The average interest rate on a savings account as of December 2020 is 0.05%. That’s far below the approximately 1.2% inflation rate. This means keeping your extra cash in a bank account costs you money in terms of lost purchasing power.
If you’re willing to take some risk, consider investing. Yes, stock prices rise and fall, and there is always the chance of getting back less than you put in. But over the long term, the market goes up — meaning you might earn inflation-beating financial returns.
When planning where to put your money, consider the four major factors that shape how you invest:
Savings. The first step to investing is learning to live within your means to build reserves. Start by recording your assets, your debts and liabilities and everything your family spends, and adjust your budget accordingly.
Goals. Maybe you want to save for a home, a higher education or travel. Perhaps you’re looking to set up for a comfortable retirement or pass on a financial legacy to your kids or grandkids. Your goals will guide your investment choices.
Time. Most investments rely on the power of compounding interest, which is additional interest paid on your principal deposit. In other words, it’s interest paid on interest. And it helps to speed up your earnings.
Vehicles. You have many ways to put your money to work — CDs, stocks, annuities and more. Factor in the risks and rewards for each.
Check out our short video on how you can make your money work hard for you:
First, make sure you’re ready
Investing means taking risks. It’s best to do it with money you can afford to tie up for the near future, and possibly even lose. First consider these financial priorities.
Have an emergency fund: Most financial planners recommend you have at least six months worth of essential living expenses socked away safely in an emergency fund. That way if the market goes does or another emergency arises, you don’t have to sell at a loss or worry about not having a roof over your head or eating every day.
Pay off high-interest debt: Before putting your money into the stock market, try launching it at high-interest debt so it won’t build up any higher. It’s a struggle for many people, but you have options. Consider a low-rate personal loan. These can give you anywhere from 24 to 60 months to pay off your debt. If you have high-interest credit card debt, a balance transfer card can help. The best balance transfer cards let you move your existing credit card debt to a new card that allows you to pay it off with zero interest within a year or longer.
Commit enough to get any 401(k) match at work: If your employer offers a company match on your 401(k), make sure you’re contributing enough of your paycheck to get it. Some companies match a percentage of your contributions up to a certain limit. This is one of the few examples of free money you’ll see.
With these under control, you’re ready to set up a trading account and start investing.
3 things to consider before investing
As you star, spend some time figuring out:
1. What is your goal?
Because of the risks involved — and the potential for loss if you are forced to sell your investments early in order to access cash — it is important to have a plan rather than simply throwing an arbitrary amount into the stock market because you happen to be able to afford it today.
Think about what you will use the investment money for. Will you rely on it for retirement? To buy a house? Or is it for something less consequential, such as a vacation, general savings or even “fun money?”
2. What is your time frame?
Investments regularly rise and fall, and the choices for what to invest in as well as what to expect to happen after you buy are largely dependent on how much time you expect to keep your money invested.
Long term: Investors with long-term or retirement goals often keep their money in the market for decades and reinvest their dividends in order to maximize the compounding of their returns. Even if markets crash, they have faith that prices will rebound before they reach their goal.
Medium term: Investors who are approaching their goal or who are trading a broad market trend may be investing for several years. They generally ignore small corrections but may be following a risk management strategy like a hard stop-loss or trailing stop-loss to protect their portfolio during bigger corrections or bear markets.
Short term: Investors or traders who put their money to work for temporary opportunities or seasonal trends often develop plans for when to buy and sell, or they follow technical chart signals.
If you think about your goal and your time frame, you might realize you don’t need to take much risk and can reach your target in time with less risky assets such as government or investment-grade corporate bonds. If you are going to need significantly more money in less time, you may face having to take more risk to get it.
3. How much risk can you take?
There are two types of risk: activity risk and investor risk.
There are five main asset classes, and each carries its own typical level of risk. In order from least to most risky, it generally goes: cash, government bonds, corporate bonds, rental real estate and stocks.
Risk typically means unpredictability of returns. With cash, you know how much you have, you know how much interest you’ll get, and you know you won’t lose any of your capital based on government insurance. What you don’t know is a) how high inflation will be and b) how likely your bank is to go under — although the latter has historically been a rare thing.
On the other hand, with stocks, you have much less of an idea about how much the price will fluctuate or how the dividend payout will change. This is why they are seen as the riskiest mainstream asset.
If you can’t afford to lose much money in a given year, you should put more of your money into government bonds and investment-grade corporate bonds — in other words, bonds from very stable companies.
If you could afford to lose more — say, 15% to 30% of your portfolio — in a bad year, and you would feel comfortable with that level of risk, then you could allocate more money to stocks.
Similar to the difference between a child driving a car and an adult driving a car, there is also risk in the person investing. A new stock investor is taking more risk than an experienced stock investor. You can reduce this risk by learning about and trying different investment strategies with a small portfolio, then expanding as you gain understanding and expertise in a particular asset type or strategy.
There are several investment account types within which to start investing in stocks or any other regulated type of investment.
Employer-sponsored retirement plans: This type covers 401(k)s, pensions, 403(b)s, 457 plans, SIMPLE plans and SEPs, all of which must be set up by an employer and offered to employees. While asset selection is commonly limited within these plans, one big advantage (as mentioned above) is the potential for your employer to match some or all of the amount of money you contribute to the account.
Individual retirement account (IRA): Not only will you have the chance to grow your money through dividends and stock price increases, but you will also avoid having to pay tax on dividends or on capital gains when you sell. More on taxes below. Depending on the company offering the IRA, you may be able to invest in select investment portfolios managed by a professional advisor, select investment portfolios managed according to computerized rules, select mutual funds or individual stocks, ETFs, options and more of your choosing.
Taxable investment account: Invest using a normal investment account without any contribution or withdrawal limitations, though capital gains will be taxed. You can get this type of account by signing up with a trading platform directly, like Tastyworks, Robinhood or You Invest by Chase.
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Other investment options
Residential property: A home is a common investment, as value tends to increase over time.
Life insurance: Some types of life insurance — like whole life, variable life or universal life — have a cash value component that produces a guaranteed and/or variable return.
Exotic assets: These could include wine, art, cars or anything that could increase in value over time.
Peer-to-peer lending: These are websites that allow you to loan money to individuals or businesses for a set rate of interest. It’s possible to earn more on these loans than you would make in cash, but some people are wary of this relatively new financial product.
Cryptocurrency: Another new and exotic asset is cryptocurrency, with Bitcoin being the most well-known. Be careful when investing in crypto: It is an exceedingly volatile asset, it trades all hours of the day — even when you’re sleeping — and it can be more cumbersome to set up and fund an account.
With investing, the idea is to use your money to make more money. By creating and preserving your wealth, you can reap the rewards of:
Return on investment. Many investments increase in value over time. Investments aren’t always guaranteed, but profit projections can help you decide what to invest in and how much to invest.
Dividends. If you purchase stocks, funds or cash-value life insurance, you own shares in that company and may receive a percentage of its profits — which you can either cash in or reinvest. These dividends are distributed to shareholders on a set schedule. Stocks and funds typically pay quarterly dividends, while mutually owned life insurance companies tend to pay annual dividends, sometimes called a return of excess premium.
Compounded interest. Many investments give you the opportunity to earn compound interest, which is essentially interest on your earnings. The longer you hold a stock, the higher its value — and the more interest you’ll earn.
Voice in how a company operates. When you own shares in a company or corporation, you get to vote or have a say in how it’s run.
What are the risks of investing?
No investment is risk-free, so a big part of investing is deciding how much risk you can comfortably assume. Generally, the higher the risk, the higher the reward.
Risks investors face include:
Losses. The value of investments can decrease for many reasons. Companies can underperform, demand for products or services can dry up and the stock market can crash. To earn an ROI on loans, stock and annuities, the company you invest in must stay in business. If it goes bankrupt and liquidates its assets, that affects how much money you get back — if any.
Volatility. The value of an investment can fluctuate, sometimes wildly, due to internal factors like faulty products or external events they have no control over, like political changes.
Inflation. When goods and services cost more in the future than they do now, your money becomes worth a little less, and if you don’t grow your money at a rate higher than the rate of inflation, you’ll essentially be losing money on your investments.
Fees. Most investment categories come with a set of fees. For example, brokers charge commissions or management fees to carry out the purchase of stocks and bonds. Weigh the fees against your potential ROI.
Taxes. Likewise, capital gains from investing are often subject to taxes. The timing of the collection of those taxes depends on the investment. Most investments are taxed on their sale, but retirement investments can be taxed on withdrawal from the account.
Are any investments guaranteed?
No. But a few protections are in place for specific vehicles and situations:
The Federal Deposit Insurance Corporation insures savings accounts, money market accounts and CDs. The FDIC insures up to $250,000 of your deposits in each insured bank. The catch? FDIC-insured accounts earn a lower interest rate.
The National Credit Union Administration insures credit union members’ deposits. Backed by the US government, it also insures up to a maximum of $250,000 of your money.
The securities you own aren’t insured against a loss in value. But the Securities Investors Protection Corporation is a non-government entity that replaces missing stocks and securities in customer accounts held by a SIPC member firm if the firm fails. The limit is $500,000, including up to $250,000 in cash.
A good investment strategy addresses the opportunities and risks of the financial markets in a way that helps you achieve your goals. Such a strategy can change over time, but consider important components like:
Divvy up your savings sensibly. This involves determining how much money to invest into each vehicle, often based on its volatility and your risk tolerance. The classic example is for younger investors to put more money into stocks than bonds to leverage long-term growth potential, while investors closer to retirement generally keep most of their investments in less risky bonds.
Know what’s coming. Business cycles, economic cycles and seasons can influence the movements of investment vehicles. Restaurants must be planned, then built. Oil must be discovered, then drilled. Prescription drugs must be developed, then tested and approved.
Don’t put all your eggs in one basket. To manage risk and protect against market fluctuations, savvy investors diversify their portfolios across multiple vehicles and sectors.
Keep your finger on the pulse of the economy. Recognize the role that generational, technological, societal and other shifts can play in the ongoing supply and demand tug of war.
Many traditional wealth management firms prefer active investing, where advisers regularly buy and sell assets for you. The idea is that skillful investing can “beat the market” and outperform a portfolio that changes very little.
Robo-advisors tend to use a passive investing approach. Rather than try to pick winning and losing investments, they put your money in a curated mix of investments and wait for it to grow.
Some actively managed funds outperform the market, but most don’t. According to the 2017 Dow Jones Indices SPIVA Scorecard — a semiannual comparison of managed funds against benchmarks — large funds usually don’t beat the S&P 64% of the time. And medium-size and small funds fall behind their benchmarks almost 90% of the time.
Robo-advisors aren’t designed to beat the market, but they move in sync with it. According to experts, robo-advisors often perform better than actively managed funds, once you account for the difference in management fees.
Taxes on investments
When you invest outside of certain tax-advantaged retirement accounts, you will owe taxes on the money you make, though there are several different tax rates depending on the type of investment:
Ordinary income tax rate: Interest, ordinary dividends and short-term capital gains (investments held less than a year) are all taxed at your ordinary tax bracket, which ranges from 10% to 37%.
Capital gains tax rate: Qualified dividends and long-term capital gains (investments held a year or longer) are taxed in a range from 0% to 20%, depending on the amount of your taxable income.
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
The keys to getting started with investing center on having a plan and understanding the assets you’re investing in. If you can handle the volatility of investing and minimize the risks, there exists an opportunity to grow your money. Evaluate your options, learn what fits you best and compare the products and services that will help you achieve your goals, starting with online trading platforms.
Frequently asked questions
That depends on your investment goals and strategy, but you can open some robo-advisor or brokerage accounts with as little as $1.
It can cost nothing, as many investment accounts can be opened at no cost, and lots of brokerage accounts now allow you to trade stocks and exchange-traded funds (ETFs) without paying a commission, making the process more accessible than it’s ever been. You’ll still pay minuscule regulatory and exchange fees on some trades, and some robo-advisors or financial advisors charge a percentage of your account balance as a management fee.
Felix Thompson is a freelance writer at Finder. He covers everything from digital banking to car insurance and, whatever the topic, he aims to make it easy for consumers to get straight to the best deal. Felix has a postgraduate qualification in international journalism and is also a broadcast journalist. In his spare time, he loves to cycle.
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