Success in investing doesn’t happen overnight. Your investment portfolio is a lot like a garden. A nice garden takes time, energy, and attention to grow its appeal. You may do some research when adding a variety of plants, flowers, and shrubs to your garden to give it its value and appeal. Some plants may grow more successfully than others that may not work out in your garden.
Like a garden, an investment portfolio takes time and attention to establish. You will want diversification to balance risks and returns. Over time, you will add different components like bonds to stocks to balance risks and returns in your portfolio.
What Is Investing?
Investing is a way to put your savings to work to earn even more money and a higher return on the respective asset. Investors make investments in the hopes of earning a positive total return.
The total return is the income an investment generates over a period of time divided by the price you paid for the asset (like a stock). Total income from a stock investment may include dividends, distributions, and capital gains.
The capital gains (or losses) are the profit earned (or loss) from owning this asset compared to its cost basis. This price appreciation occurs when your selling price is higher than the price you paid for the asset.
Maximize Returns While Minimizing Risks
Essentially, you want to maximize returns, minimize risks and returns, manage fees and costs for the best results. Investors can leverage the compounding growth to achieve wealth and financial security for the long term in their retirement and taxable investment accounts.
Optimally, this is the scenario you should integrate with your financial plan. Compounding is the closest thing to magic in finance which works for good in investing and bad when growing your debt levels.
When you have reasons to invest, your incentives to save money push you to prioritize investments as a high priority. As such, you will more likely budget for this category. You would be surprised how your motivation to invest may reduce your spending.
Have A Financial Plan
Have a financial plan that organizes the things you want to save and invest for in life. Think about what you want your life to be like and jot down a range of short-term and long-term goals. This list may include taking vacations, emergency funds, buying a home, a car, financing your children’s college education, starting a business, caring for older loved ones, or a comfortable retirement.
Making investments can help you to:
- Fulfill your financial goals.
- Increase your income.
- Meet your retirement needs.
- Maximize your enjoyment of life.
Don’t wait too long to save and begin investing. The sooner you start, the better to opportunity for you to build wealth.
Buying stock gives you partial ownership in a company, allowing you to participate in gains, losses, and potential dividends during the year. Historically, stocks tend to generate higher returns which correlate with higher risks than fixed-income investments.
Unlike bonds, which have a priority claim as creditors, stock investors could lose their entire investment should the company go out of business. Diversification, a strategy we talk about, later on, is the best way to reduce that risk.
Stock investments have higher returns correlating with higher risks than other asset classes and can better keep pace with inflation.
The Dos Before Investing
1. Get Your Finances In Order
Before you start investing, understand your needs so that you are financially ready. When you commit money for investing, you should only invest funds you can afford to lose after you pay your bills and fulfill your basic living needs.
Investing is not risk-free and is without guarantees. You don’t want to take the money saved for a home or your retirement.
Ways To Prepare Your Finances:
Are you able to balance your budget monthly? You live within your means and can pay your bills, including the payoff of your credit card balances. By automating payments, you are managing your student loans well.
Do you have savings set aside for emergencies? By saving regularly, you can allocate this money to an emergency account so that it will eventually cover six months of your basic living needs. This fund is readily available for unforeseen events like losing a job, your pet needing a medical procedure, or fixing your car.
Have you paid off high-interest debt? If you only pay the monthly minimum amount required by issuers, your credit card balances will grow faster than the rate of your investments. You need to reduce and ultimately eliminate high-interest rate debt. Commit to paying bills on time and paying off card balances in full.
Are you spending within your means? Manage your spending so that you can direct some savings for investing purposes. Understand how investing fits in with your long-term plans.
Are you saving for retirement? Take advantage of your employer-sponsored 401K plan if offered by contributing a portion of your paycheck. Your retirement savings plan is your first entry into investing. By automating small contributions of 1% of your annual earnings, you are setting aside retirement money that will provide tax and compound growth benefits for your financial future,
This plan is investing for your long-term financial future and provides tax advantages. Most workplace plans offer to match your contribution, which is free money added to your account. Automate your contributions from your paycheck, increasing the amount you can as you can get salary boosts.
2. Decide How Much And Where To Get The Money To Invest
Yes, you can start with as little as $100 or $1,000. However, you will want to increase your investments on an ongoing basis as you have more financial resources.
Pay Yourself First. Make this your motto so that you can save a portion (10%-20) of your paycheck for savings. Saving by reduced spending so that you can invest more. As you accumulate more money in your investment accounts, you will want to expand beyond stocks to other assets like bonds, real estate, money market securities.
Later on, you can meet with a financial advisor or other financial professionals. But let’s not get ahead of ourselves.
3. Understand Your Risk Tolerance
Risk tolerance refers to the amount of loss that you can handle while making an investment decision. All investments carry risks. Some investors are willing to take higher risks in exchange for anticipated higher returns. They are risk-takers compared to risk-averse investors who seek lower risks.
Those who are risk-averse may prefer the increased certainty of keeping their money in a bank savings account. This is saving money rather than investing money. The interest rate of a savings account doesn’t amount to very much these days and typically, will not beat inflation as stock investments can.
Wealth Accumulation Or Wealth Preservation
Typically, the younger you are, the more likely you can better handle risk than those closer to their retirement years. Another way of thinking about this is whether you are in the wealth accumulation or are preserving your capital phase of life.
To accumulate wealth, accept more risk, especially when you are investing for your financial future. When preservation of capital is your primary goal, typically, this means you are investing more conservatively, risk-averse to losing money in the market.
Usually, when you invest in the long term, you are more willing to accept more risk, especially if you have some liquidity set aside for unforeseen expenses.
4. What Is Your Investing Approach When Buying Stocks?
When you initially begin to invest in stocks, several options depending on your anticipated level of involvement. How hands-on do you want to be, and do you have the time to spend to make decisions?
An active investor will want to manage her accounts. They are hands-on investors who make individual stock selections. This approach requires time and a certain amount of knowledge and monitoring of the economy, market trends, industry sectors, and fundamental analysis. If you are building your portfolio with individual stocks, you need to consider diversification. On the other hand, you can achieve diversification through the purchases of mutual funds and exchange-traded funds (i.e., ETFs).
A passive investor does not engage in trading or active stock picking. Instead, they are usually long-term Buy-Hold investors who rely on index funds that typically track one of the major indices like the S&P 500. They will buy other mutual funds or ETFs.
The passive investing approach is an ideal path for beginning investors. They can get a feel for the market, decide how much time they can devote to building their diversified portfolio, and better understand their investment philosophy. This investment strategy provides savings if you stick to buying index funds with low fees (i.e., low expense ratio) and lower taxes if you hold your securities long term.
You can open an online account at a traditional or discount broker and actively invest or passively invest in individual stocks, mutual funds, or exchange-traded funds. Alternatively, you want to try a Robo-advisor. The road you decide to take will have implications on your costs.
5. Open An Online Brokerage Account
There are plenty of online brokerage options to open an account. Most have low to zero commissions, but there may be other costs so review their website. As a new investor, you can choose to open an online account at a traditional brokerage firm, emerging disruptor brokers, or Robo-advisors.
Some traditional brokers, like Charles Schwab, offer Robo-advisors, or hybrid services, while some original Robo-advisors increasingly offer human advisory services. So don’t get too hung up on the company name.
When you make your decision, consider the respective firm’s offerings in terms of an easy-to-use platform, types of securities, access to educational resources, and potentially fundamental research or stock charts. Newer providers may have limited securities for you to purchase (i.e., index funds or mutual funds, ETFs). If you are a beginning investor, you will want to make sure you can buy low-cost index funds. More on that later.
Robo-advisors are automated options that provide investment management services. They are desirable for beginning investors who do not want to make their selections. Most traditional management firms have high minimum investment requirements and charge more than Robo-advisors, which may be an excellent alternative to a traditional financial advisor. As such, Robo-advisors may fit your bill.
The Robo-advisors use computer algorithms to build an appropriate portfolio based on your profile you provide to them. They want to understand your goals, tolerance for risk, and investing preferences and use financial planning tools to rebalance your portfolio and tax optimization when needed. They vary in how much human advisory interaction you will have, with some having little to no human interaction with you, while others have more human advisory services.
6. Individual Stocks or Index Funds
You can buy stocks individually or as stock funds. Individual stock investing can be very rewarding, but there is a learning curve. Stock funds range from actively managed funds to passively managed funds. Both will provide essential diversification right away, which you won’t get buying only a couple of individual stocks at first.
Portfolio managers run actively managed funds typically with expertise in their sector and hand-pick their investments. However, actively managed funds charge higher costs (e.g., expense ratios and transaction costs) and require an increased minimum investment than passively managed index funds. The manager of the index funds targets replication of the index they are tracking (e.g., S&P 500 index).
Studies show that actively managed funds do not perform any better than passively managed funds over the long term. High fees over a long time reduce your returns.
For these reasons, low-cost index mutual funds or Exchange-Traded Funds (ETFs) are an excellent way to start investing. You will save money on their costs (ETFs are similar to mutual funds but may have lower fees), and you can purchase these funds with low to no minimum investment.
You can find index funds with expense ratios as low as 0.015% and no minimum initial investment. As such, you will pay $1.50 annually for every $10,000, less than a latte.
Buying Low-Cost Index Funds
When you buy an index fund, you are buying a low-cost index fund that tracks your chosen index. A popular index uses the S&P 500 as a market benchmark. It follows 500 of the largest US companies measured by market capitalization. Typically, the companies are leaders in their respective industries.
Among the cheapest S&P 500 index are the Schwab S&P 500 index (SWPPX), with an expense ratio of 0.02%, and the Fidelity 500 Index (FXAIX), with an expense ratio of 0.015%. Neither requires minimum initial investments. Fidelity has a series “ZERO” that has no-fee index funds.
There are index funds that track growth, value, income, and varying capitalization companies. Index funds are available for various geography, industries, a mix of assets, and different development stages. With all these opportunities, you need to be mindful of fees and costs from employing a financial advisor or actively managed funds.
7. Have A Long-Term Perspective
When investing, focus on the long-term, avoiding selling your portfolio when the market becomes volatile. Markets have periodic downturns that provide savvy investors opportunities to buy dips in shares to start or expand a position. Stock investments can be rewarding for long-term investors with the chance to earn historical average equity returns of 10%.
8. Diversification Is Essential
A cardinal rule for beginning and experienced investors is diversifying your mix of stocks using ETFs and mutual funds. The benefit of having exposure to several market sectors is when a specific industry, like technology stocks, goes down in tandem or out of favor. Other sectors may take their place as leaders.
By buying low-cost index funds and ETFs, investors can best achieve diversification, whether initially or long-term. Concentration in any one stock or asset is hazardous. Besides investing in stocks, you should expand into bonds, real estate, commodities, and other areas to disperse the risk of overexposure in any one place.
Don’ts When Investing
1. Don’t Be Greedy
When you invest long enough, you know favorite stocks that go up often come down. You will want to replace greediness with financial discipline. Trim your winning positions is always a good way to lock in gains we sometimes lose when we are greedy. Give yourself a target to trim stocks when they rise 20%-25%. Greed is one of the seven deadly sins of investing.
As the old Wall Street saying goes, “Bulls make money, bears make money, pigs get slaughtered.”
2. Don’t Concentrate Your Money In One Stock Or Asset
This factor is the risk you take on when you are not adequately diversified. Concentration in one stock, one industry, or longer-term in one asset class is risky. Sometimes one stock may have performed far better than other stocks and now is outsized in proportion to your holdings. Lock in your gains and raise some cash to buy more in a correction.
3. Don’t Fall In Love With A Stock
At times, you may feel some affection for a stock that trades beautifully, and you wish your entire portfolio will react like that name. The company management and fundamentals are above-average in a desirable part of the market. Don’t be blinded by what you may believe is the stock’s “never can do wrong” attitude. Save that for people you love, not stocks.
Good companies sometimes make bad stocks and vice-versa. I have some experience with being resistant to selling solid winners for a long time. However, things change. Maybe it was because there was a new competitor or a rare mistake on management’s part. Be aware that no stock or company is infallible, and don’t fall in love and find that you lost sight of some deterioration in its fundamentals.
4. Don’t Be Emotional When Investing
The most experienced investors come upon times when their egos or other parts of their persona get in the way of their investment judgment. We carry our biases when we shop and invest and often are unaware to our detriment. Become more aware of these tendencies by being more conscious of our decisions.
Our biases cause us to spend more money when shopping, but we only realize it when we review our bills. When investing, we may not want to give up on a poorly performing stock because we don’t want to admit our mistake.
For example, you own shares of XYZ company which continue to go down as they report revenue and earnings below expectations. As the stock drops, you add to your position even though the company reports more bad news. You may be adding to the sunk costs you already have in this position. Sunk costs fallacy is a common investment bias, along with other biases we discuss in an article here.
5. Don’t Panic In A Market Downturn
There are times when the market plunges. You panic and stress about your portfolio and decide to sell everything. Don’t do panic selling. This scenario is more common than you think. We have all had that sinking feeling where you stare at the screen and watch your stocks turn red. The operative word is “watch.” Unless you need to sell stocks for liquidity purposes, sit back and try to learn what the market is telling you.
During the first half of 2020, the pandemic caused the market to plunge in March as the economy deteriorated. The Fed stepped in quickly to adjust its policy to add liquidity to the financial markets. After entering the bear market territory, the market promptly proved its resilience by recovering its bullish stance.
Many people sold their shares, emptying their portfolios, while others used the downturn to buy opportunity. Staying put turned out to be the right move, as shares moved up quickly. Similarly, shares cratered to the bottom on March 6, 2009 (down over 50% from the 2007 high), due to the Great Recession. I sold some stocks in my portfolio, which left me with a lasting impression not to do panic selling so long as I can pay my bills. Focus on the long term, and for the most part, your stocks will come back.
6. Don’t Become A Short Term Trader
Many professionals are short-term or day traders. They are actively engaged with the market, have sophisticated trading tools, need sufficient capital, and work very long hours to learn about the market, economy, news, and respective events. It is very risky and not for the faint-hearted. I admire these traders who work hard, understand the short-term price movements, and make a living.
Day trading is not for the unsophisticated or beginning investor. As an investor, sometimes you trade or sell stocks you intended to hold for the long term. The reason for getting rid of such a position could be that the catalyst you bought the stock for didn’t materialize, or you realize you were mistaken about the fundamentals. Things happen.
Generally, you should keep a long-term perspective. Traders will make a short-term trade to lock in a profit. However, you will be paying higher taxes for the short-term gain at the ordinary rather than the capital gains rate.
In recent months, we saw many individual investors take on significant risks trading meme stocks, like GameStop, fueled by social media attention rather than fundamentals. This trend is foolish and not real investing. Sure, stocks can go up until they don’t. Know what and why you are buying, and be purposeful by avoiding unnecessary risk.
7. Avoid Unnecessary Risks
We have written about the risks associated with buying positions on margin, which is essentially an expensive loan. By doing so, you are adding significant risk, and especially if you get caught in a market correction.
Your broker has the right to make you pay your margin loan or sell stocks to satisfy the loan. Margin calls usually come at the worse time for you, the trader, or the investor. Make sure you understand the financial consequences before engaging in this practice. Short selling is a complex practice best left to professionals and those comfortable with options trading. Read our post on the market frenzy to learn about these and other risks.
7. Hard To Time The Market
The most experienced investors cannot time the market with accuracy. They understand the need to withstand market volatility causing large price swings and a long-term perspective. All of us would like to have the ability to buy stocks at the bottom and sell before a crash. We can take advantage by using some financial discipline by letting the market “settle down” before buying new shares or trimming when stock valuations become high.
8. Avoid Extended Trading Hours
Traditional hours for the NYSE and the NASDAQ Stock Market are open from 9:30 AM to 4:00 PM unless opened for a half-day during certain times of the year. Outside these hours are the extended or “after-hours.”. Everyone, individual and institutional investors, have access to making trades during that time.
That doesn’t mean it is a good idea for individual investors to do so. The after-hours market tends to be very risky as liquidity is far more limited, trading and prices are more volatile. You may be trading more blindly, unaware of what you are paying or getting in return for your position with wider price spreads. You are trading against far more professional traders during this time.
The time to start investing is now. Once you get your finances in order so you have more flexibility, start investing for beginners. Follow our “Dos and Don’ts” as guidance as you grow more confident in your investing abilities. There is an exhilarating feeling when you can make your savings work for you, achieve your financial goals, and build your wealth in the long term.
Thank you for reading! If you found this of value, please visit The Cents of Money for more articles on investing and other personal finance topics. Consider subscribing and get our free weekly newsletter and our weekly posts.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.