How to Start Investing in Stocks for Beginners
So, you’re finally ready to start investing in the stock market. Here’s how you do it:
So you’ve got your financial house in order, and you finally want to start your stock market adventure. Here’s a guide for how to start investing in stocks for beginners:
Step 0: Set Your Expectations
The strategy that I outline below isn’t magic. It’s a passive investing strategy based on sound academic research, but it isn’t perfect. In the long run, you can expect investment returns of six to 10 percent a year. Your specific returns depend on when you invest and what investments you choose. However, you should know that your portfolio won’t keep going up forever.
Many experts suggest that you prepare for your stock market investments to fall to 50 percent of their value at least once in your life.
You should also expect a 20 to 30 percent drop at least once every decade or so. This doesn’t mean that you should run and sell everything. The world isn’t on fire – you’ll survive. This is a buy-and-hold investment strategy. When you invest in the stock market, you need to know how to handle your investments falling in value. Prepare yourself for some temporary losses. This will help you handle real losses when they come.
Step 1: Decide Why You’re Investing in the Stock Market
Most people invest in the stock market because they want to eventually retire. They plan to use the money to fund their lifestyle when they no longer want to work. Some people invest money for “intermediate goals” like funding a down payment on a house. Still others just want to beat inflation so that they can retain their wealth.
The clearer your vision, the easier it is to make a specific plan. However, I’m the queen of unplanned finances. My husband and I change our minds all the time. Instead of stressing about changes, we have just one rule: money that isn’t for retirement stays out of retirement accounts.
Step 2: Decide Whether You Should Use a Retirement Account
Since you’re about to become a stock market investor, you’re going to need a fancy account. If you’re investing for retirement, check to see if your work offers a retirement plan. These plans go by fancy sounding acronyms like Simple IRA, 401(k), 457, 403(b), TSP, and more.
Employer-sponsored investment accounts have several advantages. These include:
- The money you put in is income-tax-free.
- Money grows without taxes until you withdraw it.
- Your employer matches some portion of your contribution.
- Your employer limits the number of mutual fund choices.
Of course, employer-sponsored plans have some downsides. If you withdraw the money before you turn 59 and a half, you’ll pay an early withdrawal penalty of 10 percent on all gains. Plus, you’ll be taxed on the money at your current tax rate. Ouch!
If you don’t have a retirement account at work, you can start your own. A traditional IRA (individual retirement account) has the same features and penalties as the plans listed above.
A Roth IRA is a bit different than the other accounts. You pay taxes as you normally would. However, once the money goes into the Roth IRA it grows tax-free forever. You can withdraw the money during retirement without paying taxes. You will face a 10 percent penalty on gains if you withdraw the money before age 59 and a half.
Do these accounts sound awesome? They are… if you’re going to use them for retirement.
However, the penalties are steep if you want to use the money to pay for a new car in six years. For intermediate goals, you’ll need to start a brokerage account, not a retirement account.
Step 3: Decide Where to Open Your Account
If you choose to invest through a workplace retirement plan, you don’t have a choice. Contact your HR representative and ask how to enroll in the retirement plan. It shouldn’t be too hard. In fact, your HR representative will probably send you a step-by-step document with screenshots.
If you’re investing on your own, you need to choose a brokerage for your account. There are several companies that are well-suited to beginners’ needs. If you need help deciding, consider these options:
- If you want to start a habit of investing a few dollars a day, open an account with Stash Invest.
- Want a low-cost approach to investing? Consider an account at Charles Schwab, TD Ameritrade, Fidelity, or Vanguard.
- Need help picking investments? Try WealthFront or Betterment for a “Robo-Advisor” approach at a low cost.
Step 4: Pick Your Investments
Selecting investment options is the most overwhelming part of stock market investing. Before you quit, consider these two things:
First, it’s much harder to save the money to invest than it is to actually invest.
Second, it’s better to screw up when you’re young than when you’re old. As a young person, you have time to recover from an investing mistake.
Robo-Advisors and Passive Index Fund Investing
In this section, I’m outlining an strategy called passive index fund investing. It’s not the only way to invest in the stock market, and it’s more volatile than carrying cash. However, it’s a time-tested approach to seeing real returns on your money. Given enough time, you’ll beat inflation and have money left over.
For nervous investors, I recommend choosing a robo-advisor. Personally, I like Betterment and Wealthfront because of their low fees and friendly interfaces. These robo-advisors charge a management fee of 0.25 percent of your portfolio each year and they manage your portfolio based on your risk tolerance. Both services manage your portfolio using a Nobel Prize-winning strategy called Modern Portfolio Theory. They also share three features:
First, they only use low-cost investments.
Second, they only use broad “index” funds. An index fund tracks overall performance of a specific investment. When you buy an index fund, you buy “average performance.” Instead of buying 20 or 30 individual stocks, you buy 3,000 to 4,000 U.S. stocks and even more international stocks. The result?
You own a little bit of everything – a little bit of all the U.S. stocks; a little bit of all the international stocks; and a little bit of all the corporate bonds.
And third, they use “asset allocation” to reduce risk in your portfolio. Asset allocation means that your investments aren’t all in just a few stocks or bonds. Instead, you have stocks in both big companies and small companies. You own stocks in both U.S. companies and international companies. You own corporate bonds and government bonds. And you might even own some real estate trusts.
Robo-advisors like Wealthfront and Betterment diversify your investments into “non-correlating” asset classes. This means that when one investment goes up in value, the other one goes down, which helps you increase your investment returns and reduce their volatility. How?
When your asset allocation strays, the robo-advisor will rebalance it for you. That means that they’ll sell the overweighted investment and buy the underweighted investment. Why do this? It boosts your returns by allowing you to buy low and sell high.
Would you prefer to try managing your investments yourself? It’s surprisingly easy. Nick Bradfield explains the importance of asset allocation in parts one and two of his series on the subject. Below, we explain how to do it.
In this section, I share specific ticker symbols. These are examples of broad index funds with no load fees at specific brokerages, but this article doesn’t constitute a recommendation to buy any particular investment.
Consider your individual risk tolerance before you buy any stock market investment.
If you plan to manage your portfolio yourself, you need to choose a broker. You may want to consider places like Charles Schwab, Vanguard, and TD Ameritrade. Each of these companies offers a broad array of low-cost mutual funds, and they all have “no-load” options. This means that you won’t pay a fee to buy or sell the fund. These companies also offer easy-to-use investment planning tools that will help you buy low-cost funds that you can manage on your own.
Charles Schwab, for example, has an ETF portfolio builder that shows you how to build a portfolio based on your risk tolerance. A $5,000 portfolio based on Charles Schwab’s recommendations would include:
- $2,500 of SCHX (Charles Schwab Large-Cap ETF)
- $1,000 of SCHA (Charles Schwab Small-Cap ETF)
- $1,250 of SCHF (Charles Schwab International Equity ETF)
- $250 of SCHP (Charles Schwab TIPs ETF – a low-risk bond ETF)
Vanguard gives new investors an “investor questionnaire.” Once they determine your risk tolerance, they recommend an ideal portfolio. They always recommend a “four-fund” portfolio. The investment portfolio includes a U.S. Broad Equity Fund (VTI), International Broad Equity Fund (VWO), U.S. Total Bond Fund (BND), and International Bond Fund (BNDX). The specific allocation of funds depends on your risk tolerance. Vanguard also offers “funds of funds” that manage asset allocation for you.
TD Ameritrade has an asset allocation profiler. This tool recommends specific funds based on your investment timeline and risk tolerance. The tool typically recommends low-cost index funds. At TD Ameritrade, the lowest-cost funds are iShares by BlackRock. A typical portfolio will include:
- ITOT (iShares Total U.S. Equity Markets Index)
- IXUS (iShares Total International Equity Markets Index)
- AGG (iShares Total U.S. Bond Fund)
- IAGG (iShares Total international Bond Fund)
Acting on Recommendations
Once you receive a recommendation from your broker, purchase the funds that they suggest. Many investment companies have “minimum order” amounts of $3,000 per fund. If that minimum order prevents you from investing, look for an ETF instead of a mutual fund. For example, Charles Schwab may recommend SWTSX (their total stock market index fund), but you could easily replace that with SCHB (an ETF version of the same fund).
Using ETFs instead of mutual funds should allow you to buy all the necessary funds for a balanced portfolio. Plus, you won’t run into the minimum investment problem that blocks out many begginner investors.
Step 5: Keep Investing
Once you start investing, you need to keep it up. Investing a few thousand dollars in the stock today won’t make you rich in retirement. You need to systematically invest in the stock market to build wealth over time.
In The Millionaire Next Door, Drs. Thomas Stanley and William Danko profile hundreds of real-life millionaires. On average, the millionaires saved and invested at least 20 percent of their realized income year over year. Some millionaires made huge investment mistakes, but became wealthy because they persisted in investing large portions of their income. To become wealthy, you need to do likewise.
Investing consistently in the stock market over a long period has a fancy name – “dollar cost averaging.” Dollar cost averaging helps you to manage the risk associated with investing in the stock market. We know that stock market prices move up and down. Ideally, we would only buy at market lows and sell at market peaks.
But for most investors, timing the market is a fool’s errand. Instead, you can manage your risk by consistently investing in stocks.
Many – if not most – CentSai writers recommend automating investment contributions. This helps most people to prioritize investing for the future. And automating investment contributions has another benefit, too: it forces your investment portfolio to grow even if you make an investing mistake.
Ric Edelman, founder of Edelman Financial Services, is famous for telling people that they can retire after 30 years of consistent investing. Why does it take so long? Most people can expect their investment portfolios to return between five and 10 percent in the long term. The actual returns will depend on your asset allocation and on when you invest. Most people who become millionaires by investing in the stock market save close to half of their wealth.
Step 6: Keep Learning
Once you start investing, you’ll realize that you have a lot of questions. Why index funds? Should I invest in individual stocks or not? Does a diverse portfolio really matter? Can I boost my rate of return? The answers to those questions depend on who you ask.
Now that you’ve achieved “beginner investor” status, you’ll realize that the question of how to invest in stocks is full of nuance.
Even investors who strictly adhere to Modern Portfolio Theory implement different evidence-based strategies for controlling risk or boosting returns. Other people consider alternative investing approaches when they see the limitations of Modern Portfolio Theory.
So what should you do? Keep learning more about how to invest in stocks wisely. Don’t change your investment portfolio every time you hear a new idea. Instead, open yourself up to the possibility of changing. The more you learn, the better an investor you’ll be.
This is the fourth installment of a multi-part series on investing. Pieces are published every Wednesday. To start from the beginning, click here.