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Investing is one of the most productive ways to build wealth, simply because your money works for you.
Every dollar you put into a total stock market index fund immediately starts multiplying at a rate of 7% per year. That means that at the end of the year, you have $1.07. But why stop there? That extra 7¢ (which was completely free, by the way) turns around and starts making you even more money at a rate of – you guessed it! – 7% per year.
This nifty process is called compound interest, and it is hands down the single greatest mathematical discoveries known to man. And that’s saying a lot, because there are some pretty cool mathematical discoveries.
If you are new to investing and unsure about how to get started, you may have a few questions.
- What should I invest in?
- What are some tools I can use?
- Do I need to hire a financial planner?
With so many choices out there, it can be pretty daunting to decide how, where, and when to invest your money. But it is actually quite simple! You do not need to be an expert to invest, and you don’t even need to consult with an expert.
By taking advantage of simple tools, like your employer’s retirement plan, you have an easy and straightforward way to invest regularly and start building wealth.
Determining your asset allocation
While your primary goal in investing is to grow your bank account balance, you also want to minimize your risk. That’s just a fancy way of saying limiting fluctuations in the value of your investments.
This can go either way. Minimizing risk might limit the amount your investments drop when the market crashes, but it also limits the amount that your investments grow during a bull market.
Time matters more than timing
The key is finding a balance between investment growth and risk reduction that fits your personal goals and comfort level. The longer your investment period, the more aggressive you can be. This is because even if the market drops, your investments still have plenty of time to recover. Retirement investments would fit into this category.
On the other hand, if your investment horizon is only 5 years away, you will probably want to be more conservative. An example of this would be saving for a house down payment.
So what exactly do I mean by “aggressive” and “conservative?” We basically have two choices: stocks and bonds. The weight of each of these in your overall portfolio is called your “asset allocation.”
If you want to be more aggressive, you should own more stocks. If you want to be more conservative, increase your bond holdings.
I can’t tell you what your allocation should be – that’s your decision based on your own comfort level. I can tell you that you are probably better off investing 100% stocks, as long as your horizon is long enough and you don’t panic sell.
Personally, our investment accounts are currently 100% stocks, and our overall portfolio is about 75% stocks and 25% cash because we are saving for a house.
Choosing an investment vehicle
Stocks and bonds are referred to as “investment vehicles.” They aren’t your only choices, though. There are many others, such as real estate, cash, options, futures, CD’s, annuities…you get the idea.
But we will only focus on stocks and bonds. They are both straight forward and easy for non-experts (like you and me) to understand. For the required knowledge and amount of effort that it takes to invest in stocks and bonds, they provide great returns. It’s the easiest money you will ever make.
“But I’m not an expert! I don’t even know which stocks to choose.”
Well it’s your lucky day, because you don’t have to choose which stocks to invest in! Index funds follow the entire market, so if you own VTSAX (Vanguard’s Total Stock Market Index fund), you own stock in every publicly traded American company. The weight of each company reflects its market weight, so since Apple is the highest valued company in the U.S., you own more of Apple than any other company.
You can do the same thing with bonds using funds like VBTLX (Vanguard’s Total Bond Market Index fund).
Deciding where to invest
Your employer probably offers something like a 401(k) or a 403(b). If they do and you aren’t already participating in them, YOU SHOULD STOP EVERYTHING YOU’RE DOING AND SIGN UP RIGHT NOW*.
Most employers will match your contributions to a certain point, so for every dollar you put into your 401k, your employer puts in a dollar, too. Think of it as an immediate 100% return!
PLUS – all money that you contribute is tax-deferred, meaning that if you contribute $10,000 in a year, your federal taxable income is reduced by $10,000.
BUT WAIT THERE’s MORE – all contributions grow tax-free! This allows your investments to grow as efficiently as possible. (You do, however, have to pay income tax when you make withdrawals.)
Here is a brief overview of some of the most common employer-sponsored retirement plans.
- 401(k): This is the account available to employees of private sector, for-profit companies. Annual contributions are limited to $18,000, and the employee has control over choosing the investments.
- 403(b): These are most commonly used by public educators. Other employers use them as well, such as 501(c)(3) non-profit organizations. Instead of investing in mutual funds, 403(b)’s sometimes act as defined benefit plans that pay out a set amount at retirement based on the retiree’s tenure. The annual contribution limit is $18,000.
- 457: The 457 plan is basically the 401(k) for public sector employees. It has similar rules to a 401(k), such as an $18,000 annual contribution limit.
Invest in an IRA
If you don’t have access to an employer-sponsored retirement account or you want to take it a step further, you can open an IRA (Individual Retirement Account). Like a 401(k) and similar accounts, all contributions to IRA’s are tax-deferred, but limited to $5,500 per year. In an IRA, you have more choices for which funds to invest in because you get to choose which administrator to open one with.
You may also want to consider a Roth IRA. Instead of your contributions being tax-deferred, you pay taxes up front. However, you never have to pay taxes on those contributions or their earnings again.
The one downside to investing in retirement accounts is that, under most circumstances, you cannot withdraw money from them until you reach the retirement age of 59.5.
Invest in a taxable brokerage
If you desire more freedom than allowed by the tax-advantaged retirement accounts discussed above, you can also set up a taxable brokerage account. You don’t get any tax breaks here, though.
Bonus round: if you are currently enrolled in a high deductible health plan (HDHP) you can sign up for a Health Savings Account (HSA). The HSA offers great tax incentives and allows you to invest. You can learn more about HSA’s here. These are usually sponsored by your employer, but if not you can open one on your own.
The best time to invest is now
If you have the money, invest it now!
There’s no time like the present. -Someone Famous
If you are investing, you are in it for the long haul, so why should daily stock prices matter to you? Don’t get caught up in the financial media cycle that discusses intraday stock fluctuations. They don’t matter.
So, as long-term investors, we only care about the long-term growth of our investments. If the S&P 500 drops 1%, or 3%, or even 10% in a day, that shouldn’t faze you. You know that the market will recover, and over the next 30 years, your holdings of VTSAX will have increased at an average of 7% per year.
In fact, you don’t even need to follow the stock market at all. All you care about is the value of your money in 10+ years, so why submit yourself to the daily emotional rollercoaster?
Tracking your investments
Once you have everything set up and your contributions are on autopilot, it is a good idea to track your account balances. I don’t recommend that you follow it daily (see above) because the more you monitor your investments, the more likely you will be to interfere and try to tweak your allocation. Resist the urge! You cannot time the market, so don’t. Just don’t.
But you will want to compare your portfolio’s performance to an index, such as the S&P 500, on a monthly basis. For this account tracking, I recommend Personal Capital.
Personal Capital allows you to organize all your investment accounts in one place. Once you set up your account logins (which is encrypted), you can view all your transactions and balances in lots of nifty different ways.
- Want to see if your 401(k) is beating the Dow Jones Industrial Index? Head on over to the Investment tab!
- Wondering what percentage of your portfolio is allocated in the technology sector? You can do that, along with all the other sectors.
- Feeling proud of yourself and just want to marvel at how much your net worth has progressed? You’re set.
*There are certain situations in which you might not be very excited to invest in your employer-sponsored retirement plan, such as when administrative fees are painfully high. If that is the case, it is probably still worth it to contribute up to the company match, but no more. You should put that extra money in a low cost account, like an IRA through Vanguard.