What is the best way to start investing for beginners? If you are asking yourself this question the chances are that you are expecting to be told where to put your money.
We’ll get to that, but you need to sort out several things before you start investing.
Investing is a journey. The road ahead of you is not straight. Even if you think the market will just carry on going and interest rates will do what they do and any income streams you set up will carry on providing. The chances are there will be some disruption to these best-laid plans. That is assuming you have some best-laid plans.
Essentially, before you start investing you need to work out what kind of an investor you are. You need to establish your goals, understand your risk tolerance and your risk appetite, and what your earnings are likely to look like in the future. This will put you in a position to develop plans that are right for you and will stand a good chance of working for you.
You can get all complicated about trying to put a precise number on your risk tolerance. You may not have been in situations where you have to try and gauge your risk tolerance. Here is an article that walks you through various ways of understanding your risk tolerance.
On the other hand, maybe you know yourself well enough to take a pretty accurate guess.
So rather than trying to get fancy about it, we could simplify this and just try and answer whether your risk tolerance is low, about average, or high.
But let’s remember, risk tolerance is about how much risk you can put up with before you throw in the towel and run for the nearest exit. Here is a simple question.
Imagine you have invested your first $10,000 in a few funds and stocks. Everything is bouncing along just fine but then after a few months, the market gets all jittery. Let’s say that the Standard and Poor’s 500 Index, and by that we mean large-cap stocks drop by 10%.
One way to look at risk tolerance is that under these circumstances if the main market index drops by 10% and you would only really accept that your portfolio also drops by 10% then you have medium risk tolerance.
If you would only be comfortable with your portfolio dropping by 5% under the same circumstances, you have a low-risk tolerance.
If you would be comfortable with your portfolio dropping by 15% under the same circumstances, you have a high-risk tolerance.
Accepted, this is a fairly unscientific approach, on the other hand, risk tolerance is what you are willing to put up with when things go bad. What is important is to get a handle on where the limits of your comfort levels lie.
Simply, you have to avoid setting yourself up with investments that will suffer larger losses in a down-market than you can tolerate. Because if that happens the chances are that you will jump ship and start liquidating or exiting positions at precisely the worse time.
That is likely to result in you making larger losses than you otherwise would and your investing system unwinding.
So you need to get a clear handle on whether your risk tolerance is low, medium, or high.
Your risk appetite is related to risk tolerance but it is more a question of the sort of upside movement you will be looking to find when markets are doing well.
It would be easy to think this is not so important. But the fact is investing systems and plans work when you stick with them. You will only tend to stick with them when they do what you expect of them. We could take a simple example to illustrate this.
Let’s say the main large-cap market indicator, the Standard and Poor’s 500 Index has gone up 10% in the last month. Under these circumstances, if you would accept that your portfolio increased by only 5%, you have a low-risk appetite. If you would expect and accept that your portfolio also increased by 10% like the market, then you would have a medium risk appetite. And if you would expect and accept that your portfolio increased by 15% or more, you would have a high-risk appetite.
So matching your investment plan to your risk appetite is what will keep you on board when the market is doing well. That is equally important as keeping you onboard when the market does not do well.
Again, if you are going to jump ship for some other investment approach because you feel everyone else is getting rich and you are not, then that is equally damaging to your chances of long-term success as jumping ship when things go wrong because you are unhappy with the losses.
Risk tolerance vs risk appetite?
You could ask, is it possible to have a low-risk tolerance but a medium or even high-risk appetite, or is that just a failure to accept reality?
Could we imagine someone who honestly has a very high risk appetite but only a low risk tolerance? From a practical perspective, it would likely prove very tricky to construct a portfolio that only had exciting upside potential and hence leverage but stopped any losses out if positions dropped by more than a few percent.
It is possible to stack a portfolio slightly in a direction that favors upside potential and hence could satisfy a risk appetite while at the same time limiting the downside risk to be marginally less and therefore appeasing a slightly higher risk tolerance.
But let’s face it, what we are describing here is pretty much the holy grail of investing. Everyone’s going to want unlimited upside potential while limiting downside risk to a minimum. Let’s just say that it is possible to some degree.
It comes down to understanding the risk profile of your portfolio and then deciding how much and which parts you want to hedge and when.
Hedging costs money.
There are passive approaches to hedging that are suitable for long-term investors and more active hedging approaches that better suit short-term traders. It is a complex subject and is really something you need to look into as you are structuring your approach. I’ll repeat the point though, it comes down to understanding your risk tolerance and your risk appetite.
Depending on where you are along your timeline, and since we are talking here about a way for beginners to start investing, we will assume you are somewhere near the start of the process.
So let’s say you have many earning years ahead of you, maybe decades before you need to start withdrawing funds from your nest egg. What can you reasonably expect your earnings to be over the coming years? This is going to depend on whether you have a regular job, a career, a particular line of work, or maybe you are an entrepreneur.
At one end of this spectrum, with a regular job, you may be able to project your earnings with a high degree of precision years into the future. At the other end, if you are launching your own business venture, your pattern of earnings over future years could be just a wild guess.
Pay off your debt
This may sound counter-intuitive, but especially if you have high-interest credit card debt, often the best return you will get on your money is paying off that debt. This is unlikely to be the case for a mortgage. Just to clarify this point, you absolutely need to start investing before you pay off all your mortgage.
So paying off any nasty credit card debt is one of the first things you should do as you start investing.
Are you an avid skydiver? Or maybe you have a general attraction towards different kinds of dangerous sports. Well whether you do or don’t jump off high buildings on your weekends, life can always throw you curveballs.
You can suffer an accident, be made redundant, or you or someone in your family suddenly needs expensive healthcare. Whatever it could be, the general principle is that it is a good idea to have an emergency fund. And your emergency fund should be roughly what you need to live off for a six-month period.
It goes without saying that your six-month emergency fund will need to be adjusted depending on your circumstances and your commitments. Simply put, you will need more if you have a family and a mortgage than if you are living on your own in modest rented accommodation. How large your emergency fund should be and how long you could need it to last will also be dictated by the kind of field you work in and the prevailing labor market in that field.
When will you need it?
Part of the plan is also knowing when you will need to start withdrawing funds from your nest egg. This isn’t just a question of when but how you want to live when you retire. This is a matter of personal choice and it is something you will need to revisit from time to time.
The question is whether you want to live, more frugally, about the same, or more liberally when you retire than you do before you retire. This is a matter of your circumstances and your desires. Some people find they are happy living more frugally in retirement while others indulge themselves and, for example, travel more frequently than they did before.
Max out your employer contributions
Obviously, this only applies if you have a job and your employer offers some kind of matching retirement plan. You will hear this advice over and over and it might sound boring. But if you aren’t maximizing what your employer is willing to match into your retirement plan, then you are leaving money on the table.
Now we can start investing – three pillars
So now all that preliminary stuff is out of the way, we can get down to what you should actually be putting your money into. Again we should be keeping things simple just because if you try anything complicated you will not stick with it. Building a nest egg over a lifetime of earning is about consistency and matching your plan to your means and your needs.
The first, and most likely the main pillar of your portfolio is going to be stocks or equities.
Stocks offer the best and most consistent long-term returns. This article explains how stocks have performed over successful periods.
Years ago investing in stocks as an individual was complicated and expensive. Often the only way to get diversification was through mutual funds and often they weren’t liquid. You needed to subscribe and getting out of your funds particularly at short notice incurred extra fees.
Today that is no longer the case in that mutual funds are not the only option. There are numerous low-cost, i.e. low fee Exchange-Traded Funds or ETFs that will give you exposure to a bewildering array of indexes, strategies, sectors, geographical regions, and commodities.
There are still many mutual funds though. And people who prefer a managed approach to investing are often comfortable with well-managed mutual funds.
The other big group of investment vehicles is fixed-interest investments including, bonds of all kinds, certificates of deposit, and preferred shares.
Some of these are not going to be so accessible for someone starting with small sums. Many bonds for example are priced very high, $25,000 or $100,000 for a single bond is not unusual.
There are, however, two very accessible ways to invest in bonds, bond mutual funds and bond Exchange-Traded Funds, or bond ETFs. Bond ETFs, come in a wide variety, either tracking a broad range of all bonds, or various mixtures of treasuries, or municipal or corporate to low-grade junk bonds.
Certificates of Deposit or CDs are also very accessible. You can invest in CDs through a regular brokerage account often with minimums as low as $500 or $1000.
It is always good to shop around for CDs to get the best rates. You should also be careful to choose a term that works for you. Your money is tied up in a CD for the duration of the term. You can terminate a CD before it reaches its term but you will pay a penalty. Here is a comprehensive guide to how certificates of deposit work.
Preferred shares can also be bought and sold through regular brokerage platforms. They tend to trade with low volume though so, getting ahead of ourselves a bit here if you are buying preferred shares it is often best to enter limit orders.
While all types of investment are sensitive in one way or another to changes in interest rates, this is very much the case for fixed-interest investments like bonds, bond mutual funds, and bond ETFs, It is important to know this when investing in fixed-interest investments.
The other pillar that is worth considering building into a long-term investment portfolio is real estate. Having real estate in your portfolio is a bit like having another fixed interest investment but with the advantage that real estate values don’t track interest rates as religiously as do fixed interest investments.
Real estate can add an important component of diversification to your portfolio. From this perspective alone it is well worth considering.
Investing in real estate doesn’t have to mean buying whole properties and renting them out. This article explains different ways to invest in real estate.
Real estate crowdfunding is a recent innovation that has attracted a lot of attention and for good reason. There are also very accessible ways to invest in real estate, notably private REITs with entry levels starting as low as $10 a month. This article explains the easiest ways to start investing in real estate.
A portfolio mix
So how much of our portfolio should be stock, how much should be bonds, and how much should be real estate? Now that you have a handle on what kind of investor you are, in terms of your risk tolerance and risk appetite, there are some simple rules of thumb that can guide you.
In your early years of investing, even if you gauge yourself to have a middle-of-the-road risk tolerance and appetite, your portfolio should be a strong majority of stocks with some fixed-interest investments and some real estate.
Some advisors will tell you to base your portfolio mix on your age. Subtract your age from 100 and that is the percentage of your portfolio that should be in stocks. Whatever remains you can divide evenly between fixed-interest investments and real estate.
So, let’s say you are 25 years old. Then your portfolio should be 75% stocks and you could go with 12.5% fixed interest and 12.5% real estate.
If you judge yourself to have a low risk tolerance and appetite then you may want to knock another 10% off the stocks portion and divide that part evenly between fixed-interest and real estate.
If you have a high risk tolerance and appetite, then you would probably want to start with at least 10% more so 85% in stocks.
How much should you be investing?
This one is actually easy to answer. If you are starting out earning and still in your twenties or early thirties, then you want to be putting away around 20% of your net earnings. If you start investing later in life, then you will need to set aside proportionally more. At a certain point that will become impractical for most people so you need to plan to continue working may be part-time or have other streams of income in retirement.
Dollar-cost averaging is when you invest the same sum regularly into the same funds or stocks even though the unit prices of what you are buying varies from month to month. By investing the same amount each month you will even out those variations, and relieve yourself of the burden of trying to time the market.
Set yourself up
A brokerage account will give you access to stocks, ETFs including bond ETFs, preferred stocks and certificates of deposit. This article compares some of the main brokers around today.
If you have many years of investing ahead of you, take a look at these low-cost private REITs like MyHappyNest or Diversyfund.
Professional financial advice
Too often people think they cannot afford to hire professional financial advice. Really it is healthier to ask yourself whether you can afford not to hire professional financial advice. This article explains the average cost of a financial advisor.
What stocks and funds to buy
You can either do your own research to work out what stocks and funds to buy or you can use the services of a professional financial advisor. In fact, only a registered or certified professional financial advisor can legally provide personalized financial investing advice.
Review and adjust
Every financial plan should be reviewed regularly. Once or twice a year is typical and at other times as well if there are significant changes.
For each review, you should be checking all the main parts of the plan, then make any adjustments as necessary.
So, what are you waiting for?
Questions and answers
Q. How much money should a beginner invest for the first time?
A. To build a nest egg that will last you through retirement, you need to invest around 20% of your net income and you need to be doing that when you start earning.
Q. What should I invest $1000 in?
A. If it’s a one-time investment of $1000, then I would go with one of the main ETFs that tracks a major index, either the S and P 500, or the Nasdaq composite, or the Russel 2000.
If it is $1000 every month, then you would want a mix of funds. There are many approaches. If you don’t know how to build a portfolio, then it is best to seek professional financial advice.
Q. Can I start investing with $500?
A. In a word, yes. Many of the main brokers will allow you to open an account with $500 or less. If the broker offers trading in fractional shares then you can even split the $500 into a mix of funds.
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Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as personalized investment advice, good or bad. You should check with your financial advisor before making any investment decisions to ensure they are suitable for you.
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