How to start investing
If you have never made investment decisions before, the trickiest question is how to start investing. Where do you start? What are your investment options? How much should I invest in each investment class? Are there any systematic strategies? I am going to try to answer some of these questions.
First and foremost, I recommend making a list of all your debt with the following columns – total debt in each category, interest rate, and term of the debt. Adjust the interest rate to include the tax benefit, if any. Here’s a simplified example. Say you have a $1,000 loan with a 10% interest rate, making your annual payment to be $100. But if you can also claim a tax deduction of $25, then your actual interest payment is $75, making your implicit interest rate to be 7.5%. Sort the table by this implicit interest rate in descending order.
Here’s an example.
|Debt Amount||Implied Interest Rate||Term||Debt Type|
|$1,000||15%||2 years||Personal Loan|
|$50,000||10%||20 years||Student Loan|
|$20,000||7.5%||6 years||Auto Loan|
Check if your student loan interest is tax deductible here. You may be able to deduct interest payments on your auto loan, and business loans if you can prove that the interest expenses are related to you business expenses. Also, if you have a mortgage, the interest payments on the mortgage are tax deductible as long as the mortgage is on your primary residence.
Income and expenses
Next, get a sense of your monthly income and expenditure. The way I do it is sum all the credits in my accounts for the last 12 months to get a sense of my total annual income. Similarly, I sum all the debits in my accounts to get a sense of my annual expenses. Divide both those numbers by 12 to get average monthly numbers. Your income and expenses may differ month over month, but this way you get a better sense of the average number and you can be more prepared for it. And you also get a sense for how much money you have left for investing or for paying off your debt.
Finally, you need to determine how much return potential each investment class can provide. In November of 2018, John Bogle, the founder of the Vanguard group predicted an average annual return between 4% and 5% for US stocks and 4 % for bonds. The past decade has seen an average of 13% returns for US stocks. The point I am trying to make is that we can’t expect the market to continue to provide above average returns.
By doing the above three, you gain a better sense of what you have, what you owe and what you can potentially earn.
Knocking off debt
If you have savings, but also have debt, start knocking off that debt slowly. If you have any debt with an interest rate greater than what you think your investment return would be, you are better off paying the debt than gambling in the stock market. That is almost the same as earning a return equal to the implicit interest rate. Most people expect to realize a higher than market return through investment and then learn the hard way and decide to stay away from the market. Try not to fall into that trap. Try to knock off all your high interest debt first. Be sure to still make the monthly payments on all your debt. Otherwise you are also paying additional interest. If you still have money remaining in your account for investing, you should focus on reducing the debt.
Life can throw surprises at you. Here are some examples.
- Death of a loved one
- Job loss
- Accident or Injury that prevents you from working
- Unexpected travel or medical expenses
- Car breakdown
- Unexpected home repairs
Before you start investing in riskier assets, it’s important to build a secure emergency fund. Building an emergency fund will help you be stress-free in such situations. Depending on your personality, keeping 3-8 months’ worth of expenses in a separate liquid account such as a money market account is a great way. You will still earn more than you would in a regular checking or savings account, without compromising value of the fund. What I mean is that if you have $1,000 in a money market account, it won’t fall below $1,000. Whereas, if you put your emergency fund in a brokerage account, there is a possibility that it may be much below the $1,000 since stocks are volatile. Be sure to include all your bills for the month – mortgage, rent, utility bills, childcare costs, etc, and some extra in your emergency fund. Here is a link to money market accounts.
Retirement accounts help provide tax benefit while you save for your retirement. Click here to learn more about retirement plans. This is going to be your most important investment and I highly recommend that you start here.
What are my investment options?
There are many investment options to choose from. For a comprehensive list of available options, click here.
Stocks – You can buy a small ownership of a public company by buying some shares of the company. This is a risky investment since you partake in not only the company’s profits but all the company’s losses.
Bonds – Bonds are relatively lower risk compared to stocks. However, some bonds are riskier. So know what you are getting into before investing.
Funds and ETFs – If you have never invested before, a good place to start would be broad market ETFs. They provide a low cost alternative to buying individual stocks. Index funds also are known to provide better investment returns than actively managed funds.
Where do I go from here?
The next step is to create a new brokerage account. Click here to learn about brokerage accounts. Find the best one for your buck. You don’t want a brokerage that charges high fees for trading. Next determine how much you want to put in the account and begin investing. It’s great if you have a lot of money for investing but you can start with as low as $100. Consistency is the key.
The investing process can be overwhelming but it doesn’t have to be. Now that we have answered how do I start investing, the key is to have a systematic process that you can be consistent with. Don’t trade on your fears.