Congratulations! If you're reading this article, you've probably passed a major milestone: You've stopped living from paycheck to paycheck, and you're ready to put your money to work. This is a big deal, as it puts you on the path to financial independence.
You’re thinking about beginning to invest, and that’s awesome. Investing is an incredible way to make a lot of money. Before investing, put together an emergency fund. After that, I’d suggest getting to at least your maximum 401(k) company match. Then come stocks. We’ll go into more detail below.
I'll tell you what I would do today if I were just beginning to invest. For some perspective, I'm in my mid-30s with a wife and daughter, and we (thankfully) only have a small amount of student loan debt. We currently rent, as we're waiting before buying a house.
Given that information, here's how I would proceed.
These are two things that just about everyone should check off their list once they start earning more than they are spending.
My family's emergency cash position was established so that it could pay our major expenses (housing, food, utilities, gas, etc.) for six months if we lost all income today. If we cut out extra spending (going out for food, taking vacations, etc.), we could get by on a little over $3,000 per month, so our emergency cash position is $20,000.
Everyone's circumstances are different, so you need to take yours into consideration. We hold our emergency cash in a money market fund that returns about 0.75% per year. That's not great, but it's fine with us because it's safe and available immediately.
401(k) or other defined-contribution plan
If you have access to one of these plans, use it! Specifically, if your company offers a match, contribute what you must in order to maximize that match. This is literally free money being offered to you, and there's absolutely no reason why you shouldn't get every penny of it.
While I don't personally have access to a 401(k) right now (I'm technically a contractor), back when I was a teacher, this is what I did. And because I was in my late 20s and knew I wouldn't be touching this money for decades, I chose to invest that money in the "Aggressive Growth" category that my company offered.
You have to determine for yourself what level of risk to take when investing in 401(k) plans. There are two big issues to take into consideration. First, the older you are, the less risky your investments should generally be. Second, when selecting plans, pay close attention to fees; over time, they take a huge bite out of your nest egg. Aim to keep expense ratios well below 0.75%.
After these two steps, the real fun begins!
For those who have never invested in the stock market, exchange-traded funds (ETFs) are a great starting place. ETFs generally track the performance of specific indexes or industries. So if I buy a share of an S&P 500 ETF, I will be buying a tiny piece of all 500 companies that are included in the S&P 500 index.
This approach helps by giving you lots of exposure to the 500 largest U.S.-based companies, as well as the diversification necessary to avoid being wiped out by a crash in any single stock or industry. Three popular ETFs that offer broad exposure and have low fees are SPDR S&P 500 (NYSEMKT:SPY), Vanguard S&P 500 ETF (NYSEMKT:VOO), and iShares Core S&P 500 (NYSEMKT:IVV).
If I were just beginning to invest today and had a lump sum of cash to invest, I would open a Roth IRA and put 80% of that cash into ETFs, keeping the other 20% for later (more on that below). This isn't by any means the only way to go; it's just what I would do.
Buying your first stock
I'm going to make the assumption that you not only have a lump sum to invest, but will be able to put away a little money every month -- that's what happens when you spend less than you earn!
The process of buying your first stock can be daunting. We have a whole page devoted to it. There are literally millions of ways you can go about choosing your first stock to buy. Generally, however, I would suggest using these four criteria as basic guidelines.
1. Pick a company you know. It's OK to invest in brands everyone knows, like Coca-Cola (NYSE:KO) or Apple (NASDAQ:AAPL). Be sure you could explain to even a kindergartener how the company makes money. That familiarity is important.
2. Check for sustainable competitive advantages. Does your company offer something no one else can? Will that "something" be around for the foreseeable future? If so, your company has a sustainable competitive advantage. This can take the form of a popular brand, like Coke's; a quality service or product, like Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) search engine and other offerings; or superior price and convenience, like Amazon.com's (NASDAQ:AMZN) competitive prices and fast shipping.
3. Are long-term trends in the company's favor? No one can predict the future, but we can usually see where things are headed in general. When the digital camera came along, it became pretty clear that Kodak's days were numbered. With the advent of the e-book, the same has been true of booksellers. Be sure you can see your company continuing to succeed as technology advances and tastes change.
4. Investigate management. Here at the Fool, we're big fans of founder-led companies. But you don't necessarily need to find a founder-led company to pick a good stock. Do some research on your company's CEO and search for interviews he or she has conducted. How long have they been with the company? What kind of track record do they have?
If I were to start investing today, I would probably invest about 80% of my monthly leftover cash in individual stocks. Then again, I'm not sure I would have been totally comfortable investing that much in individual equities as a beginner. You might want to start with a smaller allocation -- perhaps just 20% or 30% -- until you're ready to work your way up to 80%. The rest you can either keep in cash or invest in ETFs like those mentioned above.
For now, keep cash on hand
When it comes time to decide where to invest money, keeping cash on hand is usually not a popular choice. Over time, cash that's not invested will lose its value due to inflation -- and no one wants that! And there's lots of research out there that says you should invest all you have, as soon as you have it. Historically, over long enough periods, the market has always gone up, so it's not smart to try to time the market.
That being said, I personally think today's market is quite expensive. I'd still be investing about 80% of my cash in it (for the reasons mentioned in the paragraph above), but I think there's some value in holding on to some cash right now.
A little over a year ago, our brightest Fool, Morgan Housel, wrote about what he plans to do when the market crashes. In essence, he knows that there will be crashes in the future, and when they come, he wants cash on hand to take advantage of them, buying up quality stocks at low prices.
That doesn't mean he tries time the market; he's still investing the whole time. But he is setting aside cash -- likely more than usual right now -- to take advantages of crashes when they come.