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Nowadays anyone can start investing with a very small amount of money. Due to the proliferation of retail investment products available, you can invest as little as $100 into a basket of stocks and bonds. For a rookie investor I would generally recommend staying away from individual stocks.
1. First, look at your debt, cash flow and liquidity needs.
Before you invest, erase your high interest debt. It doesn’t make sense to carry a 24% interest rate on debt and using your extra money to invest. You can’t get that guaranteed 24% return on any investment. However, paying down a credit card with that interest rate is the equivalent of earning that return.
Also, make sure you have an emergency fund. One should have the equivalent of 6 – 9 months of living expenses parked safely somewhere, such as in CDs.
“Liquidity” means having cash on hand when you need it. For example don’t put money into the stock market that you will need in 2 to 3 years for a major purchase.
2. Determine Your Investing Timeline
This goes hand-in-hand with liquidity needs. What are you investing for? Is it truly extra money you don’t need for a while? Are you investing for your retirement 20 or 30 years away? For your children’s college education? Is this a short-term investment? Something you may need in 2 to 3 years? The general rule is for shorter timelines go with less volatile, “safer” investments such as bonds or other fixed income instruments. For longer timelines—longer than five years—it’s okay to invest in stocks.
3. Develop a Plan
A written plan, called an Investment Policy Statement (IPS), helps you get organized, puts down your goals and determines the criteria of your investments. These may be paying for a child’s college education, funding your retirement or just growing your wealth. This information will dictate the amount of return you need on your investment and how soon you’ll need it. This in turn will determine the amount of risk you may need to take in order to achieve a reasonable return. Also, how and where are you going to invest it? There are many low-cost online brokerages such as Schwab, Fidelity and Scottrade where you can open an account with a small amount of money by transferring funds from your bank account very easily.
4. Research, research, research.
Read all you can on retail investment products such as Mutual Funds, ETF’s, ETNs, etc. and educate yourself on their differences. Visit online resources such as morningstar.com, investopedia.com, fidelity.com, fool.com and vanguard.com to get familiar with investing basics, various types of risks, and investment vehicles.
5. Find Your Comfort Zone
Since all investments come with varying degrees of risk you need to assess your risk–tolerance. Being in your investing “comfort zone” means owning a portfolio that contains suitable, well-researched holdings that are in perfect alignment with your various goals, time horizon, and risk tolerance. Determining one’s risk tolerance is a very deep and complicated subject and a wealth of information is available online about it.
6. Determine Your Mix: Asset Allocation
Your asset allocation is the way your portfolio is divided between bonds, stocks, and cash and should be based on your specific goals, risk tolerance, and time horizon.
For example, there is a general rule when constructing a portfolio that one should have their age in bonds in a typical stock and bond mix. So, if you’re 40, you would have 40% of your portfolio in bonds. This rule basically says the younger you are the more risks you can take on with your investments i.e. tilt your portfolio more towards stocks. They are generally more volatile, but have higher long-term returns versus bonds.
In order to reduce the risk you need to mix a variety of investments in a portfolio. The rationale behind this is that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment. The benefits of diversification will work only if your holdings in the portfolio are not perfectly correlated.
8. Control Expenses
Investing comes with certain expenses, buying a Mutual Fund for example. They usually charge an annual expense around 1% of assets. This means they will take out this expense regardless of how the fund performs every year. If you’re buying ETF’s there may be brokerage transaction costs and management fees. It has been shown that controlling expenses is a big determinant of future long-term returns.
9. Minimize Taxes
One usually has many types of accounts, retirement and taxable accounts. In what type of account to carry what kinds of investments becomes important. Choosing the right one can help you cut taxes and keep more of your investment gains. For example, those whose gains are taxed as ordinary income would belong in tax-deferred accounts (such as REITs and bonds). More tax-efficient investments (such as stock ETFs and tax-free municipal bonds) would belong in taxable accounts.
Rebalancing your portfolio on a regular basis is the process of realigning the mix of your portfolio. Rebalancing—at least once a year—involves periodically buying or selling investments in your portfolio to maintain your original desired level of asset allocation.
Keep in mind: all investing involves risk, including the risk of loss. Diversification does not ensure profit or guarantee against loss. Good luck and happy investing!