Investing is not just something for stock market gurus and rich people. It’s an important part of your financial journey and essential for building long-term wealth.
Fortunately, you don’t need a lot of money to start investing. But you’ll need to understand the basics to be able to develop a plan and stick to it over time.
How to invest your money
Everyone’s financial situation is different. How you invest depends on your unique circumstances and the financial goals you pursue. Before you dive in, make sure you have a good sense of your financial life and understand your income level, what you own and what you owe, and what your expenses look like.
Once you’ve mastered these basics, you’re ready to begin the investing process. Here are some tips on how to invest your money now.
1. Identify your goals
Before you start investing, take a moment to think about your short- and long-term investment goals. The time frame for the goals will help determine which investments are most suitable for you.
- Short term goals: buy a car, buy a house, make plans for children, go on vacation, build an emergency fund
- Long term goals: retirement, financing your children’s education, purchasing a holiday home
Goals can vary from person to person. What is a short-term goal for some may be a long-term goal for others. In general, short-term goals are for things you expect to accomplish in the next three years or less, while long-term goals are likely for things that are at least three years away, and probably longer.
You’ll want to be more conservative when investing for short-term goals than long-term goals because you don’t have as much time before you need the money. On the other hand, long-term goals allow you to take more risks because you have more time to make up for any losses.
2. Choose your investment strategy
There are a number of different layers to choosing your investment approach, and both revolve around the extent to which you want to be involved in the management of your investments.
First you need to decide whether to engage a financial advisor (traditional or robo) or whether you will handle things yourself. If you decide to manage your own portfolio, you will also need to decide whether to choose individual investments (active) or select broad funds that track indexes (passive).
Let’s take a closer look at these options:
- Traditional financial advisor: A traditional advisor guides you through the investment process, helping you set goals, determine your risk tolerance and create an investment plan. You’ll probably check a few times a year to make sure you’re on the right track, but other than that you don’t have much to worry about. The downside is that traditional advisor fees can be about 1 percent of your total assets, which eats into your returns over time. However, some of the best financial advisors charge less.
- Robo-advisor: A robo-advisor offers a different solution and by automating much of the process, costs are typically well below those of traditional advisors. You answer a series of questions to identify goals and risk tolerance, but then your portfolio is built using the robo-advisor’s algorithms. You may also get features like automatic rebalancing and tax loss harvesting.
- Active: If you choose to go your own way, you will need to decide whether you want to identify individual investments that will outperform the rest of the market, or whether you want to take a passive approach and match the overall market returns. Although an active approach is attractive, it is difficult to outperform the market in the long term. You need to spend a lot of time following stocks and other types of investments, and you also need to be highly educated on the markets.
- Passive: A passive approach will make sense for most people and involves investing in funds that track broad market indexes, such as the S&P 500. This approach helps minimize costs and ensures that more of the market return goes to you instead from to the fund managers. You also don’t have to worry about tracking the daily movements of your portfolio. Index funds are as close to a “set-it-and-forget-it” approach as investing.
3. Choose an investment account
In order to invest, you need an investment account with which you can make transactions. There are several types of investment accounts, but most people will be covered by only a few. Some have tax benefits that come with certain rules, while taxable accounts are simpler. Most of these accounts can be opened for free with online brokers such as Schwab, Fidelity or E-Trade.
Here are some of the most common investment accounts.
- 401(k): Many people have a 401(k) retirement account through their job. These accounts allow you to make contributions directly from your paycheck and the money is regularly invested in various funds. Your employer may even offer a matching contribution, which you should maximize before investing in other accounts.
- Traditional IRA: An IRA is a different type of retirement account, but it offers more investment options than a 401(k) plan. In traditional IRAs, contributions are tax deductible, but you pay taxes on distributions during retirement. If you withdraw the money before retirement age, you will pay a penalty.
- Roth IRA: Roth IRAs are similar to traditional IRAs, but contributions are made with after-tax dollars, meaning you don’t get a tax deduction now, but you won’t pay taxes on distributions during retirement. Financial experts say a Roth IRA is one of the best investment accounts to have because it creates a tax-free pool of money that you can use during your retirement.
- Brokerage account (taxable): You can contribute as much as you want to an investment account and access the money at any time. But you pay taxes on the capital gains you generate. Brokerage accounts are good for long-term goals that may not be as far away as retirement.
- Education savings account: These accounts are designed to help you save for education expenses. A 529 plan is a popular account used to save for college that allows your money to grow tax-deferred and withdrawn tax-free as long as it’s used for qualified expenses. Coverdell ESAs also offer tax benefits and can be used for college, elementary, or secondary education expenses.
4. Select investments that match your goals and risk tolerance
Once you’ve opened an account with an online broker or robo-advisor, it’s time to start investing. You want to choose investments that match your chosen investment goals, and make sure you understand the risk profile of each investment.
Here are some of the most popular investments you can choose from:
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Stocks: Stocks represent an ownership stake in a publicly traded company, and you make money over time based on the success of that company. Stock prices can be quite volatile, so they are best for long-term goals like retirement. They have great growth potential, but are quite risky in the short term.
- Investment funds and ETFs: With these funds you can invest in a basket of securities, such as shares or bonds. Spreading risk across a larger number of investments reduces the risk of the portfolio and provides diversification through the purchase of a single fund. Mutual funds and ETFs have a lot in common, but ETFs trade like stocks throughout the day, while mutual funds trade only at the end of the day based on net asset value (NAV).
- Bonds: Bonds are debt instruments that allow governments and companies to borrow money to finance their activities or certain projects. Investors receive interest payments on their bonds and receive their principal at the bond’s maturity date. Bonds are considered less risky than stocks because they tend to be less volatile and higher in the capital structure, meaning they are paid before shareholders.
- Property: Investing in real estate can provide diversification benefits to your portfolio by adding an asset beyond stocks and bonds. While you can buy a house or rental property, you can also invest in real estate funds or real estate investment trusts (REITs).
As you build your portfolio, keep diversification in mind so you don’t get too much exposure to any one investment. If you’re young and your goals are still far away, your portfolio will likely lean toward growth-oriented investments, such as stocks and equity funds. As you get closer to your goals, portfolio allocation should shift to less risky assets, such as fixed income securities. Consider using target date funds, which automatically shift the fund’s allocation as you get closer to the fund’s target date.
In short
Investing can be confusing if you don’t know where to start. Everyone’s circumstances are different, which means what’s right for you may not be right for someone else. Take the time to evaluate your goals and choose what works best for you. Investing is the best way to build long-term wealth and achieve your financial goals.
Note: Dori Zinn contributed to an earlier version of this story.
