How to Start Investing for Beginners

Why Investing Is Important

If you had a Grandma like mine, you grew up hearing about a time when you could get a burger for just 15 cents- at Mcdonald’s. Unfortunately, the price of all goods and services increases over time due to inflation.  The takeaway (without getting into an economics lesson) is that money becomes worth less over time.

While we work hard to save some money for milestones such as retirement, a home, or college tuition, inflation works against our savings, decreasing the value of our hard-earned dollars daily.  Fortunately, we can overcome this hurdle- but we need to start investing our money and outpace inflation.

The historical inflation rate in the U.S. has been 2.55% over the past 30 years, while the U.S. stock market (S&P 500 total return) has averaged 12.8%. Despite several market crashes and recessions over the past 30 years, the difference between market returns and inflation compounds and becomes enormous.  Had you invested $1000, it would be worth $12,401 today (in 1990s dollars); had you put it under your mattress, that thousand dollars would be worth the equivalent of just $447 (in 1990 dollars).

Stock Returns vs Inflation Rates

Intelligent investing can overcome inflation in the long run. If high school math wasn’t your favorite subject, remember that compounding returns grow exponentially over time.  You are not only earning on your initial investment but also earning interest on your interest as it gets reinvested.   

Tax-deferred compound interest can grow your money even faster.  The U.S. tax system does not tax investment returns until you sell an investment or receive a cash distribution.  Combining compound returns (interest) with deferred taxes equals a successful money-making formula.

How To Start Investing For Beginners: Step By Step Guide

Before jumping in and investing, we need to take a few essential steps. First, steps 1-3 require getting our personal finances in order before investing.  Skipping these steps is as futile as trying to run a marathon with a 40-pound backpack attached.

7 Steps To Start Investing

Step 1: Pay Off All Bad Debt

Let’s keep this simple- bad debt is any unnecessary debt with an interest rate over 5%. So why do I use 5%-?  Because that’s what a very conservative investment would have returned over the past century. So you are better off paying down your debts at these high interest rates before beginning to invest.

Credit-card debt or balances is the number one item you need to eliminate before considering investing.  Average credit card interest rates are often above 14% or even significantly higher.

Other forms of bad debt include financing expensive items such as new cars, computers, or phones that you don’t really need and could not afford without the loan.

If you have student loans with rates above 5%, you should pay them off before beginning to invest.

Home mortgages are generally the ‘best’ form of debt an individual can have and provide individual leverage at a relatively low-interest rate.  As long as your rate is under 5%, this can be an effective form of “leverage”- borrowing at a lower rate and using that money to generate a return at a higher rate.

If you are at step 1 (the most challenging step), I will assume you are motivated and want to pay down your debt as quickly as possible.  The strategy for paying down your debt is straightforward- start paying off the highest interest rates first and work down to the lowest rates last.

Step 2: Eliminate Money Pits

After paying down your debt, the next wise move you can make is to eliminate unnecessary spending on things you can’t really afford.  I’m not preaching to you to avoid those $6 lattes or expensive nights out; however, eliminating money pits is crucial to building wealth which is the end goal. 

Step 3: Create An Emergency Fund

Once you have no debt (not including a home mortgage), you are in a position to start saving and growing money.

How Much To Put In An Emergency Fund

$1000 is the initial goal for your emergency fund.  Once you have saved this much, I recommend physically separating the $1000 from your day-to-day checking account by opening a separate savings account.

Many financial advisors will tell you to work up to saving 3-6 months of living expenses in your savings account before starting to invest.  I recommend three months as many new investors leave too much money in low-interest savings accounts.  

Depending on your job stability and risk tolerance, you may feel you want more money in cash.  However, by investing that excess cash in a conservative bond (such as a short term money market fund), you can at least generate a slightly higher return without taking on significant risk to your investment.

Step 4: Learn The Basics: Investing Education

Before investing, it is crucial to learn basic concepts. Here are some fundamental terms to understand. Possibly you are already familiar with some of these terms. We will cover quite a bit in this step, but they are worth learning to grow your financial literacy.

Index Funds: Mutual Funds or Exchange Traded Funds (ETFs)

Index funds allow investors to purchase a basket of holdings to replicate a market index- such as the Dow Jones or S&P 500.  These tools will enable investors to smartly diversify their risk and often have very low fees.  

I am a massive proponent of passive index ETFs, which are similar to mutual funds but cost less to hold and offer better tax advantages.  They are the best investment available for both beginner and expert investors, and investing in ETFs is the place to begin investing.  View the best ETFs to invest in for a comprehensive analysis with nonbiased recommendations.  Remember, not all ETFs are passive investments. Some ETFs are managed by an active investor or fund manager who generally charges significantly higher fees.

Investing involves risk- general market risk and individual company risk.  By investing in a diversified portfolio, an investor can significantly minimize company-level risk.  Avoid concentrating risk in too few assets in order to achieve a safer portfolio.

Top Dollar Edge: Most professional investors and wall street fund managers struggle to match the performance of the S&P 500 over the long term.  Furthermore, if we account for the taxable advantages of investing in passive index funds, it doesn’t make sense for most investors to bother with stock picking or active investing. 

Mutual funds used to be king of the passive investing world. ETFs have risen to prominence over the past 25 years. Online brokers and investment advisors offer equivalent ETFs at lower costs with more flexibility to buy or sell whenever the market is open for trading. Mutual funds are purchased or sold at the end of the day via the fund managers. 

Stock Market Investing

Stock is simply ownership of a company.  Most countries have their own stock market, but the U.S. market is the most sensible investment for new investors.  The largest 500 companies in the U.S. make up the S&P 500 index, and this index is the industry standard when stock market investing.

As an investor builds a diversified portfolio, it makes sense to add some foreign stocks to a portfolio for further diversification.  I would suggest keeping a maximum of 20% of stock investments in foreign securities for new investors.

The stock market is generally considered a riskier asset class because stocks have increased market volatility- greater downward and upward swings.  However, stocks have better past performance returns than bonds, so the mentality is to invest for the long-term and not get stressed when the stock market fluctuates.  Stocks are an essential investment as you work towards financial freedom.

Allocation History Returns

Investing in Fixed Income Bonds

Fixed Income is a fancy term for bonds.  The most common types of products to be familiar with are U.S. Government Bonds, Corporate (Company Issued) Bonds, and Municipal Bonds (State and Local “Muni” Bonds).  Bonds return a yield (interest rate) to the purchaser, as they are loans to the government or company.  Bonds are often considered safer investments, but they are not without risk, and prices could fluctuate significantly.  

Top Dollar Edge: You can buy U.S. Government bonds directly from the Treasure Direct Website without brokerage firm commissions or using any intermediary financial institution.

Interest paid on state and local municipal bonds is usually exempt from federal income tax.  Furthermore, individuals are often exempt from the state and local income taxes on the interest if they are residents within a specific municipality. 

For example, a New York City transit authority muni-bond may be exempt from federal, state, and local (city) income tax if the investor resides within NYC.  In this manner, investing in municipal bonds within your municipalities is valuable. 

When a municipal bond is eligible for state and federal exemption, it is known as being double exempt or even triple tax-exempt (if it is also exempt from local city tax too).

Bonds Compared Tax Exemptions and RIsk

Value Investing

Value Investing focuses on buying companies trading at fair prices based on their earnings, growth, and company financials.  Valuations can be applied to individual stocks or market indices by considering factors such as the economy and future earnings.

Dollar Cost Averaging

Dollar-cost averaging is a technique that commits a fixed amount of money for investing on a fixed schedule.  The purpose is to remove the psychological factor of making emotional decisions based on the market going up or down.  By committing the same amount of money to your investment strategy on a fixed basis, an investor will continue investing throughout the market’s short-term fluctuations.

Rule of 120

The Rule of 120 is a general guideline (definitely not a firm rule) that says to subtract an investor’s age from 120, put that % of your investment asset allocation in stocks, and put the rest in bonds.  The takeaway is that as an investor gets older (closer to retirement), they will usually start withdrawing from their savings and, therefore, should reduce the risk tolerance of their investment portfolio.

Rule of 120 for investing

Retirement Accounts

Retirement Accounts are tax advantaged accounts that should always be the first investment accounts for beginners.  These accounts are to be held long-term and usually require an investor to reach age 59 ½ to begin withdrawals without penalties.  

Certain financial hardship clauses and life milestones allow an investor to access these funds sooner.  There are several types of retirement accounts for individuals- but the main plans you need to be familiar with are the 401(k) and the individual retirement account (IRA).

401(k) Plans: Traditional 401k vs Roth 401k

401(k) plans are the most common type of retirement plan offered by companies.   Most 401(k) plans are structured to allow an employee to make a defined contribution every month from your paycheck.  You can choose between several mutual funds during the enrollment period and set your investments to be automated each month.

Most companies offer some sort of employer match, usually dollar-for-dollar matching contributions up to a certain amount.  Matching incentivizes employees to invest smartly in their retirement as fewer companies today offer traditional pension programs. So don’t ever miss out on fully taking advantage of the maximum amount of an employer’s match- this is actually free money that they budget for employees to take. 

Target date funds are a common type of mutual fund available in 401k.  I generally don’t support target date funds once you know how to invest because they are too rigid.  These funds allocate holding into asset classes very conservatively based on age, so you often hold too many bonds.  They also assume an investor has all of their saving in just one fund as the fund can’t possibly know what other investments you may have.  I don’t believe a 20-year-old should invest differently than a 30-year-old, as they both have 30+ years to retirement.  Nevertheless, a target fund may have the 30-year-old in 10% more bonds. 

Instead of using target date funds, I advise you to consider your own investment objectives and decide on a suitable asset allocation.  Investors who have 20+ years until retirement should often be more heavily invested in higher-returning assets, such as stocks.

There are two varieties of this plan, the Traditional 401k and the Roth 401k.  The primary difference is that the Traditional 401k allows investors to deduct their invested contribution from their taxable income.  Investing pre tax dollars means you won’t pay taxes on that amount today, but you will pay ordinary income tax on the money you withdraw in the future.  

Meanwhile, a Roth 401k does not allow an investor to reduce their taxable income immediately, as contributions are made with post tax dollars; however, you will never again owe taxes on any of this money. 

Traditional vs Roth 401k

The best choice between investing in a Traditional 401k or a Roth 401k generally comes to future tax planning.  The more planning we can do, the more we can optimize our tax efficiency. Therefore, the primary consideration between Traditional vs Roth should come down to your expectation of future tax rate during retirement vs your current tax rate.

It is often advantageous to use a traditional plan if you believe you will be in a lower tax bracket during retirement.  A Roth plan is usually advised if you are not yet paying a high tax rate.  Remember, state and local income taxes are included in addition to federal rates, so consider where you think you may live during retirement.

Top Dollar Edge: Consider your current tax rate if you are unsure about a Traditional or Roth 401k.  If you are not yet paying taxes at the highest income bracket, I recommend going with the Roth. However, if you have reached the highest federal income bracket, I recommend starting with a Traditional 401k, especially if you are currently in a high-income-tax state (over 6%).

IRA Plans

In many ways, IRA plans are similar to 401k plans; however, higher income earners are not eligible to invest in both a company-sponsored 401k and an IRA plan.

Like 401k plans, IRA plans come in the Traditional IRA and Roth IRA varietals.  

If your company doesn’t offer a 401k, you can contribute to an IRA, but the maximum contribution limits are not the same.  You can sometimes invest in both, depending on your income levels.

Roth IRA plans have a few additional benefits compared to other retirement accounts and are an awesome tool for building wealth.  I highly recommend opening and investing in a Roth IRA as it is one of the best retirement accounts

Rule of 72

The rule of 72 is an approximation for how long an investment will take to double. So you could divide 72 by an expected return or years to get a quick idea of how long your money will take to double.  

Rule of 72 Rate Return

Time Is Valuable: Start Investing Early

There is no substitute for time.  We can use the Rule of 72 to illustrate the power of time combined with compounding returns.  

Rule of 72 Time Return

More time grants more compounding interest and the ability to ride out downturns.  I highly suggest younger investors increase their risk tolerance and invest in stocks.  These higher returning assets, together with time, can produce huge returns.

Step 5: Create An Investment Plan

Making an investment plan is valuable because it outlines your future investment decisions based on your personal financial goals.  When making your investment plan, you need to consider the time horizon and needed amounts for future milestones- such as your retirement, a down payment, or tuition payment.

Objectives over ten years generally allow plenty of time to be more aggressive with stock market investments. Still, you should consider how much risk you are comfortable taking and adjust downward as you approach the end date.

During big recessions, stock markets have tumbled as much as 30-40% from their highs, but they have always recovered in the long run. So you need to be mentally prepared to stomach the swings of the markets, and NEVER panic sell- this is an absolute must!  Investors who panic sell should not be investing. In fact, a good investor buys more when the market crashes and stocks become cheaper.

Set goals and timelines that are realistic.  When considering my investing plan, I assume a conservative stock market return of 5-8%.  Based on your goals, timeline, and risk profile, you should determine what investments are proper for your individual situation.  Over time you will review your plan for changes and determine if you are still on pace to reach your targets.

I don’t love using investment advisors for ordinary investors because their fees and commissions can ultimately hinder wealth building when compared to do-it-yourself options.  However, investment advisors can add significant value when personalized investment advice is necessary for estate planning or other complicated needs. 

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Step 6: Set Your Investment Strategy

Once you know your goals and targets, you need to consider the specifics of what investments you want to hold.  I suggest keeping it basic for newer investors- all passive investing in index ETFs, meaning no individual stock or bond picking.  These investments are optimal for tax efficiency and superior growth in the long run, and you’ll likely be happy you didn’t overthink it down the line.

I recommend starting with a three-fund portfolio: one U.S. stock market ETF, one international stock market ETF, and a bond market ETF.  

Check out the ETFs comparison list to find the best fund options based on the most important criteria.

3 Fund Portfolio Example

Later you may want to add other asset categories to your investing style, such as commodities, real estate, or even sensible cryptocurrencies.

Additionally, you can also choose to target specific areas within an asset class, such as specific sectors (growth/value or industries), specific countries (international), company size (market cap), or income (dividend) focused ETFs.  These more narrow ETFs carry additional diversification as well as specific risks.

Step 7: Establish Your Brokerage Account 

Your first investment account should be a retirement plan that utilizes the maximum tax advantage possible.  If starting with a 401k, you will not have to set up your account but instead, elect to join your company’s sponsored plan, and you will be enrolled.  

If you are opening up an IRA or an ordinary taxable brokerage account, many brokers are available.  Many online brokers now offer no account minimums and zero fees.  All you need is basic brokerage services, so you should open an investment account with the lowest costs.

Most online brokers offer practice (fake) accounts structured like the real thing.  If you are nervous about placing an order or want experience with the platform, I recommend opening a paper account and playing around for a week before starting.  Paper trading is an excellent way to understand how the specific brokerage platform works and get comfortable placing orders.  Before sending orders, see my professional tips for trading stocks and ETFs.

A robo advisor is a relatively newer automated online broker that uses a related form of the three-fund portfolio type model. For example, they might choose as many as 8 or 10 ETFs to try personalizing all your preferences. Still, usually, there are significant redundancies, and the resulting portfolio will be a passive ETF index portfolio no better than the three-fund portfolio you could put together yourself.

Robo Advisors could charge between 0.20%-0.80% on the entirety of your investment.  They provide some enhanced performance tactics, such as automatic tax loss harvesting and portfolio rebalancing.  Still, their fees create a significant drag they won’t make up for even with these ‘premium’ features.

Micro investment apps also provide beginner investment tools. For example, they can provide methods for starter investors by rounding up your credit card purchases and then investing when you reach their minimum investment requirement (often as low as $5).  Mirco investment apps are more novelty than practical as they are often too insignificant even to classify as useful wealth-building tools.

FAQs Investing For Beginners

How Much Money Do You Need To Start Investing?

Because the value of time and compound interest are so powerful, any amount of money is worth investing. So get started as soon as you have your emergency fund stashed away. 

How Do Fees and Commissions Work?

There has been a trend in the financial industry over the past several years to push fees and commissions as close to zero as possible.  You should be able to open a brokerage fund for nothing with no minimum, as well as find many brokers who also charge zero commission.

ETF management fees have also trended towards zero and are now much cheaper options than mutual funds.  View my list of best ETFs to invest in for a detailed view of the cheapest ETF options.

A financial advisor or investment advisor usually charges fees as a percentage of the value of the assets they manage for a client.  But by using an online broker instead of an advisory or brokerage services firm, you will avoid these fees.

Why Are Some Stocks More Expensive Than Others

Stock prices do not say anything about the value of the company they represent; they just tell you the price of 1 share.  We need to multiply the (share price) x (# of shares) = (market cap), which tells us the value of a company.  Companies can issue more shares, conduct stock splits, and do other technical restructurings at any time to change the share price and the number of shares, but they can’t impact their market cap.

tesla stock split example for beginners

So a $50 stock vs a $1000 stock does not tell you anything about one company compared to another.

What Is a Safe Investment?

There is no such thing as a totally safe investment, as any asset could lose money.  Generally, investments with more risk have greater returns.

Cash, CDs, and savings accounts are about as safe as you can get; however, they offer minimal returns.  Stocks are considered the riskiest asset class but have historically performed with higher returns.  

Bonds are generally considered less risky than stocks.  U.S. government-issued bonds are the least risky; meanwhile, company-issued bonds have more risk.

Have any questions or comments? Feel free to contact me.

References:

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Josh Dudick

Josh is a financial expert with 15+ years on Wall Street as a senior market strategist and trader. Josh graduated from Cornell University with a business degree in Applied Economics and has held numerous U.S. and European securities licenses. In addition to running an investment and trading firm, Josh is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses himself.

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