1. Determine your goals, risk tolerance and time horizon
Your first step to becoming an effective investor is to establish a “game plan.” A good investing game plan should be influenced by three aspects: your goals and motivation, risk tolerance and horizon.
Investing goals and motivations
First up are your goals for investing: Why are you investing? What’s inspiring you to open a brokerage account? Finding your “why” is a critical first step in investing because the wrong “why” can lead you down the wrong path.
If your motivation is to “make money, fast” or “get rich,” you might want to pump the brakes. It’s not hard to get rich slowly off the stock market — but it’s immensely difficult to get rich quickly. Don’t let the front page of r/wallstreetbets mislead you; in reality, less than 1% of day traders make enough money to even cover their trade fees, according to CNBC.
FOMO is also not a good investing strategy as it can lead to making rash decisions that aren’t a fit for your risk tolerance or long-term goals. Worse still, share prices upheld by FOMO-induced investors tend to crash (see GME).
Good “whys” that lead to better long-term gains include, but aren’t limited to:
- Slowly and steadily multiplying your wealth
- Self-educating about the stock market and our financial system
- ESG investing, or investing in companies that benefit the earth and society
Again, going in with a clear “why” statement will help you stay focused throughout the emotional ups and downs of investing.
Would you prefer $2,500 in cash or a 50/50 chance at winning $10,000?
Your answer reveals something about your risk tolerance — that is, your financial and emotional ability to withstand a loss in your portfolio. Your age, income, dependents, investing goals and your personal comfort level all factor into your risk tolerance.
In tangible terms, your risk tolerance will dictate your overall portfolio mix. If you have a low risk tolerance, you’ll want to bias your portfolio towards safe investments like exchange-traded funds (ETFs) and mutual funds. If you have a high risk tolerance, you can spend more on high-risk/high-reward stocks.
Your investing time horizon determines when you plan to cash out your investments. The shorter your horizon, the less risk you want in the portfolio.
Generally speaking there are three time horizons:
- Short-term: Under 3 years
- Medium-term: 3 to 10 years
- Long-term: 10 years or longer
If you’re reading this in 2022, and you plan to pull your money out for a house down payment in 2025, you may want to open a short-term account separate from your retirement account with a specific horizon of three years. In that account, you’ll want to focus on low-risk, short-term investments like target-date mutual funds or index funds.
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2. Determine which investment account type(s) you need
Your next step is to open an investment account. The two most common types of investment accounts are brokerage accounts and retirement accounts.
- Brokerage accounts are your standard, everyday, stock trading accounts. They enable you to buy, sell and trade stocks, bonds, ETFs, mutual funds and more.
- Retirement accounts operate the same as a brokerage account but have a different tax classification with the IRS. Retirement accounts have more tax advantages but also more restrictions, such as maximum annual contributions, penalties for withdrawals before age 59.5, etc.
Some investors treat their brokerage account like their retirement account. They forgo the tax benefits of having a separate retirement account in exchange for having all of their investments in one place where they can make pre-retirement withdrawals without IRS penalties.
However, most investors still prefer to have separate brokerage and retirement accounts. This strategy lets you maximize the tax benefits of the latter while setting separate risk parameters for each.
What you don’t want to do is invest all of your money into your retirement account. Remember, withdrawing from retirement can incur stiff penalties of 10% or higher and wipe out a big chunk of your earnings.
That’s why you’ll want a brokerage account that is separate from retirement where you can stash money for pre-retirement milestones such as a house, a car or education.
3. Open your investment account
These days there are three options for opening an investment account: you can open one with a DIY investing app like Robinhood, a robo advisor like Betterment or even through a human-led brokerage firm.
You can also mix and match. For example, one smart strategy is to let your human or robo advisor handle your sensitive long-term accounts (retirement, 2028 house fund, etc.) while you go hands-on with a smaller, short-term account buying up speculative stocks. That keeps the bulk of your cash in safe hands while you learn, trade, and make mistakes.
To help you find the right mix, here’s a rundown of the pros and cons of each:
DIY investing apps
If you’d like to invest your own money and effectively be your own portfolio manager, you’ll probably be happiest with a self-directed investing app like Robinhood or Webull. Here’s a running list of our favorites.
Unlike robo advisors or even flesh and blood financial advisors, investing apps give you free reign to handpick your own investments. They typically won’t stop and ask questions, for better or worse.
The chief advantage of the DIY approach is fees: it’s usually free to trade your own stocks, while advisors charge fees. And to be clear, using a DIY app isn’t akin to day trading; you can (and should) simply use a DIY app to buy and hold stocks for the long term.
A robo advisor is essentially an AI portfolio manager that picks your investments for you. Robo advisors like Betterment will ask about your goals, risk tolerance and horizon, then design an ideal portfolio to match all three based on that information. Then, all you have to do is deposit money.
Oftentimes your portfolio with a robo advisor isn’t 100% bespoke, but rather a mix of pre-existing portfolios designed by the firm powering the AI.
Robo advisors tend to charge 0.1% to 0.5% of your total portfolio as a management fee. If you’d rather set your investments on autopilot than go for the DIY approach, they’re a massively cheap and convenient option.
Human financial advisors
Despite the emergence of cheaper and faster robo advisors, there’s absolutely still value in having a human financial advisor on your side.
Sure, letting a human manage your finances is more expensive — most human-powered firms charge a 1% management fee — but that extra 0.5% grants you access to a professional who can provide guidance, education and investment advice tailored to your specific financial situation.
More: What is a financial advisor?
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4. Decide how much to invest in stocks
Now that we’ve established your why and your how, let’s cover the how much. Depending on your income level, how much should you be investing in the stock market?
I recommend investing up to 20% of your income each month.
This strategy may require some effective budgeting, but it’ll pay off, even in the short term. To illustrate, if you make $50,000 annually, 20% of your pre-tax monthly income is roughly $830. Invest that in an S&P 500 index fund with 10% average annualized returns, and you’ll have $62,000 in 5 years — enough for a home down payment — and $1.7 million in 30 years.
1) Invest 5 to 10% in your retirement account first
A common mistake many new investors make is that they start trading stocks before maxing out their 401(k). This misstep is leaving money on the table.
And I mean that quite literally.
The chief benefit of a workplace-sponsored 401(k) is that most employers will match up to 3% of your annual contributions to it — some even higher. That means that if you make $50,000 a year and contribute 3% or $1,500 to your 401(k), your employer will also toss in $1,500 for a total of $3,000.
That’s the equivalent to an instant 3% raise, so be sure you’re maxing that out at minimum.
Then, if you can afford it, it’s best to invest 10% of your pre-tax income into your retirement account — even if you’re self-employed and have an IRA.
More: A guide to investing for retirement
2) Invest an additional 5 to 10% in a short/medium-term brokerage account
Once retirement is taken care of, invest what your budget allows into your short- to medium-term brokerage account.
While investing this much of your monthly income may feel scary, one of the primary reasons for investing in the stock market is to protect your money from inflation. Cash sitting in your checking or even savings account isn’t really “safe;” if it’s not generating interest, it’s only losing value to inflation.
I don’t mean to light a fire under your butt, but rather, to help you see that a sensible and conservative stock market investment is subjectively “safer” than letting your money just sit.
5. Choose your stocks or funds
Next up, the million dollar question (literally): which individual stocks should you buy?
We've published a feature on the best retail stocks to invest in, but before you start buying stocks, let’s consider all of your options:
Stocks vs. bonds vs. funds: which is best for you?
Once you open a brokerage account, what’s on the “menu” and which should you buy? The three most common tradable assets on the stock market are stocks, bonds and funds.
- Stocks come in units of “shares” and represent partial equity in a company. Your percentage ownership also entitles you to a share of the profits. Some companies pay this out to shareholders as dividends, but most will reinvest them to grow the company, further raising share prices. You profit from stocks by either accruing dividends or selling higher than you bought in.Preferred stock grants you voting rights with the company, while common stock doesn’t (and typically doesn’t include dividend payments). A growth stock is expected to outpace average market growth, but doesn’t always (so watch out!).
- Bonds are a loan from you to a corporation or the government. They typically have fixed interest rates, so $1,000 in bonds at 2% will generate $20 per year. Due to their fixed income, bonds are the bedrock of conservative, low-risk portfolios.
- Funds are baskets of other assets (stocks, bonds, etc.) tied together by a common theme. There can be funds full of space technology stocks, municipal bonds or even funds that are designed to emulate the overall performance of an entire market index (called index funds). The two most common types of funds are the passively-managed ETF and the actively-managed mutual fund.
So, which is right for you?
Your mix of all three will depend on your risk tolerance. If you have a high risk tolerance, you’ll want to invest mainly in stocks (which are high-risk/high-reward) and maybe a little in funds — perhaps a 50/50 split. If you have a low risk tolerance, you might want to stick to a 25/50/25 split.
Index funds are the great equalizer, providing the ideal mix of low-risk and medium-reward. But don’t take it from me: “I just think that the best thing to do is buy 90% in an S&P 500 index fund,” Warren Buffet said.
6. Relax, hold and manage your portfolio
Hollywood has given us the impression that you have to constantly buy, sell and trade stocks in order to get rich. In reality, the exact opposite is true.
Once you’ve made your first few smart investments, the next best thing to do is nothing. Just keep buying and holding, and leave your underlying assets alone.
Studies have shown time and time again that a passive investing strategy outperforms an active one. You won’t just save time and stress by letting your investments sit and mature — you’ll make more money that way.
That being said, there are certain times when it might make sense to change up your portfolio. Aside from simply selling off some of your positions to pay for a house, when is it time for a change-up?
When should you rebalance your portfolio?
The best times to rebalance your portfolio are when your risk tolerance and/or horizons change.
If you decide to get an advanced degree and need $50,000 in five years, you have a new time horizon and may want to invest in more ETFs/fewer stocks to lower the risk in your portfolio. That way, a more predictable amount of cash will be waiting for you to cover your tuition.
Similarly, if your investments are causing you anxiety, you may want to temporarily reduce your risk tolerance so you can better sleep at night.
One of the perks of having a human or robo advisor is that you can task them with rebalancing your portfolio for you. All it takes is a click or a phone call.
If you’re a DIYer, check out our guide to rebalancing your portfolio.
The bottom line
Investing in stocks sounds more complicated than it is. In reality, once you’ve made a few key decisions, downloaded an app or two, and bought and held the right shares, you’ve greatly accelerated your path to financial independence.
For more general investing tips, check out our guide on how to invest money wisely.
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