By Alex Thomas Salder, clarkhoward.com
The idea of investing for the first time on your own can be intimidating — and confusing. But with a little guidance, it doesn’t have to be either! So let’s break down the process of getting started and the best way to start investing extra cash.
3 things to do before you start investing
1. Start saving for retirement in a tax-advantaged account
Before you invest extra cash, you first want to start saving by contributing to tax-deferred (or tax-advantaged) retirement accounts. These are easy ways to save money for the future in a tax-friendly way.
Here are two ways to start:
- Traditional 401(k): This is a retirement savings plan offered through an employer (or nonprofit) that allows a worker to invest money now, and defer paying income taxes on the saved money (and earnings) until withdrawal, at retirement. The best way to take advantage of a 401(k) is to make sure you are contributing enough to get the employer match, which is essentially free money toward your retirement provided by your employer (as an incentive to save, plus employers receive tax benefits for contributing to employees’ retirement accounts). Employer matches can vary by a lot, but for many companies, the way it works is the employer will match up to 50% of the worker’s contribution up to 6% — so if you contribute 6% of your annual salary to your 401(k), your employer will contribute 3%.
- If you are contributing enough to get the employer match, and still have extra money, the next step Clark recommends is a Roth account (rather than contributing any more to your 401(k) past the match amount).
- Roth IRA: A Roth is a modified individual retirement account in which a person can set aside after-tax income — up to $5,500 per year ($6,500 for those age 50 or older). Earnings on the account are tax-free, and tax-free withdrawals may be made after age 59 1/2. This tax-free status beats just about every other retirement savings option out there. You can set up a Roth account yourself — with as little as $100! Here are some options by dollar amount for opening a Roth.
- If you have a 401(k) at work, you can open a Roth in addition to that as a way to put more money away toward in a tax-friendly account.
If you want to open a Roth or 401(k) and not have to think about how the money is invested, there is no easier choice than a targeted retirement fund. You select the year closest to when you want to retire and simply put all your money into it.
The money goes into a variety of things like big company stocks, little company stocks, international stocks and a bunch of different types of bonds. Bonds are where you are the bank lending someone money. See some good target retirement fund companies here.
2. Make sure you have a rainy day fund
If you’re saving for retirement and still have extra money, before you start investing all of it, make sure you’ve built up a rainy day savings fund. Experts say an emergency fund should be able to cover anywhere from three to nine months of expenses (in the case of a job loss). The amount may also depend on your salary, monthly expenses, spending habits etc.
Once you have a fund that’s easily accessible in case of an emergency, it’s important to not overstock that account if you want your extra money to grow — since money in a savings account earns very little interest.
3. Pay off high-interest debt
You will get a higher rate of return by paying down high-interest credit card debt than you will investing. Paying off that debt quicker will reduce the overall cost (since you’re eliminating paying more interest). Then once you’ve done that, it’s time to consider your investment options.
If you still have an extra $1,000 – $5,000 to invest…
Once you’re contributing the maximum annual amounts to your retirement accounts — and also have an emergency fund built up — then it’s time to start looking at ways to invest more without incurring big tax headaches or too much risk, depending on your situation.
But the first thing you need to consider is when you plan to spend the money you’re investing — or when you might need it. Short-term goals and long-term goals are very different in the world of investing.
And one thing to note: You don’t need as much as $5,000 to start investing. Depending on the method you choose, you can get started with as little as $1,000.
Short term (less than 5 years)
1. Online savings account
If you want to buy a car or a house in the next few years, then that’s really more about saving. You’re better off keeping your money in the bank and continuing to build up the savings for that big purchase.
“The best place for money you need in a moment’s notice is an online savings account,” says Greg McBride, chief financial analyst at Bankrate. And while the interest you’ll earn on money in a savings account is low — around 1% — you don’t face penalties when you need to withdraw the money.
2. Certificates of deposit (CDs)
Certificates of deposit — also called CDs — are deposit accounts that require you to commit your savings for a specified period of time, which may be anywhere from one month to several years. In many cases, the longest CD term banks offer is five years. In exchange for that long-term commitment, you will typically earn a higher interest rate than on a savings account. However, unlike in a savings account, your money is not available any time you want it.
If you withdraw from a CD before the specified term, you will typically have to pay a penalty.
Clark Howard suggests you take the money you want to invest and buy five different five-year CDs. So split the money into five even piles — then buy 1-year, 2-year, 3-year, 4-year and 5-year CDs in equal amounts.
The typical CD contract only calls for a 90-day interest penalty — which means if you withdraw the money before the predetermined date, you’ll have to pay a penalty of 90 days interest. So if you hold a CD for any length of time, the higher return on a 5-year CD should in theory compensate for the forfeit of 90 days interest.
To be sure you don’t end up paying too much in penalties in the case you need to withdraw the money early, make sure the CDs you get only call for the standard 90-day interest penalty. Stay away from anything with a 180-day interest penalty. Do that homework upfront and this could work out nicely for you.
If you’re wondering: “Well, why not buy just one 5-year CD instead?” Here’s why: If you just need a portion of the money, you have to cash the entire CD in and start over again. Having five different ones gives you the same kind of flexibility you would have with traditional CD laddering.
Online banks and credit unions are a great option for free, fee-free banking with easy access. Here are some of Clark’s favorites.
Check out Bankrate’s tool to finding the best CD rates. Also, here’s a guide on how to invest in CDs and avoid early withdraw penalties.
3. Money market accounts
These earn slightly less interest than CDs, but you can withdraw the money at any point. Important note: Money market accounts are different from money market mutual funds. With a money market mutual fund, if you want immediate access to your money, you will pay a fee.
Just like other savings accounts, you can automate contributions to a CD or money market account.
Long term (5 years or more)
Index funds are the most cost-efficient way to get started on longer-term investing, because they require very little work on your end and they’re cheap.
Index funds are a type of mutual fund, so before we get into how index funds work, let’s take a step back and first understand mutual funds.
According to fund tracker Morningstar: “A mutual fund is a basket of stocks, bonds or other types of assets that is professionally managed by an investment company on behalf of investors who don’t have the time, know-how or resources to buy a diversified collection of individual securities (stocks, bonds etc.) on their own. In exchange, the fund charges investors a fee, which may be around 1% or more — meaning investors would pay about $100 for every $10,000 they invest.”
Since mutual funds are more actively managed by a professional, they are more expensive for investors, because the professional has to pick and choose which stocks they think will overperform. This is why an index fund is a better option for beginner investors.
Rather than having a professional pick and choose individual stocks, with an index fund, you own all or almost all of one particular kind of investment. One index fund can invest in hundreds (and even thousands) of stocks or bonds in one single fund. So you are investing in an index. The Dow, S&P 500, Nasdaq 100 — these are all indexes.
The most popular type of index fund is the “500 index.” It holds little pieces of the 500 largest companies in the United States — and when you invest in it, you become a part owner in each of these companies.
So since an S&P 500 index fund owns stock in all 500 of those companies — when the S&P 500 Index goes up, your fund goes up; when it goes down, your fund goes down.
There are also tons of other choices of index funds. Here are some examples: You can own a mid-size company index; a small company index; an international index; an emerging market index (think Third World countries); a government bond index; a corporate bond index; a real estate index fund and on and on.
Index funds are sometimes referred to as “passive” mutual funds — because they take a hands-off approach to investing. When you put your money in an index fund, you’re investing in a broad range of stock or bonds (again, usually an entire market), so you don’t have to deal with — or do the research associated with — buying and selling individual stocks. You also don’t have to pay the management fees you would with a mutual fund.
So index funds are very cost-efficient for investors.
“I don’t recommend people investing in individual stocks unless they have done a significant amount of research,” says Andrew Fiebert, co-host of the podcast Listen Money Matters. “Unless you have the time to research in detail the inner workings of individual companies, and understand what that research means, it is better to stick to investing in passive index funds.”
When it comes to deciding on the type of fund to invest in, the younger you are, the more stock oriented you want to be. The older you are, the more bonds you want to have. You can make it ultra simple with just three to five index funds or go crazy with as many as 15.
Dollar cost averaging
Dollar cost averaging is just a fancy name to describe the practice of putting in little dribs and drabs of money in equal amounts into a retirement account every pay period or once a month. If you’re just starting to invest, you might not feel comfortable dropping a full $5,000 all at once.
If you have an amount you’re ready to invest, split it up into 12 monthly payments that get automatically withdrawn from your bank account each month.
If you have 401(k) contributions deducted from your paycheck every pay period that are invested in a stock or targeted retirement fund, you are essentially dollar cost averaging.