Investing is one of the surest ways to build wealth -- if you do it wisely. The good news is, it doesn't have to be that hard to build a portfolio that should perform well for you over the long term.
In fact, if you follow five simple steps, you'll likely be well on your way to earning generous returns that can help your money grow over time. Here's what they are.
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1. Invest in what you know
Investors tend to get into trouble when they buy assets they don't understand, as they have no way of evaluating them effectively to learn the potential risk and likely returns. But if you make sure you're fully informed before you buy, you'll be in a much better position to minimize your risk and maximize your potential gains.
Investing in what you know doesn't mean only buying stocks in your own industry; it means taking the time to learn about companies you're considering buying shares of; understanding the factors that determine share value; and finding out what drives growth. If you are willing to put in the work, you should be able to develop a solid investment thesis that helps ensure many of your investments are successful ones.
Of course, not everyone has the interest in taking the time to research stock picks. Fortunately, it can be a lot easier to learn how to invest in index funds. While you won't beat the market with them, you can still earn reasonable returns over time to build wealth.
2. Watch your fees
Investment fees can kill your portfolio's potential by eating into your effective return on investment. You need to know what fees you're paying for any investments you're considering and make sure they're worth it.
The fact is, most brokerage firms know all you need in order to buy stocks and exchange-traded funds (ETFs) without paying commission fees. There are plenty of low-fee funds out there that perform better than their more expensive counterparts. The situations are few and far between when you should accept paying a high cost for investments.
3. Invest for the long term
Short-term investing can sometimes make you a quick profit, but it's really hard to make that happen consistently. If you want to maximize the chances of your portfolio performing well, buy stocks or ETFs that you'd be happy to hold for a long time.
Taking this approach eliminates the problem of market timing; if the investment performs well over time, it won't matter as much whether you bought in at rock bottom or not. You'll also be less likely to suffer big losses because you'll be able to hold your stocks through any downturns even if you happen to buy in shortly before a crash happens.
4. Take advantage of favorable investment tax rules
One of the many reasons stocks help you build wealth is that the income you earn from them is taxed at favorable rates -- provided you take advantage of the long-term capital gains rules.
See, if you hold a stock for more than a year, you'll be taxed at the long-term capital gains rate, while if you hold it for less than a year, you'll be taxed at the short-term capital gains rate. The short-term capital gains rate is your ordinary income tax rate ,while the long-term rate is typically lower (for many investors, it's as low as 0%).
Holding onto your stocks for longer than a year can increase your effective rate of return because you'll be sending less of your profits to the IRS. This is yet another reason why investing for the long term makes a lot of sense if you want to build a winning portfolio.
5. Diversify
Finally, you want to buy a mix of different assets rather than putting all of your eggs into one basket. If your portfolio is well diversified because you own different kinds of investments, it's much more likely that some will do well even if others do poorly. Diversification is easy if you buy index funds, but you can also diversify by picking a good mix of individual stocks if you're hoping to try to beat the market.
