Stop right there.
Jumping directly from noninvestor to investor is a very big leap, one which is often understated. The decisions you make right now really will affect the rest of your life. So start slow…the markets will be there tomorrow. Here’s a quick survival guide for new investors who want to make the leap.
Step 1: Read
A little work goes a long way. Retirement is the only million-dollar question you’ll have to answer in your lifetime, so it makes sense to study up.
There is an excellent introductory book for beginning investors: The Little Book of Common Sense Investing. Written by John Bogle, founder of Vanguard Group, this book is an excellent quick read for understanding simple investment concepts.
In 216 pages, you’ll see why fees and transaction costs are the biggest drain on investment performance, why day trading to become a millionaire is a very unlikely possibility, and how to shape a portfolio so that you maximize your odds of success without risking your retirement. It’s the fastest quick-and-dirty intro into the land of saving and investing.
Step 2: Evaluate investment accounts
Your employer’s 401k and an individual retirement account (IRA) are the best places to keep your retirement dollars.
If you have access to a 401k, especially one that provides an employer match, use it. An employer match is literally free money that your organization uses to encourage its workers to invest for their future.
A match can come in all shapes and sizes. A common setup is a match up to a certain percentage of your annual salary. Example: 50% on up to 6% of your income. This means that if you put 4% of your salary in your 401k each year, your employer will add another 2%. If you put in 6%, your employer will add another 3%. An immediate return from a 401k match is the best deal you can find.
If you do not have the opportunity to open a 401k, or you do not get a match, consider an individual retirement account. An IRA is an account in which you can pick and choose your own mutual funds and exchange-traded funds without limitation. 401Ks usually offer only a handful of funds. (A 401k and IRA are not mutually exclusive – you can have both.)
Step 3: Examine potential investments
Each mutual fund or exchange-traded fund provides a prospectus for potential investors. This prospectus is filled with pages of legal jargon, disclosures, and other noise, but it also contains very pertinent information about what the fund owns, how it is managed (or unmanaged) and how much it will cost you to own.
As for fees, here’s what you want to find:
- Annual management fees – the fees the investment company charges you for owning a given mutual fund or ETF each year.
- Sales loads – Sales loads are fees paid for buying or selling a mutual fund. Avoid these at all costs! Big sales loads have a devastating effect on investment performance. A 3.5% sales load on a fund would mean that for each dollar you invest, only 96.5 cents would go to your fund. The broker takes the remainder.
- 12b-1 fees – This is really just a way for your broker to make risk-free money on your portfolio. Also known as a distribution fee, this is a way to cover a fund company’s marketing cost (the cost of paying someone to sell you a fund). Annual 12b-1 fees can add significantly to the long-run cost of holding a fund.
Knowing what a fund costs is truly half the battle.
Step 4: Select investments
Once you have collected all relevant information about potential investments, it’s time to make a selection. Use what you’ve about asset allocation (how you divvy up your portfolio between different investments) from Jon Bogle’s book to build an appropriate portfolio. I wrote an article on a really simple and diversified portfolio just two weeks ago.
An investment portfolio is not a toy. Long term investing is not about checking a fund every day, or moving money around at every move of the market. Investors in for the long haul should forget the idea of activity. Repeat the phrase “Don’t just do something, stand there!” over and over again.
Once per year, rebalance your portfolio to your ideal asset allocation. Stocks and bonds rise and fall throughout the year. Rebalancing is a way to easily sell what is expensive, and buy what’s cheaper.
Step 5: Relax
Money isn’t everything. After you’ve done the above, it’s time to relax.
One weekend of work reading a short and light investing read (Bogle’s book), evaluating retirement accounts, and sifting through fund prospectuses for key information will have you on the path to financial freedom. By this step you’ll have done 99% of all the work you’ll ever need to do to manage your retirement accounts. Investing should be the easiest money you’ve ever made. Letting your money work for you is much easier than working for your money.