You may get overwhelmed by all you need to know before investing, but you can learn. Some people choose to learn independently, while others ask for help. If you are going to learn on your own, I recommend three books (in order as each helps build a more profound understanding):
None of these books are all-inclusive, but they will give you a good place to start.
If you want to pay someone to help you learn, look for an Advice-Only, Fee-Only, Fiduciary, CERTIFIED FINANCIAL PLANNER™. Let me break that down for you:
- Advice-Only – You pay them for their time and advice. Usually, this is on either a monthly retainer or hourly basis. The good thing is that you will not pay an ongoing AUM (Assets Under Management) fee with an Advice-Only CFP® professional. Some people prefer delegating their investing to others (and paying an AUM fee of 1-1.5% per year or more), but the challenge is that you may not build your knowledge.
- Fee-Only – If they are fee-only, the CFP® professional is only paid by their clients (i.e., you). They do not get paid commissions or referral fees to sell you any product (which is good). Watch out for “fee-based,” as they are getting paid to sell you products.
- Fiduciary – While there are many components to the fiduciary definition, the bottom line is that the CFP® professional has to put your interests ahead of their own.
- CERTIFIED FINANCIAL PLANNER™. The CFP® designation means they have the training and experience to do financial planning. To earn your CFP® marks, you need to have a bachelor’s degree, special training, 6,000 hours of experience, pass an exam, and meet the CFP® ethics standards. This is important as anyone can call themselves a financial advisor, but not everyone is a CFP® professional.
I’m biased. I am an Advice-Only, Fee-Only, Fiduciary, CFP® professional. Other professionals can help you, but the bottom line is to learn either on your own or with a professional.
Understanding why you invest includes knowing your goals and how to balance risks and rewards.
Start with a good understanding of your goals in investing. Your investing strategy changes if you want to live a FILE (Financial Independence, Live Early) lifestyle or FIRE (Financial Independence, Retire Early), save for a house, leave an estate to others, or achieve any other goals. Your goal needs to be SMART (Specific, Measurable, Achievable, Relevant, and Time-bound). It isn’t enough to say you want to be a millionaire. When do you want to be a millionaire (and be reasonable)?
Risk vs. Reward
With your goal in hand, you need to balance risk and reward. Investing comes with risk. You make money on your investments because you are paid a ‘risk premium.’ Riskier investments tend to have a higher return potential, but they also have a more significant downside. The riskiest plan may be on the YOLO/FOMO side and just swinging for the fences. The problem with this approach is that it is not much different from going to a casino and putting it all on a roulette wheel. If you hit, it will be great, but if not, you are walking away with nothing. On the other hand, if you put your money in a nice, safe, high yield savings account, you won’t lose money and may not even keep up with inflation.
The challenge with investing is to balance the amount of risk with your goals. If your investments keep you up at night, you may have taken on too much risk. I’ve often had the conversation: “Do you want your investments to be sexy or effective?”. The bottom line is that effective investments are not always sexy, but they balance risk and reward to get to your goals.
Where to invest
Where you invest will impact your bottom line. I don’t mean which brokerage you use, but which accounts you invest in. Which account you use to hold your investments affects the tax you pay. You get to choose when and how you pay taxes, not if you have to pay them. While there are many choices, here are some basics:
A taxable brokerage account is just what it says. You pay taxes on the dividends and on what you sell. If you hold investments for over one year (sell them one year and one day after you buy them), you will pay long-term capital gains on what you made. The bonus of paying long-term capital gains is that the rates tend to be lower than income taxes (current long-term capital gains rates are 0%, 15%, and 20%).
A word of caution about taxable accounts: DO NOT DAY TRADE. If you sell a stock at a loss and then repurchase it within 30 days (either side), you can end up with a ‘Wash Sale.’ A wash sale results in the loss being ‘disregarded.’ The Bottom line is that you can owe more than you made (which has really hurt some people).
When people think of 401(k)s, they often think of pre-tax (traditional) contributions. The bonus of a traditional 401(k) or IRA is that you get a tax break now for what you put in. The downside is that you have to pay income tax on what you take out. Also, with a traditional 401(k) or IRA, you will have to take Required Minimum Distributions (RMDs) at 72. With RMDs, math sets the amount you MUST take out each year, even if you don’t need it. For some people, RMDs may push you into the top income tax brackets in your old age, so be careful.
For a Roth 401(k) or IRA, you pay your income taxes now on what you earned, but everything you put into a Roth grows tax-free (and comes out tax-free). The debate is whether you want to pay taxes on the seed (as in Roth) or the harvest (as in traditional). For my clients, I tend to encourage Roth unless they have a reason why they need to lower their income now (such as for some income-driven repayment programs for school loans). The other bonus of Roth contributions is that in a Roth IRA, there are NO RMDs.
Retirement accounts can come in Roth or Traditional formats, but then there are a lot of other twists and turns. If you work for an employer, you may have an option to be in a 401(k), 403(b), 401(a), 457, or a bunch of other numbers. Each of those numbers reflects a different place in the IRS code. Many of the plans work the same, but the bottom line is that there is a maximum that you can put in as an employee and that they can put in as your employer. An IRA is an Individual Retirement Account. There are maximums you can contribute for an IRA and income limits for contributions. The bottom line for all retirement accounts is to look up the maximums as they change year to year.
HSAs, 529s, and other special accounts
There are other special accounts with their own benefits (and quirks). A Health Savings Account (HAS) is available to people who have a high deductible health plan and is very special. An HSA has a rare triple tax benefit: you get to write off what you contribute to your income taxes; it grows tax-free and comes out tax-free if used for medical expenses. Another common special account is a 529, which pays for school. You can use a 529 for kids (as is expected), but you may also be able to use it for your educational expenses.
What to invest in
It seems like they invent a new thing to invest in every day. You do not need to invest in all the new types of investments to achieve your goals. Focus on what you understand. I will highlight a few popular assets, none of which should be considered a recommendation.
When most people talk about investing, they are thinking about stocks. When you own a stock, you own part of a company. By owning part of the company, you get a portion of the profits. Company profits may come to you in dividends or capital appreciation (the stock goes up). Dividends are paid over time, and if they are in a taxable account, you get a tax bill each year. You can choose to enroll in a DRIP (Dividend reinvestment plan) which uses the dividends just to buy more of the same stock, but you still get taxed on the dividend as if you took cash. On the other hand, if the stock goes up, you don’t get taxed until you sell it.
A bond is effectively you loaning someone money and collecting the interest. When you buy a corporate or US bond, you give money now for interest payments over time and then get your principal back. US treasury bonds are considered a risk-free return, so they tend to have a low return. There is a caveat, however. US I-Bonds have a mix of interest and inflation protection that have been providing a remarkable return this year. Bonds are often used to help balance your portfolio and risk. You will see terms like a 60/40 portfolio which is 60% stocks and 40% bonds. The stocks tend to be more volatile while the bonds are slow and steady.
ETFs and Mutual Funds
The challenge with stocks is that if you put all of your money into one company, you are not diversified and are taking on a lot of risk. If the company does well, you will also, but if not, you may lose it all. When you buy an ETF (exchange-traded fund) or mutual fund, you buy a basket of stocks. ETFs and mutual funds allow you to buy a basket of all stocks in the US, the world, or in a particular area such as technology. The bonus is that when you buy 1 ETF, you effectively buy many different stocks. Keep an eye on fees. ETFs tend to have lower fees than mutual funds. Any fee you pay is taking away from your investment’s growth. There are also both active and passive funds. Active funds tend to have higher fees, and you are betting on whoever is managing the fund to get better returns than that fee.
Target Date Funds
There are a growing number of Target Date Funds. In most cases, these are funds that shift between stocks and bonds over time. For example, if you have a target date fund for retirement with a date of 2040, it will have more stocks than bonds now but will move towards more bonds by 2040. You may find Target Date Funds in your 401(k) options; just be sure to check the fees and understand what the fund is doing.
Others – Commodities, Crypto, and more.
You can invest in just about anything you want. Right now, the big discussion seems to be around oil (a commodity) and cryptocurrencies. Each alternative asset class has its considerations and risks. Before you invest in any of them, be sure you understand and allocate an appropriate percentage of your portfolio (i.e., don’t put everything in one class of assets).
With technology, the actual how of investing has become very easy. The key to remember is that you need to not only fund your account but also invest what you put in. I regularly review people’s investments, and it is very common to see people who put money into their IRAs but never invested it.
Opening an account
The first step is to open an appropriate account (taxable, pre-tax, post-tax, etc.). There are many brokerages out there to choose from. Look for ones with little or no fees. Pick one and stick with it. A brokerage does the buying and selling for you and becomes the ‘custodian’ of your investments. They hold the investments for you. You are not investing in that brokerage. Having more than one brokerage does not help with your diversity; it just makes things more complex to keep an eye on.
Adding to your account
When you open your account, you will be able to add funds just as with any other financial institution. Most brokerages have an easy way to add funds directly from your bank account. If you are adding funds to your IRA (or similar account), you will have options such as which year to credit the funds to (i.e., 2021 or 2022 taxes) and if it is pre or post-tax. Be sure to take your time and make sure everything is credited appropriately. It may take up to a week or so for your funds to clear and be ready to invest.
Once you know what you want to buy and have your account funded, you can buy some investments. ETFs and stocks will be in per-share price (i.e., $50), and you will need to calculate how many shares to buy to match what you want to invest. You will also have an option of purchasing at ‘market’ or a ‘limit.’ Market will buy your stock at whatever it is selling for, while a limit will specify what you want to pay. Keep in mind that if your limit is too far from the current price, you may have to wait a period of time for it to go through, or it may not go through at all. With mutual funds, you may be able to specify that you want to buy a dollar amount, and it will sell you fractional components (i.e., if you want to spend $1k, it will do the share math for you).
It will take three days for the sale to clear, but now you own whatever you bought. Selling is a similar process, but keep in mind the tax consequences. If you keep something for over a year, it will be long-term capital gains (a favorable rate).
Investing itself is not complex if you take the time to learn. The intent of this article was not to teach you everything but to give you things to think about. Pick a method to learn and get started. You will make mistakes, and that is ok. Just learn from each of your mistakes.
If you would like help learning, I offer a no-cost 60-minute introductory meeting with me at https://calendly.com/coachdrjay/childfree.
Disclaimer: Nothing in this post should be considered investment advice. The content is for educational purposes only. Invest at your own risk, and consult your financial planner for more.