You know that you’re “supposed” to be investing, but what exactly does that mean?
Investing isn’t something that’s taught in school and any Google search will lead to a lot of conflicting information, so it’s normal to have 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 where you may be hesitant to get started.
But the truth is that good investing is actually pretty straightforward. In fact, there are only seven investment decisions that truly matter and each of them is simple enough that anyone can make them well.
Decision #1: What you’re investing for
Before you make any actual investment decisions, it’s a good idea to clearly define what 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 earn over such a short time period won’t matter much either way and, more importantly, with a savings account you 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 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 that you’re deciding how to invest for a long-term investment goal like retirement or financial independence, since that’s where the real decisions are.
Quick note: Setting goals, especially long-term goals, can be difficult. Here’s a step-by-step process you can follow to make it a little easier and more fun: A Life-Centered Approach to Setting Financial Goals.
Decision #2: How much you save
People love to talk about how to get better investment returns. They talk about what the market’s doing, what stocks look good, and what their investment strategy is, all in the name of getting the best investment return possible.
But here’s the truth: NONE OF THAT MATTERS.
Well, it does a little bit, but it’s pretty minimal when you’re just starting out. In fact, the return you earn over the first decade of your investment life, good or bad, barely has 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 the simple act of saving more money will have a MUCH bigger impact on your eventual success than trying to earn better returns.
In fact, you can cut decades off your working life just by increasing your savings rate a few percentage points.
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 contribute as much as you can 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: How Much Should You Be Saving for Retirement/Financial Independence?
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 investment accounts with built-in tax advantages, and the more you can take advantage of these accounts, the better.
Quite simply, the tax breaks offered by these accounts give you two big advantages over other types of accounts:
- The tax deductions allow you to fit bigger contributions into your budget
- The tax-free growth allows your money to grow faster
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 maximizing your employer match, you’ll have to make some choices from a variety of options.
If your employer plan offers good, low-cost index funds, then it often makes sense to keep putting extra money there until you reach the maximum annual contribution limit ($18,000 for 2017, or $24,000 if you’re 50+).
But if the investment options there aren’t good, opening an IRA is often the next best choice.
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, giving you full control over both your investment strategy and the costs associated with it.
One thing to keep in mind before going this route is that participating in an employer retirement plan can restrict your ability to contribute to an IRA once your income reaches a certain point. That’s something you’ll want to double-check.
Assuming you’re eligible to contribute though, you’ll have to make a choice about which type of IRA to use: a Roth IRA or a Traditional IRA. They offer different types of tax benefits and the right one for you depends both on the details of your situation and on a lot of unknown future variables, but this guide can help you figure it out: Traditional vs. Roth IRA: The Unconventional Wisdom.
One of the OTHER big benefits of contributing to an employer plan or IRA is that your contribution may qualify you for an additional 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 your retirement accounts. Pretty cool!
There’s one last tax-advantaged place to save that doesn’t get a lot of press, but can 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 provides a triple tax break: a tax deduction for contributions, tax-free growth, AND tax-free withdrawals.
Here are two posts that explain how the HSA works and how to find a good one:
Finally, you can consider both the Backdoor Roth IRA and the Mega Backdoor Roth IRA if you’ve already maxed out the accounts above and/or you make too much to contribute to an IRA through regular avenues.
And if you’re self-employed, there are a number of self-employed retirement accounts to consider as well, some of which allow you to contribute a lot of money each and every year (the Solo 401(k) is usually my favorite).
So, to recap quickly, here are the tax-advantaged investment accounts that typically help your money grow faster than the alternatives:
- IRA, either through regular contributions or one of the backdoor strategies
- Health savings account
- Solo 401(k)/SEP IRA/SIMPLE IRA if you’re self-employer
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 do 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 it shouldn’t be ignored.
I generally think that it’s a good idea to start a little more conservatively, 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 investing altogether.
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 your 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 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.
- 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.
Here’s a complete guide to choosing an asset allocation, including a short questionnaire that will help you decide: Asset Allocation: What It Is, Why It Matters, and How to Get It Right.
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% of the time, it’s impossible to get higher returns without taking on a greater risk of not actually getting those returns. Anyone who promises otherwise is either misinformed or trying to mislead you.
But there IS one way to lower your risk without lowering your expected return (only one!), and it’s called diversification.
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 stock in 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 with your bonds.
And the best part is that you don’t have buy all of those individual stocks or invest in a ton of different mutual funds to be diversified. 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.
In other words, diversification is both easy AND the only way to decrease your investment risk without decreasing your expected return. Might as well take advantage of it!
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. Every dollar you pay in fees is a dollar that isn’t earning returns and therefore 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. It’s usually 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 them.
- Transaction costs: The cost to buy or sell a stock, mutual fund, ETF, etc. These costs can arise 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 has seemingly been going up forever and you’ll be tempted to invest more aggressively 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: both the big ups and the big 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 these 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 taking.
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 you as well.
Quick note: Want more detailed investment advice, including step-by-step guidance through the process of creating your personal plan? Check out this guide: Investing Made Simple.
Investing really is that simple
As you work to create and maintain your own investment plan, you’ll get a lot of conflicting advice coming from a lot of different directions. It will probably feel confusing and overwhelming at multiple points along the way.
Try to remember that most of it is nonsense. Because while there are a million things you could worry about when it comes to investing, the seven decisions above are the only ones that really matter.
If you keep your personal goals at the forefront, make “good enough” investment decisions along the way, and tune out the rest of the noise, you’ll be in good shape.