Find out how to choose the best investments to create financial security without taking too much risk. Money Girl cuts through the confusion with six dos and don’ts that make it easy to invest successfully and with confidence.
A common question I receive is how to choose the best investments. Most people want to build wealth for the future, but they also don’t want to lose money.
The reality is that not taking enough investment risk might actually be the riskiest move of all! That’s because you could fall short of your goals or run out of money during retirement.
Taking calculated investment risk is an important part of your financial life. Without it, your money won’t grow fast enough to achieve your long-term goals.
But if you’re not sure which investments will create financial security without taking too much risk, it can be difficult to get started. In this post, I’ll cut through the confusion with six dos and don’ts that make it easy to invest with confidence.
6 Dos and Don’ts for Choosing the Best Investments
- Do invest small rather than not at all.
- Don’t pick individual stocks.
- Do choose diversified investment funds.
- Don’t take too much risk.
- Do invest through a tax-advantaged account.
- Don’t be afraid to ask for investment help.
Here’s more detail about each of these key investing dos and don’ts.
1. Do invest small rather than not at all.
Before you do any investing, your first financial priority should be to accumulate some amount of emergency savings. That’s how you avoid getting into financial trouble if you have a large, unexpected expense or you lose your job or business income.
Ideally, everyone should have a minimum of three to six months’ worth of their living expenses tucked away in an FDIC-insured bank savings account. If that seems unattainable, start by saving a reasonable amount, such as $500 or $1,000. Then work on building your emergency savings at the same time you invest for the future.
Getting in the habit of investing sooner, rather than having to invest more money later, is the secret to investment success.
Getting in the habit of investing sooner, rather than having to invest more money later, is the secret to investment success. Investors who start late usually have to make huge financial sacrifices to accumulate enough money to reach their goals—or they’re forced to work much longer than they want to.
It doesn’t matter if you can only put away small amounts each month; not getting started right now is a costly mistake. So, if you’ve been putting off investing because you think you don’t have enough money to make a difference, think again.
If you can invest $500 a month for 20 years with an average 8% return, you’ll have almost $300,000. But investing $150 a month for 40 years with the same return would give you $500,000. And doubling that to $300 a month for 40 years would give you $1 million. My point is that investing smaller amounts for longer periods of time can really pay off.
Once you’ve got some emergency savings, the ideal amount to invest for retirement is at least 10% to 15% of your gross income. Consider investing a monthly obligation to yourself, no different than a bill with a due date.
If you think that amount is more saving and investing than you can afford, start tracking your spending carefully. Measuring your cash flow is the first step to freeing up more money that you can set aside to create security for your future.
2. Don’t pick individual stocks.
You’ve probably heard that you should invest in stocks. A stock is an intangible asset that gives you a small amount of ownership in a company, such as Apple or Johnson & Johnson.
Buying just one share of stock makes you an instant business owner without having to invest your life savings or take on all the risk.
There are many advantages to investing in stocks. One is that you don’t need as much money to buy them as you do for other assets such as real estate or businesses. Buying just one share of stock makes you an instant business owner without having to invest your life savings or take on all the risk.
Although there’s no guarantee that every stock will increase in value, since 1926, the average large stock has returned nearly 10% a year. Over the long term, no other type of common investment performs better than stocks. So, if you’re investing for a long-term goal such as retirement, stocks are likely to give you the growth you’ll need to achieve it.
But the downside to investing in individual stocks is that prices can be volatile. The value of a stock can skyrocket or plummet in an instant as trading volume fluctuates due to breaking news, earnings forecasts, and quarterly financial statements. This is why stocks are one of the riskiest investments to own in the short term.
So, how do you own stocks in order to achieve growth without the risk of buying individual stocks? Keep reading to learn about the importance of diversification.
3. Do choose diversified investment funds.
The trick to owning stocks while limiting their risk is to own many of them. New investors are often surprised to learn that it’s better to own more investments than less. This is a common investing strategy called diversification.
Diversification allows you to earn higher average returns while reducing risk because it’s not likely that all your investments could drop in value at the exact same time. For instance, if you put your life’s savings into one technology stock and it tanks, you’re in trouble.
But if that stock only makes up a fraction of your portfolio, the loss is negligible. Having a mix of investments that respond differently to market conditions is the key to smoothing out investment risk.
Don’t get me wrong, diversification isn’t a guarantee that you’ll make a killing with your investments. However, it makes it likely that as some investments go down in value, others will go up.
So how do you become diversified, exactly? The simple solution is to invest in funds instead of individual investments.
Funds bundle combinations of investments, such as stocks, bonds, real estate, and other securities into packages that are convenient for investors to buy. They have built-in diversification because they’re already made up of many underlying investments. Some funds focus on one asset class only, such as stocks, and others may have a mix of assets.
Every investor should own a stock-based fund, such as a stock mutual fund, a stock index fund, or a stock exchange-traded fund. The products are made up of hundreds or thousands of individual stocks, giving you convenient, inexpensive, and baked-in diversification.
4. Don’t take too much risk.
There’s one rule of investing that you should always remember: Never expose your money to more risk than is absolutely necessary to accomplish your goals. While investing in a diversified stock fund helps cut risk, everyone’s risk tolerance and financial goals are different.
I like to think about investing as a scale that goes from extremely conservative to extremely risky. The conservative end is comprised of cash, such as FDIC-insured bank savings accounts and certificates of deposit (CDs). They don’t earn much, but your money is completely safe.
As I previously mentioned, stocks are on the risky end of the scale. And the middle includes investments such as bonds, which are loans made by an investor to a borrower.
The mix of stocks, bonds, cash, and other assets you may choose is known as asset allocation and it’s a powerful factor in your investment returns.
The mix of stocks, bonds, cash, and other assets you may choose is known as asset allocation and it’s a powerful factor in your investment returns. How you divide your money among asset classes should depend on your risk tolerance and when you expect to spend the invested money.
A good way to approach your ideal allocation is to figure out how much stock you should own. Here’s an easy shortcut: Subtract your age from 100 and use that number as the percentage of stock funds to own.
For example, if you’re 40, you might consider holding 60% of your portfolio in stocks. If you tend to be more aggressive, subtract your age from 110 instead, which would indicate 70% for stocks. But this is just a rough guideline that you may decide to change.
You could allocate your stock percentage to a variety of stock funds or put it all into one stock fund. The remaining amount would be in other asset classes such as a bond fund and cash.
What’s important to remember about asset allocation is that it should change over time. Take advantage of as much growth as possible in the early years by investing mostly in stocks. You’ll have plenty of time to recover from market losses. By the time you move into retirement, you should own fewer stocks and have more in bonds and cash to preserve the wealth you’ve worked so hard to accumulate.
If you want a super simple way to adjust your asset allocation, choose a target date or retirement fund. These are highly diversified, one-size-fits-all solutions that include a mix of asset classes. They automatically rebalance the ratio of risky and conservative investments over time, so you become less aggressive as you approach your desired retirement date.
You’ll know a target date fund because it typically includes a year in the name, such as Retirement 2030 Fund or Target Date 2055 Fund. The date is supposed to match the year you want to retire.
5. Do invest through a tax-advantaged account.
Now that you understand the importance of diversification and asset allocation when choosing investments, you might be wondering where you should invest. If you have a retirement plan at work, such as a 401(k) or 403(b), your choices are easy because there’s a pre-selected menu of investment funds.
The names of the funds will vary depending on the brokerage firm your employer uses, such as Fidelity, Vanguard, or Merrill Lynch. But funds are usually grouped together as stock or growth funds and bond or income funds. You may also see a category called balanced funds, which hold a combination of stocks and bonds.
Let’s say you want to invest 80% in stocks. You could choose one or several stock funds that add up to 80% of your contribution. The remaining 20% could go into one or more bond funds. Or, as I just covered, you might choose one target-date fund.
Employer-sponsored plans make investing really convenient because contributions are automatically deducted from your paycheck before you see them. Plus, they give you tax benefits that save money. Additionally, many employers encourage participation by matching your retirement contributions up to a certain amount, such as 3% of salary.
If your job doesn’t offer a retirement plan or you’re self-employed, you can open an Individual Retirement Arrangement or IRA. They also provide a menu of investment options or suggest a portfolio based on your age or stated risk tolerance. You can set up recurring deposits that transfer funds from your bank account.
Just remember that you’re typically charged a 10% early withdrawal penalty if you take money out of a retirement account before age 59½. Roth IRAs give you the most flexibility for withdrawals, but it’s wise to leave them untouched for as long as possible so you get maximum growth.
Free Resource: The Retirement Account Comparison Chart is a handy, one-page resource to understand the different types of retirement accounts. Click here to download the PDF!
6. Don’t be afraid to ask for investing help.
Just about every investment firm offers free advice. But studies show that a surprisingly low percentage of retirement plan participants take advantage of the offer.
If you’re not sure how to choose investments at work or for a retirement plan you manage on your own, don’t be shy about asking for help. If you don’t understand what an advisor recommends, push back and ask for more detail.
Setting up your accounts and automating contributions is a powerful step in the right direction. Years from now when you’ve got savings and investments to fall back on or to fund the lifestyle of your dreams, you’ll be really glad that you took control of your financial future.
Get More Money Girl!
To connect on social media, you’ll find Money Girl on Facebook and Twitter. Also, if you’re not already subscribed to the Money Girl podcast on Apple Podcasts or the Stitcher app, both are free and make sure that you’ll get each new weekly episode as soon as it’s published on the web. The show is also on the Spotify mobile app! Click here to sign up for the free Money Girl Newsletter!
Woman Choosing Golden Egg image courtesy of Shutterstock