- Understanding how to invest begins with the fundamentals, like what you want to achieve, getting started early, and leveraging the magic of compound interest.
- Choose from several types of investments such as stocks, bonds, mutual funds, exchange-traded funds (ETFs), etc.
- Consider the importance of diversification and your risk tolerance. Consult a financial advisor if you'd like professional guidance.
Knowing how to invest is a valuable skill to have. In some situations, it may mean the difference between amassing just enough and experiencing financial freedom.
However, learning how to start investing may be overwhelming — especially at first. There are many different paths you can take, strategies to utilize, and potential pitfalls to watch out for.
Here are the basics of investing and what you need to know to get started.
Understanding Investment Basics
Investing is the purchase of an asset with the intention that it will appreciate in value or generate income. An asset could be a legal obligation (such as a bond or share of stock) or a physical object (such as gold or a rental property).
Why Investing Is Important
Investing gives you the opportunity to build wealth over time. Compared to holding cash, investing has the potential to make your money multiply several times over.
Financially, this is critical for two main reasons:
- It enables the possibility to accumulate more wealth than you may have been able to save on your own.
- It puts you in a better position to keep up with inflation
These aspects may help you to achieve all kinds of future financial goals, such as buying a home, being able to retire, sending your children to college, starting a business — anything that is on your list of goals and dreams.
The Magic of Compound Interest
Many investments are rooted in the power of compound interest. This is when you make money on both your contributions as well as any previous earnings over time.
For example, suppose you invested $500 per month and got an average return of 10%. How much money would you have after 30 years?
The answer: Your contributions of $180,000 would have the potential to grow to approximately $986,982.[1]
Where did the additional $806,982 come from? That's from compound interest. Those are earnings upon earnings that have grown over time.
The Value of Investing Early
Because of the way compound interest works, it’s important to learn how to start investing as soon as possible. The earlier you begin, the more time your money has to potentially grow and snowball in value.
Common Investing Misconceptions
Despite what you may have heard, investing is not just for the already wealthy. People from all walks of life may benefit from investing because it gives them the opportunity to produce earnings beyond what they get from their paychecks.
Investing also does not necessarily require large sums of money. Thanks to lower minimum requirements by many financial institutions, you might get started with as little as a few dollars.
Finally, investing is not necessarily the same as day trading. Many investors have a long-term mindset, placing priority on multi-year trends over speculative short-term gains. They also tend to be more cautious, making risk mitigation a part of their investment strategy.
Types of Investments
One of the more important aspects of how to invest is knowing which types of assets to purchase. Here are a few popular options.
Stocks
Stocks, also called equities, are shares of ownership in a company that entitle you to a certain percentage of a company's profits. Shares of publicly traded businesses may be openly bought and sold on the stock exchange.
While there is always a potential risk that any of these companies may experience financial hardship, many often are profitable and produce annual returns for their shareholders.
Bonds
Bonds, or fixed-income securities, pay a fixed rate of interest over a specified period of time. They may be issued by the U.S. Treasury, corporations, local municipalities, or other agencies.
As instruments of debt, bonds are generally considered to be more stable relative to stocks. However, because they can be traded in the open market, their value (and yields) may fluctuate over time.
Mutual Funds
A mutual fund is a diversified collection of investments. Rather than buying individual stocks, bonds, or other assets, you (along with thousands of other investors) may purchase shares of a mutual fund that holds these investments for you.
Mutual funds can be either:
- Active - A professional fund manager makes investment decisions about what assets to hold, when to trade, etc.
- Passive - The fund mirrors a predetermined benchmark, such as the S&P 500 stock market index.
Because mutual funds come in many different shapes and sizes, their potential for risk and reward may vary. Investors might find a spectrum of funds that focus on everything from low-risk government bonds to ultra-aggressive stocks and alternative assets.
ETFs
Like mutual funds, ETFs package multiple investments into a single security. However, because of their structure, they are traded in the open stock exchange like a stock. This makes them more accessible to investors but may also carry some additional risk to the share price.
Many ETFs are passive by nature, mirroring major benchmarks. As a result, their expenses may sometimes be lower than those of mutual funds.
Retirement Accounts
Retirement accounts are special types of investment accounts with unique tax-savings benefits. Examples include:
- Employer-sponsored plans such as the 401(k), 403(b), and 457(b)
- Individual retirement accounts (IRAs), such as the traditional IRA and Roth IRA
- Self-employed retirement accounts, such as a SEP IRA, Solo 401(k), and SIMPLE IRA
Many of these accounts allow participants to invest across a variety of mutual funds, ETFs, and other assets. However, they usually will not permit you to take money out of your account before age 59-1/2 without paying a 10% early withdrawal penalty.
Education Accounts
Education accounts are tax-advantaged investment accounts designed to help you save for college or continuing education. One popular option is a 529 plan — a state-sponsored account that grows tax-free as long as the proceeds are used for higher education expenses.
Real Estate
Investing in real estate can take many forms. You might own a property outright, such as a rental property, where tenants make monthly payments. Or you could purchase shares of a real estate investment trust (REIT) — a company that owns, operates, or finances income-producing real estate. Real estate may be used by investors to diversify their portfolios beyond simply holding stocks and bonds.
How To Start Investing
There are a few steps to get started investing.
Assess Your Financial Situation
Begin by taking a snapshot of your finances:
- How much money do you have saved?
- How much debt do you have?
- How much money is left over in your budget each month?
Doing this may help you to better understand how much money is available to invest. It may reveal other opportunities to free up cash flow, such as paying down a debt or cutting back on unnecessary expenses.
Set Your Investment Goals
What is it that you hope to accomplish by investing?
- Being able to retire?
- Saving up for a down payment on a house?
- Capital to start a business?
While determining your goals, don't forget to also have a conversation with your partner, if you have one. There may be better chances of getting what you both want if you align on the targets first.
Consider Your Available Options
Choose the appropriate type of investment account to help reach your goal.
For example, if you need your money short-term for an upcoming vehicle purchase, then perhaps a high-yield savings or brokerage account might be appropriate. On the other hand, if your goal is several years away (such as retirement), then a tax-advantaged option such as your 401(k) or IRA might be more suitable.
With 401(k) plans specifically, if your employer offers matching contributions, then this may offer an additional incentive to start investing. Matching contributions are when your employer puts money in your 401(k) alongside your personal contributions — sometimes dollar-for-dollar. This may help you to save more than you would have on your own, and after taking the effects of compound interest into consideration, it may lead to more wealth over time.
Creating an Investment Plan
Many investment plans incorporate diversification and risk mitigation to potentially enhance performance.
Diversification Strategies
It rarely ever pays to invest in just one company or type of security. Instead, a better approach may be to spread out your capital across a variety of different types of industries and asset classes.
This is known as Modern Portfolio Theory (MPT), an investment framework developed back in the 1950s by Nobel Prize-winning economist Henry Markowitz.[2] Essentially, MPT teaches us that combining assets with low or negative correlations may lead to minimizing risk while maximizing returns (for their risk tolerance).
A classic 60/40 stock and bond portfolio is one simple example. With this composition, the idea is that during favorable market times, stocks may produce above-average returns. However, in less favorable years, the bonds may provide some safety by mitigating overall portfolio losses.
Risk Tolerance
As an investor, it’s important to recognize that your portfolio may lose value at any time. Though it may eventually regain value, how would you feel or react to seeing your investments decrease?
For instance, during the onset of the 2020 COVID pandemic, the S&P 500 stock market index lost 34% between February and March.[3] Although it eventually recovered, the dip undoubtedly made many investors and retirees nervous about the state of the economy and their finances.
This is where a long-term mindset may help. Many investors recognize that day-to-day fluctuations in the market are normal. However, holding reputable funds for the long term may lead to better chances for a positive outcome.
Professional Guidance
It may be wise to get a professional opinion, especially when talking about something as sensitive as your money. Therefore, you may wish to consult with a financial advisor about their investment recommendations. Many financial advisors take a holistic approach, considering other aspects of your finances, such as tax efficiency and insurance needs.
Final Thoughts
Learning how to start investing may put you on a path to building long-term wealth. Begin by understanding which options are available to you and the risks involved. Contribute often to your accounts and monitor your progress regularly. You may be amazed to see how your contributions add up over time.
