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The Smarter Way to Start Investing

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Making the decision to start investing is the smartest thing you'll ever do. But once you decide to become an investor, you still need to figure out what that means, both in terms of what you'll invest in, and how you'll choose and evaluate the investments you make.

Starting out simple
In a recent column, USA TODAY columnist Matt Krantz suggested a simple three-step process for starting out as a beginning investor. First, decide whether you'll be an active trader or a long-term investor. Second, decide whether you'll buy funds or individual stocks. Third, find a financial provider, either a mutual fund company or a brokerage firm, to help you buy the investments you want.

That's simple advice. But it may mislead you into thinking that you have to pick one or the other in each of these decisions. In reality, though, you'll find that doing a little bit of everything in moderation can maximize your chances to succeed with your investments.

A Fool's evolution
Legendary superinvestor Warren Buffett once said that his favorite holding period for an investment is forever. Although you wouldn't want to take that advice literally -- after all, you'll probably want to spend that money eventually -- the idea is that finding companies that can stand the test of time and deliver solid returns year after year is a whole lot less trouble than worrying about all the short-term bumps in the road along the way.

That's the logic behind index investing. Index funds don't entirely follow a buy-and-hold strategy, because the index components themselves change from time to time. But the concept is similar: once a stock qualifies for an index, buy it and hold it as long as it continues to meet the index's criteria for inclusion. If it ever fails, then dump it and buy a replacement.

For instance, anyone who bought the stocks in the original S&P 500 back in 1957 would find that dozens of original members are still around, including 3M (NYSE: MMM  ) , Dow Chemical (NYSE: DOW  ) , and Procter & Gamble (NYSE: PG  ) . These companies have all thrived largely from products that have been around for decades -- think Scotch tape, styrofoam, and Tide laundry detergent. Yet continuing innovation has obviously also played a huge role in their success.

When you find great companies, as indexes often do, it makes lots of sense to hold onto them. But that doesn't mean you always have to rely on indexes to do your thinking for you.

Playing defense
Indexes make life easy for investors, but they suffer from a flaw: They're brainless. Often, they own stocks that most people would already have cast off as hopeless causes.

Take the Dow Industrials as an example. The Dow included GM and Citigroup until the middle of 2009, even though GM had already filed for bankruptcy, and Citigroup had lost well over 90% of its value in the previous two years. AIG remained in the average until late September 2008, after the bulk of its price drop had already occurred. Dow-tracking investors had to stick it out to the bitter end.

But if you think you could do differently, then you open up the can of worms that is active investing. It takes work to distinguish a long-term loser like Eastman Kodak (NYSE: EK  ) , which languished at the same depressed prices for decades as its business model gave way to advances in digital technology, from a company like (Nasdaq: AMZN  ) . Amazon certainly looked as good as dead as an investment at the depths of the tech bust in 2001, but anyone who sold it suffered the consequences; the e-tailer has rebounded nearly 20-fold since. And Amazon still has room to run -- analysts project that the company will grow by at least 26% annually over the next five years.

Do a little of everything
The secret to successful investing lies in learning how to balance both active and index strategies. Consider keeping not only a core portfolio of index funds, but also a trading account to let you take advantage of short-term trends and ideas. That way, you can build your skills as a trader without putting your entire portfolio at risk.

A simple start to your investing career makes a lot of sense. But don't feel like you have to make a lifetime's worth of decisions all at once. If you treat investing as a learning experience, you'll do best by keeping your mind open to all the possibilities within your reach.

The first thing about investing is to beware of what you're buying. Matt Koppenheffer exposes yet more proof that Wall Street is winning at your expense.

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Fool contributor Dan Caplinger remembers his first investment well. He doesn't own shares of the companies mentioned. 3M is a Motley Fool Inside Value choice. is a Motley Fool Stock Advisor selection. The Fool owns shares of Procter & Gamble, which is a Motley Fool Income Investor selection. Try any of our Foolish newsletter services free for 30 days. Even with a hangover, The Fool's disclosure policy got perfect scores on its SATs.

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