Discouraged with the diminishing interest rate in your high-yield savings account? That's a sign it's time to up your wealth game and start investing. Granted, as you've probably seen on the news, the stock market's a little rocky at the moment. But that doesn't have to be a deterrent -- you can manage risk and set yourself up for success by following these five investing basics.
1. Buy and hold
Buy-and-hold is an investing strategy that involves selecting positions you can keep in your portfolio for 10 years or more. It's a passive style that relies on long-term market trends to build wealth, rather than short-term price fluctuations. And those long-term market trends are impressive: The S&P 500, a group of 500 large company stocks, averages annual growth of 7% after inflation. That's more than three times what you can earn in the highest-yielding savings accounts.
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Two strategies will help you succeed as a buy-and-hold investor. First, only use funds you don't need for at least 10 years, like the money you're saving for retirement. Second, be willing to accept price fluctuations for now. Say you buy a share of Walmart (WMT +0.58%) and the share price drops 5% the next day. Do you freak out and wish you'd never put your money in the stock market? Nope. Let it go. That blip in price won't matter in 10 or 20 years, if you've earned an average annual return of 8% or 10% on that position.
2. Invest consistently
Long-term, you'll earn more if you invest a consistent amount every month, versus waiting for a good opportunity to buy. There's too much emotion and subjectivity in waiting for the right moment. A methodical approach ensures that you're continually building your portfolio. This is why 401(k)s are so useful for retirement savings; contributions are made automatically in each pay period so that the invested balance is constantly increasing.
3. Work the tax perks
Speaking of 401(k)s, if you have access to one, use it. If your employer doesn't offer a 401(k), max out your contributions in a traditional IRA or Roth IRA. In 2020, you can contribute up to $19,500 in a 401(k) and up to $6,000 in IRAs. If you're 50 or older, you're allowed additional contributions of $6,500 in a 401(k) and $1,000 in IRAs.
These accounts offer real tax advantages that will expedite the growth of your savings. The 401(k) and traditional IRA are designed to help you save for retirement, so you can't take withdrawals without penalty until you reach the age of 59 and a half. But in return, you don't pay any taxes year-to-year on the earnings in these accounts. By comparison, if you held your investments in a regular brokerage account, you'd be taxed each year on all dividends, interest, and realized gains.
The effect of that tax deferral can be significant. Let's say you save $500 monthly and invest it to earn 7% annually in a 401(k). After 20 years, you'll have about $260,000. Had you instead put that money in a taxable brokerage account, your balance after 20 years would be closer to $225,000, assuming a combined state and federal tax rate of 25%.
4. Diversification
Diversification is the practice of holding different types of positions in your portfolio as a means of managing risk. The thinking goes this way: If your investments are spread across different companies, industries, and types of securities, you won't lose your shirt if any single trend goes sideways.
For novice investors, buying mutual funds is the simplest way to diversify. A single mutual fund share represents a slice of ownership in an entire portfolio. That's diversified on its own, but you can get more sophisticated with your diversification by investing in multiple mutual funds. The key here is to select funds with different investing strategies. For example, you might choose a total stock market index fund, an international stock market index fund, and a bond market index fund. That would spread your risk across industries, geographies, currencies, and asset types.
5. Don't be a hero
In a perfect world, you would know exactly when to buy and sell your investments and you'd always make money on every transaction. Unfortunately, the world is not perfect. Even for the professionals who've made investing their life's work, timing the market is hard. So if you see gains in your portfolio in the immediate term, resist the urge to sell and realize those gains. If you do sell, your money's no longer invested and working for you. And then, you have to figure out when and how to get back into the market. It's a bad cycle to start, and one that generally leads to lower returns for novice investors.
Stick with it for the long haul
Making the leap from saving in cash to investing increases your risk of loss, and that's scary. But you can work around that fear. Be methodical in your approach. Contribute a consistent amount each month (to a 401(k) if you can), build a diversified portfolio, and keep your focus on long-term performance. It's not the most exciting way, but it is the most reliable.
