Rent, utility bills, student loan payments and the occasional trip might seem like all you can afford your first few years out of college. But once you’ve been earning paychecks for awhile, you may be ready to do something with that extra cash. The tricky part is figuring out what to invest in — and how much.
It all depends on your saving goals and how many years you plan to let your money grow, says Mark Waldman, an investment advisor and former personal finance professor at American University in Washington, D.C.
“You need to decide how much of your money you’re going to allocate to each goal, and invest that money based on the time frame for the goal,” he says.
So how do you land on the best investment strategy for you? Follow the steps in our guide, and become the savvy friend everyone goes to for money help. Here’s what you’ll find below:
Why start investing now?
The short answer: Investing when you’re young is one of the best ways to see solid returns on your money. You probably can’t count on Social Security to provide enough income for a comfortable retirement, so having your own long-term savings is crucial. Investments that earn higher returns than a traditional savings account could also be useful for shorter-term goals.
There will be ups and downs in the market, but investing young means you have decades to ride them out.
The Nerdy answer: Investing probably sounds like something your parents or bosses do. But if you think of it as a puzzle — with a big potential payoff — it might start to feel like fun. Let us break it down for you so it’s less intimidating and more exhilarating.
Investing in the stock market is a do-it-yourself way to plan for a comfortable old age. There will be ups and downs in the market, of course, but investing young means you have decades to ride them out. It’s also important because benefits from Social Security account for only around 38% of U.S. seniors’ income, according to the Social Security Administration.
And that figure may well decline in the coming decades. For years, Social Security has been paying out more to retirees than it has been taking in from taxes paid by workers. In 2013, there was a $76 billion difference between Social Security tax revenue and the program’s costs, according to Social Security’s 2014 Trustees Report.
The program has been able to keep paying benefits because it built up reserves or “trust funds” in anticipation of the retirement of the baby boomers. But those reserves are projected to be gone by 2033. Tax money will still be coming in, so Social Security won’t be completely depleted by the time you retire. But the Social Security Administration says that, under current law, it will have money to pay only about three-quarters of promised benefits.
What does all this mean for you? It means you’re doing yourself a big favor by learning how to invest to supplement Social Security, so you can have enough money to keep brunching and vacationing into your golden years. In the meantime, investing in safe assets like bonds can help you bring in extra money in the short term. That might make a difference if you’re saving up to buy a house or another big purchase in a few years.
What can I invest in?
The short answer: Whether you save for retirement with a 401(k) or similar employer-sponsored plan, in a traditional or Roth IRA, or as an individual investor with a brokerage account, you choose which investments to put your money in. It’s important to understand each instrument and how much risk it carries.
The Nerdy answer: There are many investment instruments for you to choose from. Some of the most popular include:
- A stock is a share of ownership in a company. Stock prices can go up or down based on investors’ evaluation of the company’s performance, including leadership changes, new product releases or how it’s doing financially.
- Companies issue stock to the public when they need to raise money to grow, for example, or to pay off debt. Stocks are also known as equities.
- A bond is essentially a loan to a company or government entity, which agrees to pay you back in a certain number of years. In the meantime, you get interest.
- Bonds are less risky than stocks because you know exactly when you’ll be paid back and how much you’ll earn.
- A mutual fund is a mixture of investments managed by an individual company. When you invest in a mutual fund, you don’t have to choose specific stocks or other securities; the fund does it for you.
- Popular mutual funds include index funds, which follow the performance of a particular stock market index, and money market funds, which invest in short-term, low-risk assets.
- Mutual funds are available at all risk levels. Generally, the higher the risk, the higher the potential return.
How do I pick an investing strategy?
The short answer: Waldman sums up his advice this way: “The longer the time frame associated with your goal, the higher percentage you should have in stocks.”
The Nerdy answer: Choose your investments based on how far away your savings goal is. You’ll want to invest in different instruments if you’re saving for retirement a few decades from now, for example, than if you’re saving for a shorter-term goal.
Say you’d like to invest in a Roth IRA for retirement, and you don’t plan to touch your invested money for 40 years. The stock market can be unpredictable, with huge ups and downs depending on how well the economy is doing. But you’re likely to make more money over time in the stock market than with less risky assets (like bonds, or by putting your cash in a savings account). Over the past 10 years, for instance, the S&P 500 stock market index — which includes 500 major companies’ stocks — has seen an average annual return of 7.87%.
The data are very clear. They show that over any period of time longer than, say, 10 years, S&P 500 index funds outperform all other kinds of mutual funds.
But if you’re saving for a short-term goal, like a down payment for a house in the next five years, the risk associated with stocks makes it more likely you’ll lose money in that shorter time frame.
Now that you know how many years your investments will earn returns, you can dive deeper into the types of investment instruments that might work for you. If your savings goal is more than 20 years away, almost all of your money can be in stocks, Waldman says. But picking specific stocks can be complicated, so consider investing in an index fund, which mirrors the performance of an entire stock market index.
An index fund is a good option for new investors because it provides diversification, or a way to make sure you have stocks in multiple industries and across different geographical regions and risk levels. Research has also shown that index funds, which are “passively managed” funds, perform better than actively managed funds, which have a fund manager choosing specific stocks and bonds in an attempt to outperform the market.
“The data are very clear,” Waldman says. “They show that over any period of time longer than, say, 10 years, S&P 500 index funds outperform all other kinds of mutual funds.”
The percentage of your investments that should be in stocks will decrease as your savings goal shortens. So if you dream of buying a house in the near future, a better option would be to invest in a money market fund or a bond fund. Both will bring you lower returns than stocks but are safer places to put money in the short term.
» MORE: How to Invest in Stocks
How much should I invest?
The short answer: Only invest once you know you can pay your monthly bills and you’ve saved at least three months’ worth of living expenses in an emergency fund. Then take a look at your cash flow to see how much extra you have to work with. You can invest with just a few hundred dollars at first.
The Nerdy answer: Knowing where you can put your money is a huge step, but it’s also confusing to figure out exactly how much to put there. To start, make sure you have all your necessary costs covered. If you don’t have a detailed budget, at least make a list of all your expenses: what you spend monthly on bills, loan payments, food and entertainment. Then build up savings so you have an emergency fund to cover at least three months’ worth of living expenses, Waldman says.
“This is like a shock absorber between you and the bad stuff life throws at you,” he says.
Only after you’ve done that should you consider investing with your extra cash. One common piece of advice is to invest 10% of your earnings a year, but if that’s not realistic, let the minimum initial investment for the vehicle you choose guide you.
Many brokerage accounts, which are the vessels that hold the money you invest in specific funds, require initial account balances. A Fidelity Freedom 2055 mutual fund, for instance, which is a managed fund that will allocate a mix of investments for you knowing you have a target retirement date of 2055, requires an initial investment of $2,500 and an ongoing balance of $2,000.
But if you don’t have quite that much to work with, Waldman recommends opening a Roth IRA account, which he calls a “container” where you can keep the money you invest in individual funds. Online brokerages like Scottrade or E-Trade offer Roth IRAs you can open with no minimum balance.
Through your Roth IRA, you can invest a few hundred dollars in mutual funds or commission-free ETFs, or exchange traded funds, which reflect stock market indexes but often cost less than an index fund, without needing to save up thousands of dollars first. You can also open a Roth IRA through a so-called robo-advisor, an online investment account that lets you invest in low-cost ETFs with account minimums as low as $0.
These options can supplement your 401(k), 403(b) or other employer-sponsored retirement account. If your employer offers one, you’ll be able to contribute a percentage of your salary each pay period to your 401(k). In most cases you can choose the mix of assets you invest your 401(k) money in, depending on how much risk you’re willing to take on. Some employers will also match your contributions with company funds — extra money added to your retirement account that you’ll usually have access to once you’ve stayed at the company for a certain amount of time.
Investing may seem scary, but it doesn’t have to mean putting all your money in the stock market and watching it tank. Research your options carefully and consider starting off with a small initial investment in a passively managed fund. Especially if you’re working toward a long-term goal like retirement, it’s most important to stay confident, even during unprofitable years in the stock market, Waldman says.
“Leave it alone, don’t ever get out of the market no matter what, and just keep buying,” he says. “That’s the hard part.”
Image via iStock.