It may feel like diving off the deep end of the pool, but investing isn’t really all that difficult and need not be scary. If you can learn and remember a few basic principles about how it all works, you can learn everything else as you go along.
Here are a few things to know about investing as you get started in your pursuit to grow your wealth.
How the market works
The stock market isn’t a straight line, and although values tend to rise over time, at some point, the market will drop. Your investments will lose value. And you may get nervous seeing your portfolio go down. It happened in 2022, and actually happens about every five years on average.
But the market also rebounds after every bear market, and if you are invested in a broad-based fund that tracks the overall stock market, this is good news. If you can stay invested and continue investing over a long period of time (20+ years), you will likely see more growth than drops in your portfolio.
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How compound interest works
The backbone of investing is compound interest. It is the concept of earning interest on your money, reinvesting the interest, and then earning even more interest. This compounding effect is multiplied when you do it over a long period of time.
One of the best ways to see this is by testing out a compound interest calculator (there are many accessible online). You can see how much your money will be worth if invested over time. And you can see how the growth of your money goes up exponentially once you’ve been invested for decades.
Pro tip: Compound interest can apply to investing, but also to savings account. Taking advantage of it can be a great way to add money to your savings.
How passive investing works
Passive investing is the idea of contributing regularly to a pre-set portfolio of funds that don’t require any active management on your part, and typically have very low fees. Passive investing was popularized by Jack Bogle, founder of Vanguard, and includes investing strategies such as the three-fund portfolio.
Investing in broadly-diversified index funds allows you to own pretty much the entirety of the stock market or bond market, spreading your investment dollars among thousands of companies and fixed-income investments, and thus achieving maximum diversification.
You then contribute to this investment portfolio on a regular basis, which allows you to avoid trying to time the market and taking on excessive risk.
How to dollar-cost average
Dollar-cost averaging is the process of purchasing an investment in small amounts over a long period of time. If you invest at regular intervals, determined by the calendar and not the market close, this allows you to purchase when the market is down, as well as when the market is up, giving you an average buy price somewhere in the middle.
This is a popular strategy for passive investors that invest a portion of their income each month, and is a proven method for building wealth over a long time period. It also avoids the headaches of trying to time the market, and typically outperforms most other investment strategies.
How to diversify your investments
Diversification is the process of splitting up your investment dollars between multiple asset classes, and multiple industry sectors within those asset classes. This allows you to balance out your investments and reduce the volatility of your portfolio, while still aiming for potential growth.
A popular way to do this is through broad-based index funds, which are representative of an entire market or asset class.
How to automate your investments
Automating your investments is the process of setting up automatic transfers and purchases in your investment account on a regular schedule. This allows you to schedule your incremental investments based on your own cash flow, e.g., when you get paid, and you can build wealth.
A popular way to do this is to set up bi-weekly or monthly transfers from your checking account to your investment account, and set a rule to make purchases of your preferred investments with that money.
How your investments are taxed
Taxes can get tricky when investing, and understanding the difference between pre-tax and post-tax retirement accounts, as well as how taxes on capital gains, interest, and dividends work can help you stay one step ahead of the game. If you don’t have the time to learn the ins and outs of investment taxes, working with a licensed tax advisor can help you create a tax-efficient investment strategy.
How investment fees work
Investing fees can really hurt your savings and take years off your retirement. Understanding how investment companies charge fees can help you save thousands of dollars, and give your money a chance to grow more quickly.
Some of the more common fees include:
- Expense ratio (on a mutual fund or ETF)
- Trading fees
- Assets Under Management fees (AUM)
- Transfer fees
- Sales charge fees
These fees can range from 0.03% up to 2% per year, and the more you have invested, the more they cost. You can avoid these fees by using a discount broker for free stock and ETF trading, invest in index funds with low expense ratios, and work with a fee-only advisor with a reasonable annual fee and no sales charges.
Finding a fee-only financial advisor will help you avoid sales charges and poor investments, and allow them to help you build a proper investment plan for a fixed fee. Look for the Certified Financial Planner (CFP) designation if possible, and look up their affiliation with any professional networks to ensure they are held to a high fiduciary standard.
When in doubt, ask them exactly how they make money by managing your account.
Investing requires a general understanding of key investment principles, but once you have a baseline knowledge of how it works, you can build a plan that fits your goals and that can help you get ahead financially.
And if you find yourself overwhelmed, it’s best to work with a licensed financial planner to give you the tools needed to invest with confidence. Who knows, you might even be able to retire early.
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