ôô

10 Things Every First-Time Investor Should Know

Want to be a successful investor? Money Girl explains how to get started, build financial safety nets, use tax-advantaged accounts, choose investments, and reduce risk. Find out how to create the best investment strategy based on your financial situation, age, and risk tolerance.

By
Laura Adams, MBA
9-minute read
Episode #697
The Quick And Dirty

No matter if you're a seasoned or first-time investor, you may need to change your strategy to build as much wealth as possible. Use these essential tips to build a strong financial foundation and invest wisely without taking too much risk.

  1. Saving and investing are not the same thing.
  2. Build financial safety nets before investing.
  3. Invest sooner rather than later to turbocharge results.
  4. Diversify your portfolio to reduce risk.
  5. Take advantage of different types of investment funds.
  6. Invest through a workplace retirement account.
  7. There's a retirement account for everyone.
  8. Use tax-advantaged accounts.
  9. Ignore what you can't control.
  10. Get investing advice from a pro.

If you're like most people, you know investing money is a smart idea. But if you haven't gotten started because you think investing is too complicated or risky, it's time to learn how to invest without taking too much risk.

This episode will cover why it's essential to start investing as soon as possible and the different types of investments to choose from. You'll learn how to create the best investment strategy based on your financial situation, age, and risk tolerance.

Let's get into the details of how to be a successful investor.

Tip #1: Saving and investing are not the same

Before diving into what to know about investing, it's important to clarify that saving and investing are not the same. Saving is putting money into safe, low-yield accounts such as a bank savings account, money market account, or certificate of deposit (CD), so you preserve it.

Saving is the right move when you have short-term goals, such as buying a car or taking a vacation within a year or two. It's also appropriate for your emergency fund because it keeps your money completely safe. You know your cash reserve will be there when you need it.

However, investing is the right strategy for longer-term goals that you want to achieve in at least three to five years. They might include buying a home, paying for a child's college, and, of course, retiring. 

Investing requires some amount of risk, but without it, you aren't likely to earn enough growth to achieve significant financial goals, such as retiring.

With investing, you put money into financial instruments, such as stocks, bonds, or mutual funds, with the expectation of future growth. By using a buy-and-hold investing strategy, you increase potential returns over a long period. Investing isn't appropriate for short-term goals because market values can fluctuate wildly over a short period.

Investing requires some amount of risk, but without it, you aren't likely to earn enough growth to achieve significant financial goals, such as retiring. A good rule of thumb is to invest a minimum of 10% to 15% of your gross income for retirement every year.

Tip #2: Build financial safety nets before investing

While it's wise to begin investing as soon as possible, everyone's situation is different. First, clear up any dangerous debts, such as overdue taxes, child support, or accounts in collections. If you don't, they can cause you significant financial misery down the road.

Additionally, if you have high-interest credit card debt, consider paying it off as soon as possible. You'll get an instant rate of return by eliminating the monthly interest expense.

I mentioned savings, which is a critical financial safety net to have before investing money. Maintaining a cash reserve helps you manage unexpected expenses and hardships, such as a job loss, home repair, or medical bill.

A good savings target is three to six months' worth of your living expenses (such as housing, food, utilities, and debt payments). For example, if your living expenses total $3,500 each month, make a goal to build up a minimum of $10,500 in savings. Remember that stowing money in a savings account is acceptable for your short-term goals and emergency fund but is not appropriate for long-term financial goals.

Before putting money into investments, another safety net you need is specific insurance policies, such as health insurance. Making even a quick trip to the emergency room for an illness or accident could cost thousands of dollars.

While mortgage lenders require you to have home insurance, most renters don't buy renters insurance. It's an inexpensive policy that protects your belongings and liability, making it well worth the average cost of $185 per year nationwide.

And lastly, if you have family members who depend on your income, you also need life insurance to protect their financial futures. Getting a 10- or 20-year term life insurance policy for $500,000 may cost less than $300 a year if you're in relatively good health.

How to Create Foolproof Financial Safety Nets

Tip #3: Invest sooner rather than later for turbocharged results

The sooner you start investing, the more wealth you can build. Even if you don't have much money to invest, it's better to get started, so your money grows year after year. For example, consider two people who invest the same monthly amount and receive the same average annual return.

The first is Sarah, who begins investing at age 35 and stops at age 65. Over those 30 years, she invests $250 a month and receives an average return of 7%. When she's ready to retire, her account balance is less than $300,000.

The second investor is Matt, who begins investing at age 25 and stops at age 65. He also invests $250 a month and receives the same average return of 7%. But Matt ends up with approximately $622,000 after those 40 years.

By starting to invest ten years earlier than Sarah, Matt reaches retirement age with over $300,000 more to spend, even though he only invested $30,000 more than Sarah ($250 x 12 months x 10 years). Matt has a much higher account balance because his money had more time to compound and grow.

So, even if you don't have $250 a month to spare, start investing some amount right now. As you earn more money, you can invest more. And when you have a windfall, such as a cash gift, bonus, or tax refund, invest it, too.

Waiting for the perfect time to invest causes you to lose significant earnings. And trying to catch up later will be more challenging and costly.

Got Cash? What to Do with Extra Money

Tip #4: Having a diversified portfolio reduces risk

For the average investor, buying and selling individual securities or stocks isn't a wise strategy. That's because no one can predict with certainty whether their values will go up or down. While no other common investment outperforms stocks, their prices can be volatile, rising and falling throughout the day.

A better strategy is to invest in one or more diversified funds, which bundle investments, such as stocks, bonds, real estate, cryptocurrency, and many other types of securities, making them convenient for investors to purchase. They may focus on one investment asset class or a combination.

Investment funds are diversified because they're made up of hundreds or thousands of underlying securities. Diversifying allows you to earn higher average returns while reducing risk. If some of the securities within a fund lose value, some will hold steady or increase in value, which minimizes your potential losses.  

Since the 1920s, the historical average return of the stock market has been approximately 10%. So, if you have decades to go before you retire, consider investing a large percentage of your portfolio in stock funds. Stock prices will indeed fluctuate during the short term, but prices are likely to increase over the long term, giving you an excellent return on your investment.

But even if you only earned an average 7% return on your investments, you'd have a nest egg worth just over $1 million after investing $400 a month for 40 years.

But even if you only earned an average 7% return on your investments, you'd still have a nest egg worth just over $1 million after investing $400 a month for 40 years. If you chose to put money in a savings account instead, by saving $400 a month for 40 years with a 0.5% return, you'd end up with just $212,000.

However, if you're close to retirement or already retired, taking a more conservative approach is essential to minimize risk. A good rule of thumb to get an idea of how much stock you should own, subtract your age from 100 or 110.

For example, if you're 30, consider owning at least 70% to 80% of your investment portfolio in stocks, with the remaining 20% to 30% in bonds, real estate, and cash to take advantage of as much growth as possible. If you're 60, you should be more conservative. You might want from 40% to 50% in stocks and 50% to 60% in less-risky assets (such as bonds) to preserve your wealth. 

Tip #5: Take advantage of different types of investment funds

In addition to stock funds, there are different types and categories of funds you should be familiar with. Here are a few you're likely to see on a typical investment menu for a retirement plan or brokerage account:

Mutual funds are a collection of assets managed by a fund professional. Buying and selling shares in a mutual fund are restricted to the end of the trading day when the fund's net asset value gets calculated.

Exchange-traded funds (ETFs) are similar to mutual funds in that they are baskets of assets. However, they trade like individual stocks, meaning you can buy or sell ETF shares throughout the day and should expect price fluctuations. 

Index funds are mutual funds that usually come with low fees and may be made up of thousands of underlying investments. Index funds aim to match or outperform a specific index, such as Standard & Poor's 500 Index or Dow Jones Industrial Average.

Target date funds are mutual funds that automatically reset the mix of assets in their portfolio according to your set time frame, such as when you plan to retire.

Be aware that funds come with different fees, which are known as an expense ratio. For example, a 1% expense ratio means that 1% of the fund's assets will get used for paying yearly expenses, such as management and advertising. In general, it's best to choose lower-cost funds, such as ETFs and index funds, to avoid unnecessary costs that eat away at your returns.

Tip #6: Invest through workplace retirement accounts 

When you purchase investments using a retirement account, such as a workplace 401(k) or 403(b), you accumulate wealth for retirement and get terrific money-saving tax benefits. Most employers offer both traditional and Roth accounts, which have different rules and advantages.

Traditional accounts allow you to defer paying tax on both contributions and earnings until you make withdrawals in the future. Roth accounts, such as a Roth 401(k) or Roth 403(b), require you to pay tax upfront on your contributions, but provide you with tax-free withdrawals upon retirement. Note that you can choose either type no matter how much you earn.

Workplace retirement accounts are even more valuable if your employer pays matching contributions. For example, your company may match your contributions up to a limit, such as 3% of your salary. If you earn $60,000 and contribute $1,800 (3% of salary) per year, your employer would add $1,800 a year or $150 per month to your retirement account. Pretty sweet!

But even if you don't get employer matching, it's wise to max out your workplace retirement account every year. For 2021, you can contribute up to $19,500 or $26,000 if you're over age 50.

Your elected retirement plan contributions get deducted from your pay automatically, making it easy to invest consistently. Plus, if you leave your job, you can transfer your vested balance into an IRA by doing a tax-free rollover.

Tip #7: There's a retirement account for everyone

But what if your employer doesn't offer a retirement plan? Or you're a stay-at-home spouse or self-employed as a freelancer or solopreneur? Yes, you can invest using a retirement account, too.

Everyone with earned income (even minors) qualifies for a traditional IRA. You make pre-tax contributions and defer taxation until you make withdrawals in retirement. There are no income limits to qualify. If you're married and file taxes jointly but have no income, you can invest in a spousal IRA based on your spouse's income.

For 2021 you can contribute up to $6,000 or $7,000 if you're over age 50 to a traditional IRA. The annual contribution limit is the same for a Roth IRA, but it comes with a qualifying income limit. For 2021, you must earn less than $140,000 as an individual taxpayer or $208,000 as a married couple filing jointly to make Roth IRA contributions.

With a Roth IRA, you must pay tax upfront on your contributions but can make tax-free withdrawals of both your original contributions and account earnings in retirement. Using any Roth account makes sense when you believe your taxes in retirement will be higher than they are now.

In addition to investing through a traditional or Roth IRA, you have more account choices when you're self-employed. Two popular accounts are a SEP-IRA and a solo 401(k). They're similar to a traditional IRA but have higher contribution limits, such as up to $58,000, based on how much you earn.

Tip #8: Use tax-advantaged investment accounts

If you like the idea of cutting your current or future taxes, don't stop with retirement accounts. Here are a couple more money-saving tax-advantaged accounts:

  • 529 college savings plan allows you to invest in a menu of options for qualified education expenses for yourself, a child, or another close family member. You must pay tax on your contributions, but your earnings grow tax-free. Then you can take tax-free withdrawals to pay costs including private school (up to $10,000 per year), college tuition, room and board, computer equipment, books, and supplies.
  • Health savings account (HSA) is available when you're enrolled in a high-deductible, HSA-qualified health plan. You might purchase the coverage through a group plan at work, the federal or state health insurance marketplace, a health insurance website, or an insurance broker. With an HSA, you can make tax-deductible contributions (up to an annual limit) and invest in a menu of options. Your withdrawals are entirely tax-free when used for eligible healthcare expenses, which is a terrific benefit!

No matter which types of tax-advantaged investment accounts you use, it's a good idea to automate your contributions and increase them slightly each year. That will help keep you on track to reach your financial goals.

Tip #9: Ignore what you can't control 

Drops in the stock market are uncontrollable, so don't drive yourself crazy by focusing on unavoidable actual or potential losses when it comes to your investments. Instead, stay focused on building wealth over the long term using a buy-and-hold strategy.

What happens in the financial markets day-to-day only matters if you need to liquidate your investments during the same period. In other words, ignore media hype and stock tips from friends and never make rash decisions, such as selling your investments when their value drops. Your goal should be to get investment growth over decades, not month-to-month or even year-to-year.

Your goal should be to get investment growth over decades, not month-to-month or even year-to-year.

Tip #10: Get investment advice from a pro

The money you invest today will grow and ultimately support you after you stop working or change your lifestyle in retirement. If you're unsure how to choose investments, don't hesitate to seek advice from your benefits department at work, an account representative, or an independent financial advisor.

And if you don't understand a financial professional's explanations or recommendations, keep asking questions until you do. You'll be glad you did, especially when you build a healthy nest egg that gives you peace of mind and financial security in the future.

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.