Everyone’s heard the same advice: “Don’t just sit on your money, invest it in something. You’ll never get ahead keeping your money under your mattress.” While this is true, it’s funny how they never specify what that “something” is.
Let’s change that. Here are the steps I would take in order to start investing in the stock market, and what I would consider investing in first.
- Set up an emergency cash fund
- Check with your employer about retirement options
- Use IRAs to your advantage
- Taxed brokerage accounts
- What to invest in
Set Up an Emergency Cash Fund
While not part of investing directly, this is an important piece that should not be skipped. Investing has risks associated with it, so you should have a fall-back fund in case things turn for the worst. Most professionals suggest saving 3-6 months worth of expenses before investing.
There are only two rules to this emergency fund. Rule #1: Don’t touch this money unless there is an emergency. Rule #2: Don’t touch this money unless there is an emergency. It’s important to give yourself a solid base in case some unexpected expenses come up. So before you get too excited about throwing your money at the stock market, make sure you start with a good foundation.
Check with Your Employer about Retirement Options
Once you have a rainy day fund set up, the next consideration is dodging Uncle Sam as much as possible (legally, of course). The best way to do this is to make full use of all tax-advantaged accounts. 401k and IRA accounts (which we’ll talk about in the next step) are two examples of this.
A 401k is taxed in 2 ways, depending if its a traditional or Roth. Traditional 401k accounts are taxed when you pull your money out during retirement. When filing your annual taxes, all taxes paid on contributions to a traditional 401k account will be reimbursed to you in your tax return. Contributions to a Roth 401k accounts, on the other hand, are taxed before they enter the account. With a Roth 401k, you don’t have to worry about paying taxes when you pull the money out in retirement. Consult with a financial advisor to find the best option for you.
Another fun bonus to a 401k account is that many employers will match your contributions, effectively giving you free money just for contributing to your own retirement. Who doesn’t like free money?
You might be saying, “wait, if all of my contributions/distributions are being taxed, how is this helping me avoid taxes?” Great question. The money you put into or take out of your account will be taxed. What’s not taxed are the gains made on your investment. In other non-retirement brokerage accounts, if your investment increases in value, you will get taxed on that gain when you sell your investments. This is called a “capital gains tax”, and tax-advantaged accounts like a 401k or IRA completely avoid this.
Using IRAs to Your Advantage
IRAs are a great option for investing in the stock market, as well. An IRA (Individual Retirement Account), as the name would suggest, is a personal account created outside your employer. These too allow investors to lessen their tax burden.
Since IRA accounts are outside of your employer, they do not offer the same contribution matching advantage that a 401k does. For this reason, I encourage you to take full advantage of your employer-sponsored retirement program before moving to an IRA account.
Several investment firms offer IRA accounts, including Charles Schwab, TD Ameritrade, Fidelity, and many more. Do your research, and choose the one that works best for you.
Taxed Brokerage Accounts
The tax-advantaged accounts are great, and they should be your first option considered when contributing to an investment account. The only problem is there is a cap on how much can be contributed during each year. In 2020, the contribution limit on a 401k account is $19,500 (employers may have a limit on how much they will match as well) and the limit for IRA accounts is $6,000. If you go above these limits, the next available option is a taxed brokerage account. These will be taxed on the capital gains and dividends you receive.
While Robinhood is perhaps the most popular option for new investors, Charles Schwab, TD Ameritrade and Fidelity offer taxable accounts as well.
What to Invest In
Now that you’ve opened your accounts and have some money to invest, what should you invest in? If I were a beginning investor, the first place I would look would be a market index ETF.
An ETF, or Exchange Traded Fund, is essentially a basket of stocks that can be purchased and traded like an individual stock. There are thousands of ETFs all with different stocks in their baskets. This can give you exposure to specific markets, industries, or commodities. Some examples include:
Broad Market ETFs
While these are good options, one of the most popular ETFs on the market is SPY, Spyder’s ETF that tracks the S&P500. The S&P500 is a group of the 500 largest public companies in the United States, and the S&P500 index is largely considered to be the best gauge on the stock market as a whole.
Essentially, the SPY ETF is a way to invest in the stock market as a whole without having to buy 500 different stocks yourself. Vanguard also offers several broad market ETFs to choose from.
Buying a broad market ETF is a good place to start because your portfolio will be automatically diversified and is easier to track. It’s also important to note that the S&P500 has shown a historical average return of 8%. With returns like that, your investment would more than double in ten years! See below chart for 8% return compared to a 1% return (ballpark estimate for bank rates in 2020).
Depending on your 401k, buying specific ETFs may not be an option for you. Your provider may have their own funds and ETFs to choose from, so do your research and choose the ones best for you.
Check out Investing in a Volatile Stock Market for more on market conditions and momentum.
Only the Beginning…
Congratulations, you’re a fat cat stock investor now! But remember, this is only the beginning of the journey. There are hundreds, if not thousands, of different strategies that can be used in molding your investment portfolio, and not all of them include buying stocks. My post on the principles of Warren Buffett dives into his, and my, strategy for investing. Until then, I offer this: stick to your gut and do your research. No one person invests the same, so find out what works for you.
DISCLAIMER: At time of publication, I was long GLD.