Investing your money is one of the best ways to build wealth and save for your future goals. But because most people's goals and preferences are unique, how they invest varies. Building an investing strategy usually relies on the same basic principles and requires building good financial habits.
Learn how to invest money wisely to meet your goals.
Set Goals and Start Investing
The first step of any investment plan is to set goals. Think of it as a road trip: Your goal is to get to your final destination, and your investment plan is the route you’ll take to get there. Many people start investing as a way to save for retirement. You can also invest to save for other big goals like your child’s education, future medical expenses, or the down payment on your dream home.
When you’re just getting started, simple is better. You hear plenty of finance experts argue that the best strategy is a boring one. That usually means researching and buying a stock or fund and letting it grow for a long time.
Types of Investments
Before you begin, it helps to know what kind of investments are out there and what you can expect from them. There are a few basic types to know about if you are new to investing.
A stock is a piece of ownership (“equity”) of a business. Some stocks are not available to the public (called "private stocks"), while many more are publicly traded on the exchanges. Companies sell stock as a way of raising funds for operating and capital expenses. If you buy stock in a company, you can make money in two primary ways:
Other bonds do not pay interest. You buy them for a percentage of the face value, then receive the full value when it matures. These are called "zero-coupon bonds." You can make money through regular interest payments and selling a bond for more than you paid for it.
Some of the most popular investments on the market are funds, which combine many stocks or bonds (or both). Here are the primary types of funds:
- Passively managed funds (indexed mutual funds): A pool of investments that passively tracks a particular market index, such as the S&P 500 or the total stock market.
- Actively managed funds (mutual funds): An actively managed investment pool where a fund manager hand-picks the holdings, often hoping to beat the overall market performance.
- Exchange traded funds: These are similar to an index fund or mutual fund. However, ETFs can be traded during and after trading hours, while index and mutual funds can’t.
Manage Your Risk Levels
A bond is a type of debt security that allows companies and government agencies to borrow money. One way they do this is to sell you a bond. Some bonds have a face value and an interest rate (called a "coupon"). The rate can be set or variable. The interest is paid over the life of the bond (often twice per year). Then, when the bond reaches maturity, the issuer pays back the principal amount to you.
Anytime you invest, you take on a certain level of risk. Make sure that when you begin that that you understand the risk each asset brings with it. Then, learn how to set up your portfolio in a way that reduces your risk exposure.
- Dividends: When a corporation periodically passes on some of its profit to its shareholders.
- Capital appreciation: When the value of an asset grows over time, becoming worth more than you bought it for.
The first thing to consider when choosing your asset allocation is your risk tolerance. This is how willing you are to lose money in exchange for a greater possible reward. In most cases, there’s a correlation between the risk and return an investment brings. The higher the risk, the greater the return often is. Lower-risk investments tend to have smaller returns.
Everyone has their own risk tolerance. It is important that you build an investment portfolio you’re comfortable with. Keep this in mind as you choose your assets. If you’re using a robo-advisor, it’ll ask you about your risk tolerance and choose investments that reflect it.
Your cash doesn’t have to sit around waiting to be invested. Instead, consider putting it into a high-interest savings account or money market fund to get a modest return on the money you aren’t ready to invest.
Below are a few steps you can take to help mitigate risk in your portfolio.
Diversification is when you spread your money across different investment types. The more diversity in your portfolio, the less impact the performance of a single investment has on the rest of it.
The first way you can diversify is to invest across asset classes. For instance, you might invest in stocks, bonds, real estate, and cash equivalents to ensure that your money isn’t all in a single class. That way, if the stock market is doing well, but the bond market is doing poorly, your overall portfolio is still growing.
The other way you can diversify is within asset classes. For example, you would invest in many different stocks or a stock market index fund instead of buying stock in just one company.
Dollar-cost averaging refers to making recurring contributions to your investments no matter what’s happening in the market. Many people use dollar-cost averaging without realizing it, by making monthly contributions to a 401(k) plan at work.
Rather than trying to time the market, dollar-cost averaging follows the theory that the market continues to grow over the long term.
Core-satellite investing is a strategy designed to reduce costs and risk while also trying to outdo the market. This strategy involves having a “core” of investments in your portfolio. These are typically passively managed index funds.
The rest of your money would go into actively managed investments. These funds make up the satellites. The core portion of your portfolio helps to reduce volatility, while the satellites work to achieve higher returns.
Cash on Hand
No matter your investment strategy, experts generally recommend keeping at least some of your money in cash or cash equivalents. That is because cash doesn't respond to downturns in the market. If you’re saving for a goal that’s just a few years away, you won’t have to worry about losing your investment just before you need it.
Cash isn’t entirely without risk. When you keep cash in savings, your money isn’t growing because interest rates are historically low. Because the Federal Reserve's target inflation rate is 2%, you can expect your money to lose value over the years. With that in mind, consider making cash just a part of your overall investment strategy.
DIY Investing vs. Professional Management vs. Robo-Advisors
Many people choose to hire a financial advisor to help manage their investment portfolio. These advisors either charge a fee (often a percentage of your portfolio’s value) or make a commission on the products they get you to invest in.
You can also manage your investments and hand-select where to put your money. This requires quite a bit of time and desire to learn, both of which are hard to come by.
The most modern way to carry out your plan is to use a robo-advisor. This is an automated digital investment advisory program, a financial service that chooses your investments on your behalf. It bases the investments on the answers you gave to questions about your investment goals, risk tolerance, time horizon, and more. Robo-advisors generally charge lower fees than human advisors, and you don't need to choose your investments.
Take Advantage of Compounding
There’s a common investing phrase that says, “time in the market beats timing the market.” In other words, you’re better off consistently putting money in the market and letting it grow vs. trying to time the market for bigger returns. This concept fits hand-in-hand with the dollar-cost averaging strategy above.
The reason that time in the market makes such a big difference is that your returns can compound.
Compounding is the interest earned on the interest that is added to your principal every period.
Let’s say you invested $200 per month from the ages of 25 to 35. After the age of 35, you never contribute another dollar, but you let your money continue to grow. We'll assume a return of 10%, which is the average for the stock market. Your investment of $24,000 will turn into more than $676,000 by the time you reach age 65.
But what if you invested the same amount of money later in life? If you contribute the same $200 per month over 10 years but don’t start until age 55, your investment would grow to just $38,768. As you can see, time in the market can make hundreds of thousands (or even millions) of dollars.
Minimize Your Taxes and Costs
The more of your investment that goes toward taxes and fees, the less you have left to help you reach your goals. While the percentages may seem small, remember that your investments compound. Money that goes to taxes and other expenses isn’t compounding, which costs you a lot more in the long run.
The first investment expense to watch out for is taxes. Taxes are unavoidable and have a purpose; that doesn’t mean you should pay more than you have to. One of the best ways to save money on taxes is to invest in tax-advantaged accounts. You might have heard of them: 401(k)s, individual retirement accounts (IRAs), 529 plans, and health savings accounts (HSAs).
The other types of expenses to be careful of are fees that you pay to invest. Common fees include advisor fees or expense ratios on funds.
Luckily, it’s easy to reduce these fees. Many people opt for a robo-advisor or stock trading app to manage their investments. These tend to have lower costs than a human advisor.
You can also look out for the fees each investment has. Mutual funds have higher fees because they're actively managed. Index funds are passively managed; they often have significantly lower expense ratios.
Check on Your Money
Even the most passive strategy cannot be set up and forgotten about. It’s vital to review what you have regularly, to check performance, adjust your strategy for your goals, and rebalance as needed.
Think about setting a reminder for every six to 12 months to review and adjust your portfolio as needed.
Rebalancing is the adjustment of your investments to return your portfolio to the asset allocation you want to keep. Certain investments grow more quickly than others, so they’ll expand to take up a greater portion of your portfolio.
For instance, you might decide to allocate your portfolio to 75% stocks and 25% bonds. Stocks usually have a higher return. As they grow, they’ll make up an increasingly larger portion of your portfolio. To rebalance, you would sell off some of your stock and reinvest that money into bonds.