When you're fresh out of college, planning for your financial future may mean brown-bagging your lunch so you can afford to go out to dinner with your friends. But after a few years of living paycheck-to-paycheck, you might be pleasantly surprised to see that your checking account balance is actually growing month by month. So what should you do with that extra $100 or $500? You could buy a Nintendo Wii, pick up the new iPhone, or you could invest your money.
Investing doesn't have to be scary. And it's not just for people with thousands of dollars in spare cash. In fact, the earlier you start investing, the more you can take advantage of the miracle of compound interest. The little you can start investing now could reap huge rewards 30 years down the line. Every good plan starts with a clear statement of goals. Where do you want to be in five years, 10 years or even 50 years? If you know what you want, a solid investment plan will help you get there.
But first, you need to understand investment tools. Choosing a broker is a crucial part of your investment plan. An expert can give you guidance, but you'll pay for his or her advice. Whether or not you hire a broker, it's good to learn about investment strategies. Successful long-term investing isn't just simple guesswork. But it doesn't have to be rocket science either. There are some basic formulas that even new investors can use to maximize their returns year after year.
Armed with your new knowledge of stocks, bonds, mutual funds and investment strategies, you'll be ready to invest. In this article, we'll walk you through the basics of how to become a successful investor, explaining the safest strategies for making your money work for you.
Step 1: Set Your Investment Goals
Before you invest a single dollar, it's helpful to figure out exactly why you're investing. Here's how to start: Grab a piece of paper and list all of the things that you want to do in your life, focusing on those big moments that come with a price tag. Use time frames to help organize your goals and future plans.
Five years out, your plan might be to get married, have your first child and buy your first home in a nice neighborhood. Ten years out, maybe you'd like to have two more kids, which might mean a second car and a bigger house. Twenty years out, college tuition payments begin. And what about retirement?
If it seems like your future financial obligations are quickly adding up, don't get discouraged. That's why you're investing. The best thing you can do now is to be as specific about your future plans as possible, even if they're far off on the horizon.
Retirement is the perfect example. The amount you need to save for retirement substantially differs depending on when you plan to retire. If you want to retire early -- perhaps in your 50s instead of your 60s -- you may need to invest as much as 20 percent of every paycheck to have enough to live on for the remaining 30 or 40 years. If you plan to wait until age 65 in order to collect full U.S. Social Security benefits, perhaps you can get away with investing significantly less.
Keep in mind that not all retirements are created equal. Do you want to buy a home in Mexico and spend your golden years swinging away in a hammock? Or do you want to rent a one-bedroom apartment in midtown Manhattan and catch a Broadway matinee every Friday? Maybe you know that a full retirement isn't your thing. Perhaps you'd like to keep working, at least part-time, as long as possible. These are the kind of details that will determine your long-term investment strategy.
Now that you have your goals in place, it's time to familiarize yourself with the most common investment instruments.
Step 2: Learn the Different Types of Investments
Knowledge is power. Even if you don't plan on personally managing your individual investments, it pays to know the details about the most common types of investment instruments: stocks, bonds and mutual funds.
When you buy stock, you're buying partial ownership in a company. Stocks are sold as shares, and every shareholder is entitled to a percentage of the company's annual profits called a dividend. But most people don't buy stocks for the dividends. They buy them as long- or short-term investments.
The price of a share of stock is constantly changing. Stock prices go up and down based on the value of a company on paper and the perceived value of a company in the eyes of investors.
The golden rule for investing in stock is to buy when the price is low and sell when the price is high. This is easier said than done. Unless you have ESP, it's very difficult to predict when a stock has reached its lowest or highest price. The best you can do is invest in companies that you're sure are going to grow. For example, if Microsoft releases particularly weak sales numbers after Christmas, its stock price will probably go down. But since Microsoft is such a successful company, it's probably safe to assume that the price will rebound quickly and keep growing. This is an opportunity to buy Microsoft stock for a relatively cheap price and sell it later for a profit.
Historically, the stock market has grown on an average of between 10 and 12 percent a year. This is why many financial advisors consider stock an excellent long-term investment. The stock market is also attractive for short-term, higher-risk investors. With stock prices changing every minute, there's tremendous potential for a quick profit or an equally quick loss.
Another investment tool, bonds are considered some of the safest investment securities around. This is because a bond is essentially a loan. In this case, the investor is the one who's loaning the money. The most common bond is a Treasury bond or a T-bill. When you buy a T-bill, you're loaning money to the United States government at a fixed interest rate. You can also by bonds from local governments -- municipal bonds -- and businesses -- corporate bonds. Because bonds are such safe investments, they carry some of the lowest interest rates.
With a mutual fund, your money is pooled together with cash from thousands of other investors to buy a portfolio of stocks, bonds and other securities. A mutual fund is run by a team of professional money managers.
The advantage of mutual funds is that they give you instant diversity in your investments. For a beginning investor, it would be very expensive and time-consuming to make lots of individual stock and bond purchases, and we'll talk more about these fees later. With mutual funds, your money is invested in a balanced portfolio of stocks and bonds without incurring fees for each purchase.
Stocks, bonds and mutual funds are the most common investments, but certainly not the only ones. Real estate investment trusts (REITs) are companies that own and manage a portfolio of real estate properties and mortgages. By investing in an REIT, you're entitled to a cut of the company's profits. Stock futures are contracts to buy or sell a certain amount of stock on a specific date. You can also trade international currencies on the foreign exchange market known as forex. The list goes on and on.
But if you're just getting started as an investor, it's best not to leap into complicated, high-risk investment instruments. Stick with stocks, bonds and mutual funds for now and learn more about the other options as you go.
The person who will help you devise and execute your investment strategy is your broker. Let's talk about how to choose a broker in the next section.
Step 3: Choose an Investment Broker
To buy and sell stocks, bonds and mutual funds, you need a broker. A broker can either be an individual licensed agent or a brokerage firm like Merrill Lynch, Smith Barney or Charles Schwab. The most basic function of a broker is to execute trades for the investor, but many brokers offer additional services like investment advice and portfolio management. Brokers make money by charging commissions on each trade and collecting fees from investors.
It's important to understand how these commissions and fees work. First of all, most brokers require a minimum deposit in your brokerage account. It's similar to a bank account, and the broker will withdraw money from it every time he or she needs to make a trade. The average minimum deposit is between $500 and $2,500, but it's not uncommon for minimums to be as high as $10,000 [source: Investopedia]. If you can't supply the minimum deposit, you can't work with the broker, so look for that information first.
As we mentioned, brokers make money by charging a commission on each trade. The amount a broker charges varies greatly between discount and full-service brokers. Traditionally, discount brokers don't do anything but execute the trade. Many online brokers, therefore, are discount brokers. You fill out the details of the trade on the Web site, hit "buy" or "sell" and someone on the other end makes the transaction. Discount brokers can charge as little as $5 to $15 per trade.
Full-service brokers do much more than just execute trades. They're professional money managers and financial planners who work with a client to develop a clear investment strategy and maintain a portfolio that supports that strategy. Because full-service brokers do considerable market research and meet in person with each client, the average full-service commission is between $100 and $200 a trade.
In addition to commissions, brokers also charge annual maintenance and operating fees. Some brokers even charge inactivity fees if you go for months without making a trade. And others charge minimum balance fees if your brokerage account dips below a certain level or amount. Before working with a broker, make sure you understand what fees apply to your account and how they will be calculated.
As a beginning investor, it can be difficult to choose between a discount and full-service broker. Discount brokers are cheap, but you get what you pay for: A discount broker doesn't get paid to give you advice. On the other hand, not all full-service brokers are worth their hefty commissions. Some are arguably salesmen who only peddle their brokerage firm's investment products. As we discussed earlier, they get paid by the trade. Some full-service brokers have been accused of encouraging clients to make multiple, unnecessary trades, which is an unethical practice called churning [source: Investopedia].
The good news is that there's a new generation of online brokers that fall somewhere in the middle of the discount and full-service extremes. You'll pay between $15 and $30 per trade, but you'll get more guidance and support than from a traditional discount broker. And now some full-service brokers are offering discounted, online-only trades.
Once you have a broker, it's time to develop an investment strategy. Read more in the next section.
Step 4: Learn About Investment Strategies
There are some basic investment strategies that every beginning investor should understand before putting their savings on the line.
When you're building your first investment portfolio, your broker will probably suggest that you put most of your money in stocks. But if you read the financial page, you know that the stock market can take big dips and unpredictable jumps. Isn't putting so much money in stocks too risky? On one hand, you're right -- stocks are riskier than other investments like bonds or money market accounts.
But you're also confusing short-term volatility with long-term risk. The truth is that the stock market has always crept higher and higher over the long-term, even if there are a few rough years along the way. As a young investor, you can wait out those bad years. Kiplinger.com puts it this way: "Invest aggressively for the long-term and conservatively for the short term" [source: Kiplinger]. If you're putting money away for 30 years, go for stocks. If you're saving money for next year, put it in something ultra-safe, like a CD.
Another important principle of investing is something called dollar-cost averaging (DCA). The problem with investing in something like the stock market is that it's hard to know when stock prices are going to go up and when they're going to go down. And as a beginning investor, you don't have the time or money to waste responding to every slight market fluctuation.
DCA takes a lot of the guesswork out of investing. Every month, you invest the same exact amount of money -- whether it's $25, $100 or $500 -- in the same investment instrument. Let's use stocks as an example. Every month you buy $100 of Microsoft stock. When the price of Microsoft stock is down, that $100 will buy you more shares. When the stock price is up, the same $100 will buy you less shares. The result, over time, is that you end up buying Microsoft stock at an average price per share.
That average price per share is guaranteed to be better than anything you could have come up with by jumping in and out of the market, trying to guess when Microsoft stock had bottomed out and predicting sudden upturns. With DCA, "bad" months aren't really that bad, because you pick up more stock during those months to offset the "good" months when the stock price is back up. Even if you have a large lump sum to invest, like $10,000, consider breaking it up into 10 $1,000 investments spread over 10 months. It's much safer than trying to pick the exact right moment to invest everything at once.
Mutual funds are ideal for dollar-cost averaging. Many mutual funds allow investors to automatically deposit a set dollar amount each month. For beginning investors, this is perfect, because there's usually no minimum, and it's a great way to get into the habit of investing regularly.
But the real benefit of using DCA with mutual funds has to do with the fee structure. Most mutual funds charge a commission based on a fixed percentage of your investment, say 0.2 percent. So if you invest $50 every month in your mutual fund, you'll be charged 10 cents for the transaction. If you tried to do the same thing with stocks, you'd be charged $15 or $30 for that same $50 transaction, because stockbrokers get paid by the trade. So instead of paying 0.2 percent in fees, you're paying 30 or 60 percent.
In the next section, we'll explain how to build and maintain a balanced investment portfolio.
Step 5: Build Your Portfolio
Your investment portfolio consists of all of your individual investments in stocks, bonds, mutual funds, REITs and other instruments. The goal of any portfolio, whether you're just starting out or have decades of investing experience, is diversity. The idea is to invest in enough different sectors of the economy so that if one investment does poorly, your other investments will make up the difference. If you have too many of your eggs in one basket, you could end up magnifying your risk. A diversified portfolio spreads the risk evenly so that no single mistake will ruin everything.
As we mentioned in the previous section, the best investment strategy for new investors with limited funds is to invest in mutual funds using dollar-cost averaging. This allows for regularly scheduled, modest contributions without incurring substantial fees. The great thing about mutual funds is that they come in all flavors, meaning it's relatively easy to pick and choose a handful of mutual funds to create a diversified portfolio.
For most Americans, a diversified portfolio should include investments in five major areas
An easy way to invest in these different sectors is by investing in index funds. Index funds are mutual funds that are diversified across a particular sector.
For example, there are stock index mutual funds that invest in the 500 largest U.S. companies, closely tracking the performance of the S&P 500. There are bond index mutual funds that invest in a diverse mix of U.S. and foreign government bonds and corporate bonds. And there are real estate index funds that invests in several different REITs diversified across the residential and commercial sectors.
By investing in these types of index funds, not only do you achieve basic diversity across the five major sectors, but the investments within those five funds are also highly diversified. That's called covering your bases.
Now that you've built a diversified portfolio, you need to balance it. Even with diversified mutual funds, some investments are riskier than others. You need to work with your broker to come up with ratios that balance the risk among your investments and that make sense for the goals you established in step one.
For young investors, most of your money will go into stock index mutual funds, perhaps 35 percent in U.S. stocks and 25 percent in foreign stocks. The rest will be split among bonds, real estate and commodities; perhaps 15 percent each in bonds and real estate and another 10 percent in commodities.
The trick is maintaining this balance even as some sectors perform better or worse than others. With dollar-cost averaging, this is actually pretty easy. Let's say that last month your stock index fund performed poorly, but bonds did great. This will temporarily throw off the balance of your portfolio, because bonds will suddenly represent more than 15 percent of the total value of your investments.
Instead of selling off some of your bond investments to bring the ratio back to normal, you need to pump more money into stocks. At first, it sounds strange to invest more in the worst-performing sector of your portfolio. But based on the principles of DCA, you get more shares for your money and keep the average cost of the investment down over the long-term.
In the next section, we'll talk about the importance of sticking to your plan.
Step 6: Stick to Your Investment Strategy
The worst thing a beginning investor can do is to try to predict the future performance of the market and invest lump sums of money in the next "hot" sector. Between 1998 and 2002, for example, the S&P 500 index grew at a rate of 12.2 percent a year. But during that same period, investors in sector-specific mutual funds received annual returns of 2.6 percent [source: Jenkins].
The only solid investment strategy is a long-term strategy. If you try to time the market -- only buying when you think the market has bottomed out and only selling when you think it's peaked -- you'll have to guess correctly three out of four times to equal the success of an investor who uses dollar-cost averaging over a long period of time [source: Jenkins]. Those are tremendously steep odds, considering that even paid experts are blindsided by completely unexpected market fluctuations.
The idea is to stick to the plan, even if the plan changes slightly as you get older. The ratios of your portfolio will slowly shift into more conservative investments as you accumulate more and more wealth. When you're ready to retire, you'll have less money in stocks and more money in bonds, because you want to safeguard your money from any last-minute drops in the stock market. When you first started, you had less money to lose and more time to recover from adverse fluctuations. But when you're retired, it's more important to have guaranteed income from low-interest, low-risk investments.
With all this talk of sticking to the plan, don't forget that it's OK to change courses if part of the plan obviously isn't working. For example, say you've had a mutual fund for 10 years and every year it's lost an average value of 3 percent. At this point, it's probably a good idea to shop around for a different mutual fund in the same sector with a better annual performance record. The important thing is to keep these changes to a minimum and be able to tell the difference between a temporary dry spell and an all-out drought. Your broker should be able to help.
For even more information on investing and personal finance, follow the links on the next page.
Related HowStuffWorks Articles
More Great Links
- Janssen, Cory. Investopedia. "DCA: It Gets You In at the Bottom" http://www.investopedia.com/articles/01/090501.asp
- MSN Money. "A Beginner's Guide to Investing" http://moneycentral.msn.com/investor/beginnerguide.asp?page=introduction
- Jenkins, Richard. MSN Money. "Start investing with just $100" http://articles.moneycentral.msn.com/Investing/StartInvesting/StartInvestingWithJust100.aspx
- Kiplinger.com. "Control Your Risks" http://www.kiplinger.com/basics/archives/2007/08/investing3.html
- Kiplinger.com. "How to Start Investing." August 2007 http://www.kiplinger.com/basics/archives/2007/08/investing.html
- Fraud.org. "Investment Fraud." http://www.fraud.org/tips/internet/investment.htm
- McWhinney, Jim. Investopedia. "Dollar-Cost Averaging Pays" http://www.investopedia.com/articles/mutualfund/05/071305.asp
- Langager, Chad. Investopedia. "Start Investing with Only $1000" http://www.investopedia.com/articles/basics/06/invest1000.asp?viewall=1
- Investopedia. "10 Things to Consider Before Selecting an Online Broker" http://www.investopedia.com/articles/00/112100.asp
- Investopedia. "Advantages of Mutual Funds" http://www.investopedia.com/articles/basics/03/040403.asp
- The Motley Fool. "What Wrong with Full-Service Brokers?" December 21, 2007 http://www.fool.com/investing/brokerage/whats-wrong-with-full-service-brokers.aspx
- Investopedia. "Brokers and Online Trading." http://www.investopedia.com/university/broker/default.asp