All things being equal, it's better to start investing sooner rather than later. Consider that $1,000 invested at the stock market's historical rate of return for 20 years will grow to about $6,000. Over 30 years, the same amount would grow to more than $15,000.
However, there is such a thing as starting too soon for you. Before you start investing, you need to make sure your money isn't being wasted elsewhere and that you're financially prepared for emergencies. You also need a basic working knowledge of how investments work, so you can use your investment dollars effectively.
With that in mind, here's a quick guide that can help you answer the question, "Am I ready to start investing?"
Get rid of high-interest debt
It doesn't make sense to start investing if you have high-interest credit card debt. The reason why is simple mathematics.
Let's say that you have $5,000 in credit card debt at an average interest rate of 18%, and that you recently discovered that you're getting a $5,000 tax refund. You're trying to decide whether to pay off this debt or use the money to start investing in mutual funds.
Well, at 18% interest, your credit card debt is costing you $75 per month in interest alone. Even very good investors can only expect to average about 10%-12% annualized returns over the long run -- at the high end, this translates to an expected return of about $50 per month. Sure, this is an average and some months will produce higher returns, but mathematically speaking, by choosing to invest, you're setting yourself up to lose $25 per month over the long run.
It's important to point out that I'm not talking about any debt at a 0% (or close) APR (annual percentage rate, the effective interest rate you're paying). In this case, it's smart to take advantage of the extra time to pay (but be sure you do before the low interest period runs out).
Prepare for the unexpected
In addition to getting your credit card debt under control, it's also a smart idea to make sure you're financially prepared for emergencies before investing.
Experts suggest that you should aim to set aside six months' worth of expenses in a readily accessible emergency fund. While I agree that this is a good goal to shoot for, I don't thinkyou need this much put aside before you start investing.
However, you should at least be prepared for small emergencies. The majority of Americans can't cover a $1,000 unexpected expense without going into debt (see previous section) or selling something.
In a nutshell, you don't want to be forced to sell some of your investments shortly after you make them because your car gets a flat tire, or your air conditioner breaks down.
My suggestion: If you don't have substantial emergency savings yet, pick an attainable goal (say, $1,000) that you can reasonably set aside in the next several months to a year and try to build up this much of an emergency fund before you start investing. After all, a $1,000 emergency fund puts you in better shape than about half of Americans. The peace of mind that you won't need to tap into your investment portfolio for every little expense will be well worth the wait.
One exception to these rules
Before we go any further, there's one potential exception to these two rules: your company's retirement plan.
If your company has a 401(k), 403(b), or similar retirement plan, and your employer offers matching contributions, take advantage -- even if you have some credit card debt or lack emergency savings. If you earn $50,000 per year and your employer will match up to 5% of your salary dollar-for-dollar, this translates to $2,500 in additional money that you wouldn't otherwise get. It's an instant 100% return on your investment -- the best you're likely to find anywhere.
An employer match should be thought of as part of your compensation. Would you let your employer keep $2,500 of your salary? Well, that's exactly what you're doing if you don't take advantage of the match.
Understand your goals
- Are you investing for a specific expense, such as college tuition for your child? For example, if you want to invest for college, you might want to consider the benefits of a Coverdell ESA or other college-specific account. If you want to save for say, home renovations in a few years, you want to make sure to invest in a standard (non-retirement) brokerage account, and probably want to prioritize capital preservation over growth.
- Do you want to invest for retirement, or do you want to have the ability to use your money sooner? There are excellent tax benefits for investing in a retirement account such as a traditional or Roth IRA, but there are downsides as well. For example, a traditional IRA contribution can get you a big tax deduction this year, but one big downside is that you'll need to leave the money in the account until you turn 59 and 1/2, or pay an early withdrawal penalty.
- Would you characterize yourself as a risk-taker, or would large fluctuations in your portfolio's value make you nauseous? There's a wide variety of risk involved with investments, even within the same asset class. For example, a 30-year Treasury bond and a 30-year high-yield corporate bond are two completely different levels of risk.
- Is your main investment priority to grow your money, generate income, or preserve your capital? For example, growth-oriented investors can focus on fast-growing companies without having to worry much about dividends or bond income. On the other hand, income-focused investors would need to make those things a top priority.
- How much time are you willing to spend on your investments? If the answer is "not much," that's fine, but investing in mutual funds or exchange-traded funds (ETFs) would probably be more appropriate for you than individual stocks. These can allow you to invest in a pre-packaged portfolio of stocks and bonds, as opposed to researching individual stocks and bonds and constructing a portfolio.
Having well-defined goals can help guide your decisions, both before and after you start investing.
Know how asset allocation works
Another important step before you start investing is to understand what to invest in. For beginners' purposes, we can narrow this down into two basic categories -- stocks (equities) and bonds (fixed income).
I strongly suggest that you read through our guide to asset allocation, but here's one general idea you need to know. Stocks have the higher long-term return potential, but also have more short-term volatility, making them more appropriate for younger investors with a long time horizon. Bonds, also known as fixed-income investments, have lower returns over long time periods, but tend to be less volatile and can produce reliable streams of income, making them more appropriate for older investors.
All investors should have some combination of the two, with younger investors more stock-heavy and older investors more bond-oriented.
One good rule of thumb is that you can find your appropriate stock allocation by subtracting your age from 110. For example, I'm 35, so this implies that I should have about 75% of my portfolio in stocks, with the remaining 25% in bonds. As I get older, I'll adjust my holdings accordingly.
Start with easy-to-understand investments
Now that you understand the types of investments you need, how do you go about building your portfolio?
If you're completely new to investing, it's generally a smart idea to keep your investments broad and easy to understand. This generally means investing in stocks and bonds through mutual funds or ETFs (exchange-traded funds) .
For example, you can get some of your stock allocation through a S&P 500 index fund, which invests your money in all 500 stocks that make up the benchmark S&P 500 index. As legendary investor Warren Buffett has said, an investment like this guarantees that you'll do as well as the market over time, which is why he's called index funds the best investment most people can make. Buffett is a legendary stock picker, but his point is that most people don't have the time, knowledge, and desire to invest in stocks the right way. In fact, Buffett has made it clear that he wants his wife's inheritance invested in an S&P 500 index fund after he's gone.
There are many great stock index funds and bond index funds, and these can help you put your money to work if your knowledge of investing is still somewhat limited.
If you want to buy individual stocks, you'll need a little more knowledge
Don't get me wrong. At The Motley Fool, we're big fans of investing in individual stocks -- if you do it right. This means that you need the time to research stocks and the knowledge to research them correctly.
Obviously, I can't tell you everything you need to know to start effectively buying stocks in this article, but my best advice to would-be stock investors is to learn all you can before you invest. This way, you can learn from other people's mistakes and successes, instead of learning the hard way.
For example, there are some basic investing metrics, such as the price-to-earnings ratio and dividend payout ratio, that all investors should know. And there are some common mistakes you should be aware of, such as selling stocks too early or investing in dividend yield traps.
One smart way to quickly boost your stock-picking knowledge is to learn from people who have mastered the art. Two books I highly recommend for beginning investors are:
- The Intelligent Investor by Benjamin Graham: Many experts agree that this is the best investing book ever written. Graham was Buffett's mentor and is considered to be the father of value investing. Graham gives an excellent foundation of how to value a stock, properly allocate a portfolio between stocks and bonds, and more.
- One Up on Wall Street by Peter Lynch: Lynch is one of the most successful investors of all time, and shares his winning formulas in this book. Lynch believes that contrary to popular belief, everyday investors actually have an edge over professional money managers, and can use things they already know to their advantage.
Don't let a lack of capital get in your way
As a final point, you'll notice that one thing I didn't mention anywhere in this article was having a certain amount of money before you start to invest. A lack of money to invest is one of the most common excuses for not investing, and is one of the worst possible reasons for staying out of the market.
With the emergence of commission-free ETF investing and low-commission stock trading, it's possible to get started investing with very little money -- even if that means you only have $100 or less to invest right now.
Think of it this way. If you're 25, that $100 invested in a S&P 500 index fund could be worth nearly $3,800 by the time you're ready to retire at 65, based on the stock market's historic returns. If you can add another $100 each year, each quarter, or even each month, you could grow a substantial nest egg with seemingly small investments.
If you're in a solid financial position, with little or no credit card debt and a reasonable emergency fund, your money will never again have the long-term compounding power that it does right now. Time is your best friend as an investor -- even if you don't have much to invest.