If you’re ready to get started building wealth, then you probably already know that you need to invest. Getting started investing can be overwhelming. There’s so much to learn that it’s easy to fall into analysis paralysis and never actually pull the trigger on putting your money to work.
While there will always be more to learn, here are the five things you absolutely must understand before you get started.
1. You don’t need to save to invest
There’s a common misconception that you need to save up in order to start investing. I’ve seen advice stating that you can start with a little as $1. That’s definitely true. You can open a Robinhood account and buy $1 of any stock or fund, and Robinhood will charge no fee.
While this is a great way to get started, Robinhood can be controversial. Part of this is that their revenue stream comes from working through “market makers”. Essentially, wholesalers for stocks. While you aren’t directly paying a fee, Robinhood is making a cut when your order is sold to this wholesaler.
Other options would be Betterment or Acorns, however, you’ll lose that dollar to fees after a month.
If you want to go a more traditional route and go through a standard brokerage firm, you will need to save to invest, but not much. This is because these firms don’t sell fractional shares the way that Robinhood does.
In order to buy through a brokerage, the most important question is what do you want to buy. You’ll need enough to buy at least 1 share of whatever you’re investing in. For example, SCHB, the Charles Schwab US Broad Market ETF, is trading at $107.66 as I write this blog. If I want to buy into that, Ill need that amount of money to buy a whole share.
Look around at broad market funds, see what range they’re selling in. You should be able to get your feet wet investing through a brokerage with about $100.
2. Compound interest is amazing
If you’re just getting started with investing you’ll often hear that time is your greatest asset. This is because of a little thing called compound interest.
Simple interest vs. compound interest:
If investing worked on simple interest, if you started with $100 and made 10% in interest, you’d make $10 every year. In 10 years you’d have $200.
With compound interest, you make interest on the interest you’ve already earned. So if you invest $100 at 10%, here’s what your balance will look like at the end of each year:
- Year 1: $110
- Year 2: $121
- Year 3: $133.10
- Year 4: $146.41
- Year 5: $161.05
- Year 6: $177.16
- Year 7: $194.87
- Year 8: $214.36
- Year 9: $235.79
- Year 10: $259.37
That’s 129% of what you would have made with simple interest. In fact, in the early months of year 8, you would have already surpassed your simple interest earnings.
This is why time is so important, your earnings compound, even without continuing to invest.
3. Know your investing goals
This one kind of annoyed me when I started investing. I was like, “um…make money”. But knowing what I want that money for is important to how I choose to invest my money.
Most people will have two separate investing goals – one long-term (ie retirement) and one short-term (ex: down payment for a house, trip to Nepal). For the long term, especially if you’re younger, time gives you more opportunity to absorb more risk. The market is going to flux, that’s the nature of the game. When you have 20 years to let the market do its thing, those corrections over time don’t really matter. You’ll still end up ahead.
This isn’t the same story when it comes to a shorter-term goal. Imagine you have been working to put away $15k for a down payment on a house. If the market goes through a 15% “correction” (re: dip) at the same time that you’ve approximated you’ll have enough and be ready to buy, then you’ll be out of luck. A 15% correction in this instance would mean you’d be down to $12,750 – far short of your goal.
Examples like these are a core part of the reason that there aren’t many hard and fast rules for investing strategy. Your goals and your timeline will dictate the right strategy for you.
4. Tax-sheltered accounts are your friend
One of, if not the most, expensive bills you will pay in your lifetime is to the taxman. The average American pays almost 30% of their income to taxes. The only cost that rivals this is housing, which generally represents 30% of take-home pay (re: after taxes).
Saving money by decreasing this bill can be a huge win.
What does tax-sheltered mean?
Tax shelters are a legal way to store assets that minimize the amount of taxes you pay on them over time. This is not to be confused with the very illegal practice of tax evasion (just not paying when you owe).
The most common tax-shelters are IRAs, Roth IRAs and 401Ks. All of these accounts work in different ways, but the most important piece is that you can buy and sell as you please without paying taxes until the time of withdrawal.
This is different than a standard, taxable brokerage account. When you put money into one of these accounts you have more flexibility than a tax-sheltered account. You also have to pay taxes on your earnings, specifically when you sell shares or make withdrawals. The way those taxes work out is split between short-term (less than a year) and long-term (longer than a year).
Let’s say you buy $1,000 worth of shares in the aforementioned VTI. After holding it for 9 months you have $1100 and decide to sell. You’ll owe your standard income tax rate on the $100 you earned, potentially reducing your earnings from $100 to $70.
These taxes add up the more you trade. This is why being able to manage your investments in tax shelters allows you to compound more money over time.
5. Assess your risk level
According to the FINRA Foundation, nearly two-thirds of Americans can’t pass a basic financial literacy test. One of the basic principles of financial literacy is protecting your money. Protecting your money is all about risk tolerance.
Risk tolerance is your emotional and financial ability to withstand loss. For example, if you were offered $1,000 cash or the opportunity to participate in a coin flip where you would win $5,000 if you guessed correctly, which one would you choose?
Your answer demonstrates your risk tolerance. If you choose $1,000 guaranteed over the 50% chance of gaining 5X more, you’re less risk-tolerant. The important thing to focus on when you think about risk tolerance is how you handle the loss. Taking on more risk is going to open the opportunity to more reward, but are you able to handle risking loss during times of volatility?
This concept is important for financial literacy because it’s so easy to only focus on the opportunity for reward without thinking through the potential for loss. This is apparent watching investors get into crypto. Crypto is incredibly high-risk investing. Many of us have friends or family who have done more than well through buying crypto. Maybe you are now thinking of getting into it. It’s important to think through if you will be ok if a particular currency crashes.
This chart shows the value of Ethereum (ETH) over the past year. If you bought on May 11, 2021, the price would have been at its top at $4,177.78. By June 25, 2021, you would have lost over half of your investment when the price hit $1,830.32.
It’s important to be honest with yourself in realizing if you’re the type of person who, on June 25th, would have calmly said “I’m going to ride this out”. Or if you’re the type of person who would have cut your losses and sold your shares. If you’re the latter there’s potential for you to lose a lot of money if you try to take on high-risk investments.
If you’re not sure, the internet is full of quizzes to test your risk tolerance. Try this Investor Questionnaire from Vanguard or Google around.
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Also note, I am not a certified financial advisor. I’m just someone who loves learning about money. Advice offered in this blog is strictly for education purposes.