Investing in the financial markets might sound like one of the scariest parts of managing your finances, but it’s also potentially the most rewarding. Major market declines such as those caused by COVID-19 concerns or the housing crisis can be frightening, and watching your investments shrink is not fun.
Despite these fears, investing in financial markets is one of the best things that Americans of any age can do to get on the road toward financial well-being. Investing helps you build a more secure future.
Here’s how you can start investing and enjoy the returns that can build you a better future.
Why investing is important
The sooner you begin investing, the sooner you can take advantage of compounding gains, allowing the money you put into your account to grow more rapidly over time. Your money earns money – without you doing anything. You’re looking for your investments to grow enough to not only keep up with inflation, but to actually outpace it, to ensure your future financial security. If your gains exceed inflation, you’ll grow your purchasing power over time.
Five things you can do to get started in investing
1. Look into retirement accounts
For many people, the best place to begin is your employer-sponsored retirement plan – likely a 401(k) – offered through your employer’s benefits package.
In a 401(k) plan, the money you contribute each paycheck will grow tax-free until you begin withdrawals upon reaching retirement age. Many employers even offer matching contributions up to a certain percentage for employees who participate in their sponsored plans.
These plans have other benefits, too, depending on which type of 401(k) plan you choose:
- A traditional 401(k) allows you to deduct your contributions from your paycheck so that you don’t pay taxes on it today, only when you withdraw the money later.
- A Roth 401(k) allows you to withdraw your money tax-free – after years of gains – but you have to pay tax on contributions.
Regardless of which option you choose, here are all the details on 401(k) plans.
Bankrate’s 401(k) calculator will also show you how much your money can grow throughout your career.
The logistics of a 401(k) can be confusing, especially for recent grads or those who have never contributed. Look to your employer for guidance. Your plan’s administrator – which is sometimes a big broker such as Fidelity, Charles Schwab or Vanguard – may offer tools and planning resources, helping you educate yourself on good investing practices and the options available in the 401(k) plan.
If your employer doesn’t offer a 401(k) plan, you’re a non-traditional worker, or you simply want to contribute more, consider opening a traditional IRA or Roth IRA. A traditional IRA is similar to a 401(k): you put money in tax-free, let it grow over time and pay taxes when you withdraw it in retirement. A Roth IRA, on the other hand, invests taxable income and then is not taxed upon withdrawal. There are also specialized retirement accounts for self-employed workers.
The IRS limits the amount you can add to each of these accounts annually, so be sure to stay within these rules:
- For 2020 and 2021, the contribution limit is set at $19,500 for 401(k) accounts (before employer match) and $6,000 for an IRA.
- Older workers (those over age 50) can add an additional $6,500 to a 401(k) as a catch-up contribution, while an IRA allows an additional $1,000 contribution.
2. Use investment funds to reduce risk
Risk tolerance is one of the first things you should consider when you start investing. When markets decline as they did during the coronavirus crisis, many investors flee. But long-term investors often see such downturns as a chance to buy stocks at a discounted price. Investors who are able to weather such downturns may enjoy the market’s average annual return – about 10 percent historically. But you have to be able to stay in the market when things get rough.
Some people want a quick score in the stock market without experiencing any downside, but the market just doesn’t work like that. You must endure down periods in order to enjoy the gains.
To reduce your risk as a long-term investor, it all comes down to diversification. You can be more aggressive in your allocation to stocks and bonds when you’re young and your withdrawal date is distant. As you inch closer to retirement or the date you’re looking to withdraw from your accounts, start scaling back your risk. Your diversification should grow more conservative over time so you don’t risk major losses in a market downturn.
Investors can get a diversified portfolio quickly and easily with an index fund. Instead of trying to actively pick stocks, an index fund passively owns all the stocks in an index. By owning a wide swath of companies, investors avoid the risk of investing in one or two individual stocks, though they won’t eliminate all the risk that comes from stock investing. Index funds are a staple choice in 401(k) plans, so you should have no trouble finding one in yours.
Another common passive fund type that can reduce your risk aversion and make your investment journey easier is a target-date fund. These “set it and forget it” funds automatically adjust your assets to a more conservative mix as you approach retirement. Typically they move from a higher concentration in stocks to a more bond-focused portfolio as you approach your date.
3. Balance long-term and short-term investments
Your time frame can change which types of accounts are most effective for you.
If you’re focusing on short-term investments, those you can access within the next five years, money market accounts, high-yield savings accounts and certificates of deposit will be the most useful. These accounts are insured by the FDIC, so your money is going to be there when you need it. Your return won’t usually be as high as long-term investments, but it’s safer in the short term.
It’s generally not a good idea to invest in the stock market on a short-term basis, because five years or less may not be enough time for the market to recover if there’s a downturn.
The stock market is an ideal vehicle for long-term investments, however, and can bring you great returns over time. Whether you’re saving for retirement, looking to buy a house in 10 years or preparing to pay your child’s college tuition, you have a variety of options – index funds, mutual funds and exchange-traded funds all offer stocks, bonds or both.
Getting started is easier than ever with the rise of online brokerage accounts designed to fit your personalized needs. It’s never been cheaper to invest in stocks or funds, with brokers slashing commissions to zero and fund companies continuing to cut their management fees. You can even hire a robo-adviser for a very reasonable fee to pick the investments for you.
4. Don’t fall for easy mistakes
The first common mistake new investors make is being too involved. Research shows that actively traded funds usually underperform compared to passive funds. Your money will grow more and you’ll have peace of mind if you keep yourself from checking (or changing) your accounts more than a few times each year.
Another danger is failing to use your accounts as they’re intended. Retirement accounts such as 401(k) and IRA accounts offer tax and investing advantages but specifically for retirement. Use them for almost anything else, and you’re likely to get stuck with taxes and an additional penalty.
While you may be allowed to take out a loan from your 401(k), not only do you lose the gains that money could be earning, but you also must pay the loan back within five years (unless it’s used to purchase a home) or you’ll pay a 10 percent penalty on the outstanding balance.
Your retirement account is meant to be used for retirement, so if you’re using it for another purpose, you’ll want to stop and ask yourself whether that expense is truly necessary.
5. Keep learning and saving
The good news is you’re already working on one of the best ways to get started: educating yourself. Take in all the reputable information you can find about investing, including books, online articles, experts on social media and even YouTube videos. There are great resources available to help you find the investing strategy and philosophy that’s right for you.
You can also seek out a financial planner who will work with you to set financial goals and personalize your journey. As you search for an adviser, you want to look for one who is looking out for your best interest. Ask them questions about their recommendations, confirm that they are a fiduciary acting in your best interest and make sure you understand their payment plan so you’re not hit by any hidden fees.
Generally, you’re going to have the least conflicts of interest from a fee-only fiduciary – one whom you pay, rather than being paid by the big financial companies.
Many people are a little leery of investing, but if you learn the basics, a sensible approach can make you a lot of money over time. Starting to invest can be the single best decision of your financial life, helping set you up with a lifetime of financial security and a happy retirement, too.