as much fun as having a root canal (Mike: low blow, The Money Mix, low blow…). But if you don’t know where your money is going it will be difficult to consistently save and invest. I’m not suggesting you need to be slaves to your budget. Quite the contrary. But you need to know where your money is going every month to know to analyze areas where you might be able to reduce expenses and increase the amount available to save and invest.
Many people use spreadsheets to budget. If you’re not a spreadsheet person, consider some of the budgeting apps available. Mint.com and You Need a Budget (YNAB) are two of the most popular. Both programs allow you to connect your bank accounts to pull expenses into the app. You can then set up categories to better manage where cash is going.
If you’ve been disciplined enough to pay off your debt it’s likely you have some budgeting mechanism set up. If not, these two apps can help you get started.
2. Determine how much you can save
Your budget tells you how much you can save and invest. That’s the foundation that must be in place to assure you can contribute a consistent amount to grow your wealth.
If you want to save and invest more money, increasing your income means you have more to save and invest. If you’re working in a corporate job, look for ways to get promoted. Learn the art of negotiation when asking for raises. Become more valuable by working harder and doing more than what’s asked of you.
Look for ways to gain income outside of work. Find a side hustle or part-time work that has flexible hours and can bring in more money. The more money you make, the more you can save and invest.
If money for an emergency fund is not part of your budget, it needs to be. What’s an emergency fund? It’s money you keep in a liquid (risk-free, penalty free) account that you can access at any time. Use this money to pay cash for unexpected expenses. If your car breaks down, you have an unexpected medical bill or any other expense, don’t pay for these on a credit card. Use cash from the emergency fund.
The emergency fund should have a minimum of three to six months of monthly expenses in it. So, if your monthly expenses are $1,500, you would keep from $4,500 (3 months) to $9,000 (6 months) in the account. If expenses are $2,000, you’d keep $6,000 or $12,000 in it.
Some people keep one or more years of expenses in their emergency fund. Whatever amount you choose, be sure not to compromise that number. Financing unexpected expenses on a credit card will put you right back into the hole you just dug out of.
After the emergency fund is in place, look at what’s left over in your budget. The money to invest will come from money left after bills are paid and your emergency fund is full. If that amount is zero (it shouldn’t be), then it’s time to look at where you can cut some costs. Since you’ve had the discipline to pay off debt, it’s likely you’ll have a good sum of money for investment.
3. Finding the right type of account
Most people thinking about how to invest their money should look at retirement accounts first. Remember, this is after you’ve set your budget, created your emergency fund and determined how much you can invest each month.
If you have a career, it’s highly likely that your company offers its employees a retirement plan. These go under different names – 401(k), 403(b), etc. The plans offer a way for employees to contribute money every paycheck to an investment account where the money invested grows tax-free as long as it remains in the plan.
In most cases, the employer contributes money to your account as well in the form of a matching contribution. They agree to match what you put into your account with their own money up to a certain percentage.
Here’s a common example. They offer to match your contribution up to 50% of the first 6%. For every six dollars you invest, you’re getting three dollars more from the company. That’s a 50% return on the first 6% you put into the plan. There is no other investment out there that offers a 50% guaranteed return.
Plus the money you contribute is tax-deductible, meaning it reduces your taxable income by that amount. You pay tax on the money at the time you withdraw it at retirement It’s free money and a tax deduction. It’s truly the best investment you can make.
The IRS allows you to contribute up to $19,000 of your own money into employer-sponsored plans. That means you can put a chunk of money toward saving for your retirement.
You should also consider contributing to a Roth IRA.
Unlike employer plans, contributions are not tax deductible. The money you contribute to a Roth IRA has already been taxed. You can contribute $6,000 to a Roth in 2019. Earnings on the money while it remains in the account grow tax-free.
You can withdraw contributions at any time without penalties or taxation. Earnings are a little different. If the Roth account is five years old, earnings can be taken out without paying any taxes. However, if you are under age 59 ½ at the time you withdraw, you will pay the IRS a 10% penalty.
The great thing about a Roth IRA, especially if you start one when you’re younger, is that money withdrawn after five years and when you’re over age 59 ½ is tax-free income. That’s a huge benefit when you’re calculating retirement income. Having tax efficient or in this case, tax-free income in retirement is a major advantage of the Roth IRA.
4. Find the best investment options
If you’re investing in your employer’s retirement plan, the options you have are the ones available in the plan. In the vast majority of plans, these are mutual funds.
In their basic form, mutual funds are managed portfolios of stocks and bonds. They are professionally managed, offer some diversification, and a variety of choices in the types of stocks and bonds available. Most plans have a lot of choices (sometimes too many) of funds. Your benefits department can provide information to help you decide which funds to select.
For any money you’re investing outside of the employer plan, mutual funds are also a very good option. You aren’t limited to a set of funds chosen by your employer. In many cases,m you can find lower cost funds offering better performance.
There are other options to consider as well.
Individual stocks and bonds
In mutual funds, the fund managers decide which stocks and bonds to invest in, and often invest in hundreds of stocks. You can also purchase individual stocks and bonds on your own. When you’re just starting out investing and have smaller amounts of money, it’s hard to diversify a portfolio of individual stocks. It takes a significant dollar amount to buy enough stocks to diversify your portfolio.
Picking stocks and bonds on your own is also riskier. There are a variety of stock picking newsletters and services to help you make the choice. Many of these services tout their ability to beat the market and provide higher returns. If you’re just learning how to invest or just starting out, I would not recommend individual stocks and bonds. If you’re up for taking on more investment risk, it may make sense for you. Individual stocks are a high-risk high reward proposition.
Index funds are a specific type of mutual fund. As we described earlier, funds have professional managers who decide which stocks to buy and sell based on their research. Index funds do just the opposite.
Index funds invest in unmanaged indexes made up of hundreds of stocks. The index you’ve likely heard of and are familiar with is the S & P 500 index. The index is made up of the largest 500 publically traded companies in the U.S. The size of the companies is based on the market value of their stock. The larger companies have a much greater impact on the return of the index.
An S & P 500 index fund invests in all 500 of these companies. Managers don’t decide on how much to put into each company. Rather, the amount they put in each aligns with the size of each company in relation to the total index. There are dozens of stock and bond indexes available for investment.
Index funds are among the lowest cost funds you can own. The lower costs mean more of your money gets invested. Expenses on professionally managed funds are much higher than index funds. Returns of index fund outperform professionally managed fund about 75% to 80% of the time.
For most people, index funds are a great option.
Robo Advisors (Automated investments)
Robo advisors are a fairly new entrant to the investment landscape. They’re called robo advisors because they use algorithms to build and manage portfolios. These technologies automate the investment process. The investment vehicle most use to create their portfolios is exchange-traded funds (ETFs). ETFs are, in many ways, like mutual funds. They pool together investor money and purchase a diversified portfolio of stocks or bonds.
Unlike mutual funds, ETFs are bought and sold more like stocks. I won’t get into the details of how they work here. The main point is that ETFs can be bought and sold during the day. They provide more flexibility in buying and selling shares. Robo advisors like that feature of ETFs.
ETFs also give robos the ability to easily diversify their portfolios at a very low cost. Investing with one of the many robo advisors offers a ready-made, broadly diversified portfolio of stocks and bonds. Most of them require investors to complete a short risk questionnaire to determine which portfolio is a good fit.
In its simplest form, diversification means having your money invested across different types of asset classes (stocks, bonds, cash) to help lower the risk of owning individual securities. With mutual funds, investors who own three or four different funds get fooled into thinking they own a diversified portfolio. In reality, they may not.
If the four funds all invest in large, U.S. based companies, they have four funds with lots of companies all in the same asset class (large U.S. companies). True diversification means having money spread across many different asset classes (large stocks, small stocks, growth stocks, value stocks, etc.). That diversification applies to bond investments as well (short term, medium term, government, corporate).
With regular monthly investments, it’s next to impossible to get proper diversification with individual stocks and bonds. And with mutual funds, you need to have a good understanding of the asset classes and how they work together.
To that end, when you’re learning how to invest or investing smaller amounts of money, your two best options are index funds or automated investment programs (robo advisors).
They allow you to invest smaller amounts of money in a broadly diversified portfolio. In the case of robo advisors, there is also some effort put into finding a portfolio that fits your tolerance for risk.
6. Monitoring and rebalancing
Last but certainly not least comes the need to monitor and rebalance your investments.
Monitoring, as the name suggests, means watching the investments to make sure they are doing what they said they were going to do. It’s making sure you diversification and mix of investments stay close to where you wanted it to be when you started. If it sways from that mix, you could be taking on more risk or compromising the performance you wanted when you started.
Rebalancing means that if parts of your portfolio grow or fall in value beyond what the managers targeted, you should sell the ones that have gone up and buy the ones that have dropped. In other words, bring the portfolio back into the balance (mix of stocks, bonds, cash) you designed when you started. Rebalancing does not need to be done every month. In fact, once a year is probably enough. With markets going up and down a rapidly as they do these days, the market often rebalances the portfolio on its own with its up and down moves.
My thoughts on investing were targeted to those who may be just learning how to invest. It’s also applicable to those who may have some knowledge of investments but not a lot of money to invest.
I’m one who believes that the best way to invest in today’s markets is to own the market. The best way to do that is through index funds or robo advisors. These two options are low cost. They offer an easy way to own pieces of the entire market. There are index funds available for any market, stock or bond, around the world.
Take advantage of employer plans and Roth IRAs to the extent they are available. Be consistent with your investing. Put money in regularly in good and bad markets. Keeping costs low, owning a broadly diversified global portfolio, staying invested in that portfolio, and periodically rebalancing as needed will bring you investment success.
There are no guarantees when investing. Following this formula offers you the best chance for investment success.