This is the final installment of Stock Market for Beginners, our six-part series on investing and the stock market. You can read the previous piece, Investing Tips, here.
You’ve read the rest of this series, you’ve got your financial house in order (or know what you need to do), and you’re ready to begin your stock market adventure in earnest. With an endless stream of advice and tips, where do you start? After all, when half of the financial world is screaming conflicting information about the recent GameStop and AMC Entertainment volatility on social media, how do you know what to believe and who to trust with your money?
Unless you understand the fundamentals of investing, you stand a good chance of running with the herd. If all you understand is fear and greed, you will react instead of embracing a long-term plan. For instance, it’s essential to know that long-term investing strategies are a smart way to grow your money over time.
The Standard & Poor’s (S&P) 500 has had an average annual return of 9.5 percent since 1978, and the Dow Jones Industrial Average has seen a return of 10.3 percent since 1979, according to the New York Stock Exchange. Think about what even 8 percent compounding over your lifetime will mean for your financial security.
As you can see, investors that focus on a long-term strategy tend to see growth in their assets, but your specific returns depend on a number of variables: when you invest, which investments you choose, how much money you are able to allocate to investing, and your risk tolerance.
You should know that no one’s portfolio will be a straight line to the sky. All portfolios will weather market volatility, so understand you won’t be different.
“Investors in the stock market should prepare for volatility in the market and should adopt a long-term time horizon,” says financial professor Robert R. Johnson, Ph.D., of Creighton University.
Though dramatic declines are rare, it is not uncommon to see some sectors decline by 20 percent in a 10-year period. As such, you should expect some volatility.
If this happens, should you sell off your portfolio? Most financial advisors would recommend that you stay informed, but committed to your long-term investing strategy. The world isn’t on fire — you’ll survive. That said, you should routinely review your portfolio as you age. A 20 to 30 percent dip is much easier for a 20-something to recover from than it is for a 60-something who is nearing retirement, especially if you need your money now.
Investment Returns Over Time
Though many financial advisors agree on the big picture, the investment strategies they use will vary. Some are protecting new investors by putting them in an index fund and calling it a day.
“Investors are best served by taking a long-term, passive approach to investing using low-cost index funds to build maximally diversified portfolios,” says Anthony Watson, a certified financial planner (CFP) from Thrive Retirement Specialists. Though this is seen as a safe approach, there are a myriad of ways to approach the market when you gain knowledge.
One of these ways is known as a buy-and-hold investment strategy. When you invest in the stock market, you decide how you want to diversify your portfolio and in which asset classes, and you stay in it for the ride. Your investments will go up and down. No one likes to think they are losing money, but as long as you don’t sell — it’s an unrealized or paper loss.
A paper loss means your investment has lost value since you purchased it. The loss can be for a day, a month, or a year. This doesn’t mean you should sell and realize your loss. In truth, as you become more involved in investing, you will periodically evaluate your portfolio and decide if you need to rebalance, as we all tend to have a few losers in our portfolio.
Over time, you’ll learn to be strategic with both your gains and losses, allowing you to maximize any benefits — tax or otherwise — for both.
Though making money is preferable to losing it, you may be able to take a part of a realized loss against a realized capital gain to reduce your tax burden. So not all realized losses are the end of the world, but I digress.
Now that you know the basics of long-term investing, it’s time to get started. Here are your key considerations before investing in the stock market.
Step 1: Determine Your Time Horizon
In case you haven’t noticed, though we may receive a small Social Security check starting in our 60s, the ability to live comfortably — or at one’s current lifestyle — is unattainable without additional retirement income. As a result, many people invest in the stock market to help supplement their Social Security income in retirement. Many investors plan to use the money they invested and grew over decades to help fund their lifestyle when they no longer work. Keep in mind, many people realize belatedly how much they need to maintain a basic lifestyle, and end up working, not for fun, but out of necessity. Financial planning and investing ideally give you more financial options as you age.
Some people invest for “intermediate goals” like funding a down payment on a house. Others want to beat inflation, so that they can retain their wealth.
The clearer your vision, the easier it is to make a specific financial 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 our retirement accounts.
When you’re determining your own time horizon for your investments, take note of:
- Your age
- How much time your investments will have to grow
- When you will need to use the money you invested
- Your comfort with risk
If you’re interested in investing for retirement, your time horizon isn’t difficult to determine. “For aggressive investors, an easy way to determine a retirement timeline is to subtract their age from 60,” says Doug Jackson, a CFP from Tennessee Tax Solutions. “This will give them the number of years before they can make qualified withdrawals from 401(k) plans, traditional IRAs, and other qualified accounts. More conservative investors should subtract their age from 67, which is the full Social Security age for people born after 1960.”
A similar process can be used to determine your time horizon for other life milestones.
If you have a newborn baby and intend on providing for their educational needs, you’ll need to save for 18 years and take some risks to fund their goals, according to Julian B. Morris, a CFP with Concierge Wealth Management.
If you intend to buy a house within 18 months — a much shorter time horizon — you may not want to take on a substantial amount of risk because you will need the cash much sooner, Morris adds.
“Time horizons may also change due to external circumstances such as job loss, disability, divorce, inheritance, an unexpected windfall, or a company IPO,” Morris says. “Work with a financial planner to help you adjust when your time horizon and life change.”
Step 2: Determine Your Risk Tolerance
Part of investing is taking a look at your time horizon, your personal investing perspective, and your life circumstances to help determine your risk tolerance.
In most cases, the younger you are, the higher the risk you can take with your investment allocation. Volatility in the market could shrink your assets, but you’ll have time to recover. As you age, you typically move to more conservative investments that experience less volatility.
The downside to this strategy is that, in your later years, you may earn less in investment-related income. Of course, the benefit is that you are less exposed to downside risk.
Step 3: Decide How You Want to Invest
In this section, I’m outlining a strategy called passive index fund investing. It’s not the only way to invest in the stock market, and it’s more volatile than keeping your money in cash, but it’s a time-tested approach to seeing real returns on your money. Given enough time, you’ll likely beat inflation and then some based on historic returns.
When you first start investing, you’ll want to buy-and-hold over a long-term basis. If you’re planning on investing for a goal that isn’t related to retirement, consider if you would like to have a relationship with a person or if you prefer the idea of a robo-advisor.
Many investors tend to prefer experienced advisors over robo-advisors, according to a recent study published in the Journal of Services Marketing. The same study also shows that investors tend to view the advice of novice advisors and robo-advisors equally.
If you’re a nervous investor, I recommend choosing a robo-advisor. These services typically manage your portfolio using a Nobel Prize–winning strategy called Modern Portfolio Theory. This theory uses strategic diversification to ensure that investors will receive the maximum return for the risk their investment presents, according to the Corporate Finance Institute.
How Robo-Advisors Can Help Beginning Investors
First, their fees tend to be lower than their human counterparts.
Second, robo-advisors typically use broad index funds such as the S&P 500 and exchange-traded funds (ETFs). An index fund is a portfolio of stocks or bonds that is meant to mimic the larger market in a particular sector or reflect a broader market index. When you buy an index fund, you generally are purchasing a small amount of each of the stocks that comprise the index, from 30 in the Dow Jones Industrial Average up to about 3,500 in the Wilshire 5000.
An index ETF, on the other hand, is a security that tracks indexes, but can be bought and sold directly on the stock market. The main difference between index ETFs and index funds is that, while index ETFs can be bought and sold throughout the day, index funds can be traded only for one set price after the market closes.
The result? You can diversify without getting into the weeds of stock market research.
You may want to own an ETF in a particular sector like energy or green technology, or you may focus on a stock or bond ETF. There are a plethora to consider.
And third, robo-advisors typically use “asset allocation” to manage risk in your portfolio. Asset allocation means that your investments are diversified based on your goals, your time horizon, and your appetite for risk.
When your asset allocation strays, your robo-advisor will rebalance under certain triggers. This doesn’t happen willy nilly or every time your portfolio dips up or down. Typically your portfolio will rebalance when it deviates a certain percentage from the desired allocation, or at a set time interval, such as quarterly. That means that your robo-advisor will sell the over-weighted investment and buy the under-weighted investment. Why do this? It boosts your returns by forcing you to buy low and sell high.
“I’ve been investing for a few years,” says Daniel Caughill, an investor and co-founder of the Dog Tale. “When I started, finding a good robo-advisor was square one. At the time, I knew just enough about investing to know I was clueless, so I wanted ‘someone’ to tell me what to do. I also believed financial advisors could have mixed motives, and I thought they would charge hefty fees, so having that someone be a something was even better. Now I do some investing on my own, but I still rely on Betterment to keep me on track for my long-term investing goals.”
Step 4: Pick Your Investments
Selecting investments can be the most overwhelming part of getting into the stock market.
Though it’s best not to make impulsive or uniformed investment decisions — it’s better to make a mistake when you’re young than when you’re old.
As a young person, you have time to recover from an investing mistake.
This is a topic you should take seriously. Type “investment advice” in your favorite social media channel and you will hear from hundreds of so-called experts. Some may really know their stuff. Most are heralding their own opinions.
With the recent popularity of subreddits such as WallStreetBets, younger investors might think shorting GameStop or buying Dogecoin is a clever way to become rich. Guess what? You may get lucky once or twice, but it’s people who invest purposefully over time with defined goals who tend to do best.
So where do you go for investing advice? Check out our chart where we review investor education portals.
Step 5: Keep Investing
Investing a few thousand dollars in the stock market today isn’t, by itself, a sound retirement strategy. What is smart is to always pay yourself first. If you can, set up an automatic deduction from your paycheck of $100 or whatever you can afford, and contribute consistently, every paycheck or every chance you get. That way, you harness the power of compound interest and the potential for a healthy market return over time, provided your holdings are well diversified.
In The Millionaire Next Door, Thomas Stanley, Ph.D., and William Danko, Ph.D., profiled hundreds of millionaires. On average, the millionaires saved and invested at least 20 percent of their income year after year.
Some millionaires made huge investment mistakes but became wealthy because they persisted in investing large portions of their income. To have the best chance at becoming wealthy — if that’s your goal — you need to do likewise.
We know that stock market prices move up and down. Ideally, we would buy only at market lows and sell at market peaks. A good way to manage your investments is through dollar-cost averaging, which helps you to manage the risk associated with investing in the stock market. Through this method, you contribute a fixed amount of money at specified intervals into a volatile stock. This results in a greater amount of stock than you might otherwise have purchased.
Many experts recommend automating investment contributions. “From a behavioral finance perspective, automating investing over the long term is a great way to build wealth since you’re really paying yourself first and eliminating the option or temptation to spend those dollars,” says Scott Sturgeon, a CFP with Falcon Wealth Advisors.
“Just like you pay a mortgage each month and build equity in your home in the process, the same concept can be applied to putting funds into the market at regular intervals,” Sturgeon adds.
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, the 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?
People can generally expect their investment portfolios to return between 5 and 10 percent in the long term. The actual returns will depend on your asset allocation and on when you begin to invest.
Step 6: Keep Learning
Once you start investing, you’ll realize that you have lots of questions. Why should I invest in index funds? How diverse does my portfolio need to be? How can I boost my rate of return? The answers to your questions depend on who you ask.
Now that you’ve learned how to start investing in the stock market, you realize even the simplest questions are nuanced.
This is the final installment of Stock Market for Beginners, our six-part series on investing and the stock market. To start from the beginning, click here.
Past performance is not a predictor of future results. Individual investment results may vary. All investing involves risk of loss.
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