Every now and then, a news story circulates about a custodian or teacher or secretary who amassed millions of dollars, usually by investing in the stock market. They’re inspirational stories that can get you suddenly determined to jump into the market, too. And it’s not a bad idea.
In order to invest in stocks, first you need to open a brokerage account. Then you can start investing to help you reach your financial goals, such as retirement, sending your kids to college, or buying a home. But how do you know when you’re even ready to invest? First, you should have a robust emergency fund and little or no credit card debt. You need an investing strategy and a financial plan, too, so you know how much to sock away each month, and what growth rate to expect from your investments.
Here’s a quick review of 12 steps to help you get started investing:
- Get ready to invest
- Know what to expect
- Have a plan
- Open a brokerage account
- Make it simple — with index funds — or aim higher
- Consider dividends
- Really understand any individual stocks you buy
- Keep your commission costs in check
- Don’t over- or under-diversify
- Avoid common blunders
- Assess your holdings — and yourself — regularly
- Keep learning
Step 1: Get ready to invest
You may not be quite as ready to invest as you think you are. Here are a few questions you should answer first:
- Are you carrying high-interest-rate debt? Having a manageable mortgage at a low interest rate shouldn’t be a problem, but if you owe thousands on a credit card that charges 20% or 25% interest, that’s a big problem — even if you aren’t looking to invest. Owing, say, $20,000 and being charged 25% (a typical rate) means you’re forking over $5,000 annually just for interest alone! Get out of debt as soon as you can using a repayment strategy that works for you.
- Do you have an emergency fund? Financial emergencies, such as a job loss or a costly medical expense, don’t just happen to other people. Aim to keep about six to nine months’ worth of living expenses in an accessible place such as a money market account or a savings account. When adding up what that amount looks like, be sure to include money for housing, food, transportation, utilities, taxes, insurance, and everything else you absolutely have to pay for should you lose your job. And whenever you tap this fund, be sure to refill it so that it’s fully available to support you when needed.
- Will you be investing long-term money? Making money in stocks the most dependable way is a marathon, not a sprint. Over the long run, great wealth can be built. Over the short run, a lot can be lost if you suddenly need to sell some holdings for cash right after the market temporarily swoons. Thus, be sure to only invest with money you don’t need for at least five years — or, to be more conservative, 10 years. Be sure your dollars have the time they may need to recover from a market downturn.
Step 2: Know what to expect
Next, you have to know what to expect with stock investing. For example, if you’re investing in some individual stocks you’ve chosen, expect some of them to disappoint you, losing ground instead of gaining it.
Even your best performers are likely to rise via a jagged line instead of one that goes straight up.
More specifically, you should expect reasonable returns.
You’re not likely to enjoy average annual gains of 25%, and you very likely will not be doubling your money every other year.
Over many long periods, the stock market has averaged annual returns of around 9% to 10%, but in some years, it can surge 20% or more.
It can drop by 20% or more, too.
The table below shows how much you might amass over time with a slightly conservative annual average growth rate of 8%. It’s also demonstrating the power of compounded growth — where not only does your original investment grow, but your earnings on that investment also grow, generating earnings of their own.
Meanwhile, if a stock (or mutual fund) has surged mightily over the past year, don’t expect that kind of performance to continue. It might, for a short while longer, but the security might retract instead, or it might just grow more slowly.
Step 3: Have a plan
Now that you have your finances in good shape and know what to expect, you need a retirement plan. Without one, you might be saving and investing much more than you need to — or much less.
Most of us need to save for retirement. You’d do well to take some time to figure out how much money you need for retirement and how you will amass it. You might start by estimating how much annual income you’ll need or want in retirement. Then list your expected income streams — the ones you already have and ones you can set up.
Say you’ll need $60,000 annually in retirement, and you expect to have $25,000 coming to you from Social Security a year, so you only need to come up with the difference — $35,000. (By the way, the average Social Security retirement benefit was recently $1,470 per month, or about $17,640 over a year.) You might use the the 4% rule as a rough guide to help you figure out how big of a nest egg you’ll need in order to generate $35,000 per year.
The rule says that if you withdraw 4% of your nest egg in your first year of retirement and adjust that sum for inflation in subsequent years, your money should last 30 years. So, invert that 4%, and you’ll get 25 (100 divided by 4 is 25). Multiply $35,000 by 25, and you’ll arrive at a needed nest egg of $875,000.
Now think about how much you can manage to save and invest annually in order to amass your needed sum. The next table shows what a difference there is between different amounts saved annually:
One good strategy is to invest a certain sum regularly, no matter what the economy is doing. That’s called dollar-cost averaging, and here’s how it works: Imagine that you’re aiming to invest $10,000 annually in the stock market.
You might sock away $833 per month in stocks, which will total $10,000. If the market swoons, your $833 will go further, getting you more shares as prices will be depressed. And if the market surges, you’ll get fewer shares. But by sticking to the system, you’ll keep adding shares, no matter the price. That’s a good way to keep your emotions out of the process.
Step 4: Open a brokerage account
You need to have at least a rudimentary understanding of investing before you start parking your money in stocks — and you’ll also need a financial account in which to do your investing. That will probably be an account at a good brokerage. (A brokerage is a company that facilitates the buying and selling of assets such as stocks for its customers.) Some banks or other financial services companies offer brokerage services, so you may be able to open a brokerage account through a company with which you already do business.
Depending on the brokerage, you can open an account online, over the phone, and/or in person. Once you have your brokerage account, you can fund it with money and then proceed to buy and sell stocks, mutual funds, or other securities.
You can open a regular, taxable account, and/or a tax-advantaged account such as a traditional IRA or a Roth IRA.
Step 5: Make it simple — with index funds — or aim higher
Investing can be terribly complicated, but it doesn’t have to be. You can keep things super simple by sticking with inexpensive broad-market index funds, such as ones that track the S&P 500 index of 500 leading American companies. There’s no shame in that, either — even guru Warren Buffett has recommended index funds for most investors.
Index funds are mutual funds or exchange-traded funds (ETFs) that track various indexes of stocks or other securities. In other words, an index fund will buy and hold the same securities in a given index and will thereby be able to offer its investors roughly the same return (less fees, which tend to be quite low).
An index fund is a “passive” one, as there isn’t much decision-making involved — just copying an index. “Active” funds, on the other hand, are run by managers buying and selling securities based on their research and convictions. Index funds based on a wide swath of the stock market have a long history of outperforming stock mutual funds managed by Wall Street pros. According to Standard & Poor’s, as of the end of 2018, 85.1% of large-cap stock funds underperformed the S&P 500 over the past 10 years, with 91.6% underperforming over the past 15 years.
A handy low-cost broad-market index fund is the SPDR S&P 500 ETF (NYSEMKT:SPY), which distributes your assets across 80% of the U.S. stock market. The Vanguard Total Stock Market ETF (NYSEMKT:VTI) or the Vanguard Total World Stock ETF (NYSEMKT:VT) will, respectively, have you invested in the entire U.S. market, or just about all of the world’s stock market. By investing in an index fund, you’ll earn just about what the index does. It’s a great way to earn close to the overall market’s return — very easily.
If you want your portfolio to have a shot at an above-average performance, you can add some individual stock holdings to it and/or some managed mutual funds. But know that you shouldn’t invest in individual stocks (and many mutual funds) unless you can (and will!) spend time studying them and keeping up with them; reading many quarterly reports, annual reports, and news reports; and crunching some numbers.
The next few sections will offer some guidance for investing in individual stocks.
Step 6: Consider dividends
It’s important to understand just how valuable dividend-paying stocks can be in your portfolio, whether you’re a new investor or a seasoned one. Understand that when a company generates profits, there are a lot of things it can do with that money, such as buy more advertising, hire more workers, build new factories, pay off debts, and so on. It can also pay out a dividend to shareholders. That can provide welcome income to investors — especially those in retirement.
Dividend-paying stocks aren’t sleepy investments just for older people, though: “Over the past 30 years, dividends from S&P 500 stocks have, on average, contributed exactly half of the index’s total return on an annual basis,” according to State Street Global Advisors. Since 1970, they’ve contributed 77%.
Here’s more: Researchers Eugene Fama and Kenneth French studied data from 1927 to 2014 and found that dividend payers outperformed non-payers, averaging 10.4% annual growth vs. 8.5%. The table below shows the difference between those growth rates over long periods:
Remember, too, that healthy and growing companies tend to make their dividend payments regularly, no matter how the economy is doing. (If a company reduces or eliminates its dividend, that’s a red flag requiring a closer look. The company is likely to be in trouble.)
Step 7: Really understand any individual stocks you buy
It’s not enough to just add dividend payers to your portfolio, trusting in the power of dividends. With any company you invest in, dividend payer or not, you need to have a solid understanding of exactly how it makes money, and you should have a good grasp of its competitive strengths and challenges, too. Some companies and industries are easier to comprehend (think shampoos or shoes) than others (such as biotechnology or financial services), and even superinvestor Warren Buffett long avoided many technology stocks because he saw them as being outside of his circle of competence.
Consider Google parent Alphabet (NASDAQ:GOOGL). It’s not good enough to just know that the Google search engine is its main business, and a huge one. Alphabet has a bunch of other operations, too, such as YouTube, Android, Chrome, its cloud computing platform, and the Google App store. On top of that, it has a host of “moonshot” ventures, some of which might become major profit generators, including:
- Access (formerly Google Fiber, offering broadband)
- Calico (anti-aging research)
- CapitalG (late-stage venture capital investments)
- GV (early stage venture capital investments)
- Nest (Internet of things, connected-home technology)
- Verily (health data technologies)
- Waymo (self-driving vehicles)
- X (early-stage experimental research)
Step 8: Keep your commission costs in check
As you invest, keep commission costs in check. Most brokerages will charge you a fee for every buy or sell order that you have executed. Fees generally range from around $5 to $15, but in some situations, you may be charged nothing, and some brokerages might charge you $25 or more. In general, aim to have your commission expense be no more than about 2% of the value of your trade. So with a $3,000 trade, you’d spend no more than $60 on commissions, and no more than $10 with a $500 trade. If you trade very infrequently, though (which tends to be much more effective than frequent trading), you can pay less attention to commission costs.
Step 9: Don’t over- or under-diversify
Most of us know that our investments should be diversified. If your portfolio consists of shares in just one or a handful of companies, you have too many eggs in too few baskets. If one of those eggs breaks (stocks can plunge in value sharply), your whole portfolio will take a big hit.
Owning 50 or 100 (or more) stocks is problematic, too, though — because if one of them soars, it won’t have too much of an impact on your overall portfolio. Also, the more you own, the harder it is to keep up with and follow each holding. For most, owning 10 to 20 different stocks is reasonable.
You should diversify by industry, too — you don’t want to have 70% of your portfolio in only a few industries. It’s also good to include some international diversification in your portfolio; some big U.S. companies with sizable foreign operations can fit the bill, too, and there are many of those, such as Coca-Cola, IBM, Ford, ExxonMobil, Amazon.com, Nike, McDonald’s, and Wal-Mart.
Step 10: Avoid common blunders
While you strive to do all the right things — or as many as possible — remember to avoid making investing errors, too. Here are some common ones:
- Investing in penny stocks. Penny stocks — those trading for less than about $5 apiece — attract many new investors because they like the idea of being able to buy, say, 5,000 shares of a stock for just $500. (That reflects a per-share price of just $0.10, which is not unusual in the penny-stock world.) Unfortunately, these stocks are often tied to unproven, unprofitable, and sometimes shady companies, and they’re also frequently very volatile and easily manipulated by scammers. Lots of money has been lost on penny stocks. It can be hard to believe, but a $100-per-share stock can be a bargain, while a stock priced at just $0.50 per share is not likely to be a bargain and can easily fall to $0.01 per share, or lower.
- Trading too frequently. Those who buy into stocks without much conviction can easily get their heads turned by new stocks they learn about, and that can result in a lot of buying and selling. It happens if investors are impatient, too, not realizing that many great wealth-building stocks will take years to triple or quadruple in value. Trading frequently will generate a lot of commission costs and can leave you facing higher taxes, too, as short-term gains are typically taxed at a higher rate than long-term gains (from assets held for more than a year).
- Trying to time the market. Finally, avoid, market timing — where you get in and out of the market based on whether you think it’s heading up or down. Don’t believe investing gurus who tell you the market is about to crash or soar, because no one can really know such things. Some gurus are right on occasion, but not consistently. Many people end up sitting on the sidelines, waiting to get back into a recovering market, and miss major gains. The late index fund pioneer John Bogle said, “Sure, it’d be great to get out of stocks at the high and jump back in at the low, [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I’ve never met anybody who had met anybody who knew how to do it.”
Step 11: Assess your holdings — and yourself — regularly
Once you fill your portfolio with stocks and/or funds, it doesn’t end there. You can generally leave index funds for many years without paying them much attention, but you should be keeping up with and following the progress of your non-index mutual funds and individual stocks.
Ideally, you’ll do so at least quarterly. Check out their quarterly financial reports, look up what management teams have been saying about their funds’ or companies’ performance and strategy, and read any stories in the news about the funds or companies. If there are big developments, such as new product launches, shrinking sales, lawsuits, or major leadership changes, you’ll want to know about them.
Reallocate your assets periodically, too. If you want to have 75% of your portfolio in stocks and 25% in bonds, and you start out that way, a few years later, your stocks may have grown to make up 85% or 90% of your portfolio — because, on average, stocks tend to grow faster than other kinds of securities.
You can rebalance your portfolio by selling some stocks and buying more bonds to get back to your desired proportions. Meanwhile, within your stock portfolio, if any stock(s) have grown so much in value that they’re now making up a big chunk of your portfolio, you may want to pare back those holdings and redistribute the money. (Note, though, that great wealth is often built by letting great stocks continue growing — so stay invested with a meaningful sum, as long as the company is healthy and growing and you retain confidence in it.)
Assess your own performance regularly, too. Remember that you can roughly match the overall market’s return by just investing in an index fund, so if you’re aiming for more than that and you’re not succeeding over several years, consider just sticking with index funds. That’s still an effective way to build wealth.
Step 12: Keep learning
Finally, keep reading and learning about investing to refine your strategies over time and end up with better results. Read good business and investing books, including those by The Motley Fool, and articles on Fool.com. Find some great investors, understand their investing strategies and styles, and study up on what makes a great business succeed over time. Ideally, you’ll notice things that great investors and great businesses have in common. Read up on psychology, too, as our own biases can trick us into making bad money moves. Learning how to be more rational in your money management can really pay off.
Investing can be an involved endeavor requiring lifelong learning — or you can keep it very simple, just investing regularly in one or more low-cost, broad-market index funds. Either way, you can do very well over time, but you have to get started.
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Source: The Motley Fool