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Engaging in the financial markets may seem daunting when it comes to managing your finances, but it also holds the potential for significant rewards. While market downturns can be unsettling, investing is one of the few ways to outpace inflation and enhance your purchasing power over time. Simply relying on a savings account will not lead to wealth accumulation.
This makes investing one of the most beneficial actions that individuals of any age in America can take to embark on the path toward financial well-being.
Here is how you can initiate investing and reap the returns that can pave the way for a better financial future.
How to initiate investing: 6 steps to follow
1. Explore retirement accounts
For many individuals, the ideal starting point is their employer-sponsored retirement plan – typically a 401(k) – provided through their employer’s benefits package.
In a 401(k) plan, the funds you contribute from each paycheck will grow tax-free until you commence withdrawals upon reaching retirement age. Many employers even match contributions up to a certain percentage for employees participating in their sponsored plans.
These plans offer additional advantages based on the type of 401(k) plan you opt for:
- A traditional 401(k) allows you to deduct your contributions from your paycheck, deferring taxes until you withdraw the funds in the future.
- A Roth 401(k) enables you to withdraw your funds tax-free – after accumulating gains over time – but requires you to pay taxes on contributions.
Regardless of your choice, all the details on 401(k) plans can be found here.
Additionally, Bankrate’s 401(k) calculator can illustrate the growth potential of your funds throughout your career.
Understanding the logistics of a 401(k) can be complex, especially for recent graduates or those new to contributing. Seek guidance from your employer. Your plan’s administrator – sometimes a major broker such as Fidelity, Charles Schwab, or Vanguard – may offer tools and planning resources to help you educate yourself on sound investing practices and the available options within the 401(k) plan.
If your employer does not offer a 401(k) plan, you are a non-traditional worker, or you wish to contribute more, consider opening a traditional IRA or Roth IRA.
- A traditional IRA is akin to a 401(k): You contribute pre-tax funds, allow them to grow over time, and pay taxes upon withdrawal during retirement.
- With a Roth IRA, you invest post-tax income, and the funds grow tax-free, with no taxation upon withdrawal.
There are also specialized retirement accounts for self-employed individuals.
The IRS imposes annual contribution limits on these accounts, so ensure compliance with these guidelines:
- For 2024, the contribution limit is $23,000 for 401(k) accounts (excluding employer match) and $7,000 for an IRA.
- Individuals over 50 years old can make an additional $7,500 contribution to a 401(k) as a catch-up contribution, while an IRA allows an extra $1,000 contribution.
2. Utilize investment funds to mitigate risk
When commencing investing, one of the initial considerations should be your risk tolerance. During market downturns like those experienced in 2023, many investors panic. However, long-term investors view such downturns as an opportunity to acquire stocks at discounted prices. Investors who can endure these downturns often benefit from the market’s historical average annual return of around 10 percent. But it is crucial to remain invested during challenging periods.
Some individuals seek quick profits in the stock market without facing any downside, but the market does not operate on such principles. Enduring downturns is necessary to realize gains.
To reduce risk as a long-term investor, diversification is key. When young with a distant withdrawal horizon, you can afford to be more aggressive in stock allocation. As retirement or your desired withdrawal date nears, start scaling back risk. Over time, your diversification should become more conservative to avoid significant losses during market downturns.
Investors can swiftly attain a diversified portfolio with an index fund. Instead of actively selecting stocks, an index fund passively holds all stocks in an index. By owning a broad range of companies, investors evade the risk associated with investing in individual stocks, though not entirely eliminating stock investing risks. Index funds are commonly featured in 401(k) plans, making it easy to locate one in your plan.
Another popular passive fund type that can reduce risk aversion and simplify your investment journey is a target-date fund. These funds automatically adjust your assets to a more conservative mix as retirement approaches. Typically, they transition from a higher stock concentration to a more bond-oriented portfolio as the retirement date nears.
3. Familiarize yourself with investment options
A brokerage account opens up various investment opportunities, including:
Stocks
Stocks confer a fractional ownership stake in a business and are among the top methods to accumulate long-term wealth for yourself and your family. However, they can be highly volatile in the short term, necessitating a holding period of at least three to five years – the longer, the better. Learn how stocks function and how you can generate substantial returns as a stock investor.
Bonds
Investors utilize bonds to establish a dependable income stream, with bond ownership yielding less risky but lower returns compared to stocks. Bonds tend to exhibit less fluctuation than stocks, making them suitable for balancing a high-octane stock portfolio. Discover how bonds function and leverage various bond types to bolster your portfolio.
Mutual funds
A mutual fund is a compilation of investments, typically stocks or bonds, but sometimes a combination, owned by numerous investors. By purchasing shares in the fund, which is often diversified across multiple investments, you mitigate risk and potentially enhance returns. Mutual funds are an excellent vehicle for inexperienced investors seeking substantial returns in the market.
Exchange-traded funds (ETFs)
ETFs resemble mutual funds, offering the opportunity to invest in stocks, bonds, or other assets. However, they present a few advantages over mutual funds, such as minimal management fees, making them more cost-effective to own. Moreover, ETFs can be traded throughout the day like stocks and have the potential to deliver significant returns to even novice investors.
4. Strike a balance between long-term and short-term investments
Your investment horizon influences the most effective account types for you.
If your focus is on short-term investments – those accessible within the next five years – money market accounts, high-yield savings accounts, and certificates of deposit prove most beneficial. These accounts are FDIC-insured, ensuring your funds remain secure. Although short-term returns may not match those of long-term investments, they offer safety in the short run.
Investing in the stock market on a short-term basis is generally unwise, as a period of five years or less may not suffice for market recovery in the event of a downturn.
Conversely, the stock market is an ideal avenue for long-term investments and can yield substantial returns over time. Whether saving for retirement, planning a home purchase in a decade, or preparing for your child’s college expenses, a range of options – such as index funds, mutual funds, and ETFs – featuring stocks, bonds, or both are available.
Commencing your investment journey is easier than ever with the proliferation of online brokerage accounts tailored to your specific requirements. Investing in stocks or funds has never been more affordable, with brokers eliminating commissions and fund companies continuously reducing management fees. Engaging a robo-advisor for a modest fee to select investments on your behalf is also a viable option.
5. Avoid common pitfalls
A prevalent mistake among novice investors is excessive involvement. Studies reveal that actively traded funds usually underperform compared to passive funds. Your funds are likely to grow more steadily, and you will experience peace of mind by refraining from checking (or altering) your accounts excessively throughout the year.
Another pitfall is failing to utilize your accounts as intended. Retirement accounts like 401(k)s and IRAs offer tax and investment advantages specifically for retirement purposes. Utilizing them for other purposes could lead to tax implications and additional penalties.
Although you may be permitted to take a loan from your 401(k), doing so results in forfeiting potential gains that the funds could have accrued, in addition to the requirement to repay the loan within five years (unless used for home purchase), or facing a 10 percent penalty on the outstanding balance. Some exceptions to the 10 percent penalty exist, however.
Since your retirement account is designated for retirement, using it for other purposes necessitates a careful evaluation of whether the expense is truly essential.
6. Continue learning and saving
The positive news is that you are already taking a significant step towards getting started: educating yourself. Absorb reputable information on investing, including books, online articles, social media experts, and even YouTube videos. Numerous resources are available to help you identify the investing strategy and philosophy that aligns with your preferences.
You can also engage a financial advisor who will collaborate with you to establish financial goals and tailor your journey. When seeking an advisor, prioritize finding one who prioritizes your best interests. Inquire about their recommendations, confirm their status as a fiduciary acting in your best interest, and ensure comprehension of their payment structure to avoid hidden fees.
Typically, a fee-only fiduciary presents the least conflicts of interest – one whom you remunerate rather than being compensated by major financial entities.
Why investing is crucial
Investing stands as the most effective means for Americans to amass wealth and save for long-term objectives like retirement, college expenses, home purchases, and more.
Initiating investing early enables leveraging compounding gains, accelerating the growth of your account over time. Your funds generate returns – without any active effort on your part. Aim for investments that not only keep pace with inflation but surpass it, securing your future financial stability. Outperforming inflation enhances your purchasing power over time.
What is the minimum investment required?
There is no fixed minimum when embarking on investing. You can commence your journey with any amount, even as little as $1, thanks to brokerage accounts with minimal or no minimums and availability of fractional shares. However, prior to initiating investments, assess your financial status, establish a robust emergency fund, and ensure manageable debt levels.
Regarding retirement, the suggestion is to begin as early as feasible, even with modest amounts, and strive to save approximately 10% to 15% of your income. For non-retirement investments, ensure financial stability and readiness to handle the inherent risks of investing.
Concluding thoughts
While many individuals may harbor reservations about investing, mastering the fundamentals can lead to substantial financial gains over time. Commencing investing could be the most impactful decision for your financial well-being, paving the way for long-term financial security and a fulfilling retirement.
— Bankrate’s Brian Baker contributed to an update of this story.