You know that you’re “supposed” to be investing, but what does that mean exactly? It’s not like investing is something that’s taught in school, so it’s normal to have a lot of questions when you first get started.
- What should I be investing in?
- What kinds of accounts should I use?
- Isn’t the stock market really risky?
- I have no idea what I’m doing here. What if I make a mistake?
It can all feel pretty overwhelming, to the point that you may be hesitant to get started. But the truth is that good investing is actually pretty simple. In fact, there are only a few investment decisions that actually matter, and each of them is simple enough that anyone can make them well.
In this post we’re going to go in-depth on the only 7 investment decisions that matter so that you can focus on what’s important, ignore everything that isn’t, and use investing as a powerful tool for reaching your most important long-term goals.
Decision #1: What you’re investing for
Before you make any actual investment decisions, it’s a good idea to clearly define what exactly it is you’re investing for. That is, what specific goal are you trying to achieve and when will you need the money for that goal?
It’s really the second part of that question, when you need the money, that’s the key here. Because there’s a real difference in how you should approach investing for a short-term goal vs. a long-term goal.
If it’s a short-term goal (money you’ll need within a few years, like for a house down payment), the rest of your decisions are actually pretty easy. You’re probably best just putting the money into a savings account, CD or other conservative investment. The return you’ll earn over such a short time period won’t make much of a difference and this way you’ll know the money will be there when you need it.
Then you can simply decide how much money you’ll need, divide it by the number of months you need it, and VOILA! You have your monthly savings target. Automate that amount into a savings account and your short-term goal is handled.
Longer-term investment goals give you a little more flexibility. With more time to ride the ups and downs of the stock market and make adjustments as needed, you have the opportunity to take on a little more risk and reach for better returns.
For the rest of this post, I’ll assume you’re deciding how to invest for a long-term investment goal like retirement/financial independence, since that’s where the real decisions are.
Decision #2: How much you save
People love to talk about how to get better investment returns. They want to talk about what the market’s doing, what stocks look good, or what their investment strategy is, all in the name of getting the best returns possible.
But here’s the truth: NONE OF THAT MATTERS. Well, it does a little bit, but not much. In fact, the returns you earn over the first 8-10 years of investing barely have any impact on the amount of money you end up with. That may sound funny, but it’s true.
What DOES matter, a lot, is the amount of money you save. It may not be quite as sexy as talking about returns, but for that first decade of your investing life the simple act of saving more will have a MUCH bigger impact on your eventual success than trying earn better returns.
All of which means two simple things:
- Since your early returns won’t have much of an impact on your end result, it doesn’t actually matter how good you are at investing when you first start.
- All that matters is that you get those contributions going as soon as possible.
So how much should you save?
Lucky for you, I have a simple calculator that helps you answer that exact question. You can find it here: Retirement Planning The Easy Way.
If you can’t save that amount right now, just do what you can and increase it slowly over time. Maybe you can increase your savings rate by 1% every 6 months, or put half of every raise towards savings (or both!). Slow and steady increases will have a big impact over time.
The important thing is that you start saving as soon as you can. Nothing else is more important to your long-term success.
Decision #3: Where you save
The government has created certain types of savings accounts with built-in tax advantages, and the more you can take advantage of these accounts, the better. The tax breaks make it easier for you to save more money today AND allow that money to grow faster, both of which will help you reach your long-term goals sooner.
If your company has a retirement plan, like a 401(k), 457(b) or 403(b), that’s a good place to start. And if you’re offered an employer match, then that’s DEFINITELY the place to start. That match is a guaranteed return on investment you won’t find anywhere else, so you’ll want to contribute at least enough to get that full match before looking at other options.
Above and beyond that employer match, you have some more options.
But if the investment options there aren’t good, opening an IRA is another great option. An IRA is a lot like a 401(k) but you open it on your own instead of getting it through your employer. And one of the big advantages is that you can invest in pretty much whatever you want. There are some restrictions on IRA contributions if you participate in an employer plan though, so you’ll want to check those out first.
There are two different types of IRAs, Roth and Traditional, with different types of tax benefits. Which one is best for you really depends on the details of your situation as well as a lot of unknown variables about the future, but here is a series of posts that can help you figure it out:
- Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors
- 5 Reasons a Roth IRA Might be Right for You
- 3 More Unconventional Reasons to Contribute to a Traditional IRA
One of the OTHER big benefits of contributing to an employer plan or IRA is that your contribution may qualify you for an additional special tax credit called the saver’s credit. Not everyone is eligible, but you could actually get up to $2,000 back at tax time just for contributing to a retirement account. Pretty cool!
There’s one last tax-advantaged place to save that doesn’t get a lot of press, but can actually be even more powerful than any of the other options we’ve talked about so far: a Health Savings Account (HSA). When it’s used right an HSA is the only account that can give you a triple tax break: a current deduction, tax-free growth AND tax-free withdrawals. Here’s a good post summing up exactly how it works: An HSA – The Ultimate Retirement Account.
Finally, once you’ve exhausted all those tax-advantaged accounts, you can always open a regular old taxable brokerage account and invest in there just like you would in a 401(k) or IRA.
So, to recap quickly, here are your best options for where to put your long-term money:
- Health savings account
- Regular taxable account
Decision #4: What kinds of things you invest in
There’s a fancy investment term you’ll hear used a lot called asset allocation. But all it really means is how you divide your money up between different types of investments.
There are a lot of different types of things you could invest in, but there are two that are most important:
- Stocks – A stock is a piece of ownership in a company. Investing in stocks give you the highest potential return but also the biggest variability in what returns you actually receive.
- Bonds – A bond is actually a loan you give to a company. In exchange they pay you interest (just like you would on your own loans) and eventually pay back the full amount you loaned them. Bonds are more conservative investments than stocks, with a smaller expected return but also less variability.
The most important decision you’ll make here is what percent of your money you invest in stocks, and what percent you invest in bonds. The more you put towards stocks, the higher your potential return, but the more you’ll lose when the market goes through one of its eventual drops.
Conventional wisdom is that younger investors should put more in stocks (around 90%) because they have more time to weather the ups and downs. But when I work with clients, I actually encourage them to start more conservatively.
My reasoning is simple. Your asset allocation decision is only part science. The science says that you want to invest some significant portion of your long-term money in the stock market, since that’s where the best long-term returns come from.
But the other part of this decision is emotional, and this is an important consideration that shouldn’t be ignored. I generally think it’s a good idea to start a little more conservative, wait until you’ve lived through a market crash, see how you feel and how you react when it’s happening, and re-evaluate after that. That way, you avoid having too much money in the stock market, losing more than you’re comfortable losing, and being scared away from the whole thing.
As an example, my personal asset allocation is 70% stocks and 30% bonds, even though conventional wisdom would have me closer to 90% stocks. It’s a level of risk I know I can live with even when the stock market tanks.
A good rule of thumb is to be comfortable losing 50% of whatever you have in stocks in a given year. So if you’re asset allocation is 70% stocks, you might see a 35% loss in any given year (though you would also expect to recover that over time).
So when it comes to deciding on your own asset allocation, there are two big takeaways I’d like you to keep in mind:
- Don’t be afraid to invest in the stock market. Yes, there will be ups and downs. But the stock market is also where you’ll find the best long-term returns, which will make it easier to reach your goals.
- BUT don’t feel like you have to follow the conventional wisdom and go super-aggressive either. It’s okay to start a little more conservatively and make adjustments as you gain experience.
Decision #5: How you diversify
Here’s another fancy investment term that you’ll hear a lot: diversification. And just like asset allocation, this one can be explained pretty simply: don’t put all your eggs in one basket.
Here’s the deal. Investing is a constant balance between risk and return. 99.9999% of the time, it’s impossible to get higher returns without taking on more risk (meaning the chance that you won’t actually get those returns). Anyone who promises otherwise is either misinformed or is trying to mislead you.
Diversification is simply the practice of spreading your money out over a lot of different investments instead of just a few. And there are a number of different ways you can do it.
One is by investing in different types of things, like stocks and bonds. That’s really the asset allocation question from above.
But you can also diversify within those bigger categories. For example, instead of buying the stocks of just a few companies, you can invest in the entire stock market. And you can go even further by investing in both the US stock market AND international stock markets as well. You can do the same kind of thing with your bonds as well.
And the best part is that you don’t have to invest in a lot of different funds to be diversified. By using index funds, it’s actually possible to invest in the entire US stock market, all international stock markets, the entire US bond market and all international bond markets with just a single fund. Or 4 funds at the very most.
Diversification is quite literally the ONLY way to decrease your investment risk without decreasing your expected return AND it’s pretty easy to do. Might as well take advantage of it!
Quick note: For more step-by-step guidance through creating your personal investment plan, check out the guide Investing Made Simple.
Decision #6: How much you pay
Here’s a surprising stat for you: if you’re trying to predict how well an investment will perform going forward, the single most important variable you can look at is how much it costs.
The reason why is pretty simple too. Every dollar you pay in fees is a dollar that isn’t earning returns and isn’t helping you reach your goals. The less you pay, the more money you actually have invested.
There are a number of different types of fees to watch out for, and this post goes in-depth on all of them, but here’s a quick rundown:
- Expense ratio: The cost of owning a mutual fund or ETF. Every fund will have an expense ratio, though some will be much lower than others.
- 12b-1 fees: Another cost of owning a mutual fund, but not all of them have it. Usually it’s best to avoid funds with these fees.
- Loads: A commission paid to a salesman when you buy or sell a mutual fund. Not all mutual funds have this.
- Transaction costs: The cost to buy or sell a stock, mutual fund, ETF, etc. These costs can come up both when YOU make a trade to buy or sell something, and also when a mutual fund you own makes its own trades.
- Taxes: If you’re investing in a retirement account like a 401(k) or IRA, you don’t have to worry much about taxes. But if you’re investing in a taxable account there can be tax consequences every time you make a trade. And if you own a mutual fund that makes a lot of trades, those trades can have tax consequences for you as well.
Decision #7: How well you stay the course
Deciding on your investment strategy and putting it in place is just the start. The real challenge lies in sticking with your plan when everyone else around you is freaking out.
There will be times when the stock market is going up, up, up and you’ll be tempted to get more aggressive with your investments to take advantage.
There will be other times when the stock market is crashing you’ll feel like you need to get out before all your money is gone.
Here’s the thing: those big ups and downs are simply a normal part of investing. They’ve happened hundreds of times before and they will continue to happen for as long as investing is a thing you can do.
The best investors know that those ups and downs are coming. They choose their asset allocation with those big swings in mind, taking only as much risk as they’re comfortable with.
And then, when the stock market makes one of its big moves and everyone else is freaking out, they do nothing (other than simple rebalancing).
Warren Buffett is famous for saying that “Benign neglect, bordering on sloth, remains the hallmark of our investment process.” If the greatest investor we’ve ever seen strives to mostly do nothing, it’s probably a good idea for the rest of us as well.
There are a million other things you could worry about when it comes to investing, but the 7 things above are the only ones that really matter.
As you work to make your own investment plan, remember that your personal goals are the only goals that matter. If you keep the focus on making “good enough” decisions in these 7 areas and tune out the rest of the noise around you, you’ll be well on your way to making those goals a reality.
Quick note: If you’d like more in-depth, step-by-step guidance through creating your investment plan, check out the guide Investing Made Simple.