Investing is one of the most important endeavors we undertake. If you are new to investing then this is the place to begin.
Investing is a learned process that requires one to apply their knowledge in a disciplined way. It is very easy to lose money and very hard to make money. While there isn’t enough space here to cover all the aspects of investing, I can get you started in the right direction. I encourage you to start with getting your finances in order. Once you have a handle on your expenses you can begin to invest. If you already feel you are in control of your finances and are saving 10% or more of your income then go to step 6. I include these steps since many people tend to overlook the importance of managing your money and living within your means. They are the foundation to a good investment program. Step 9 describes how to begin your investment journey.
Step 1: Create a Budget.
A budget is a tool that can both reveal problem spending areas and help fine-tune your cash flow. The mere process of gathering information to begin or maintain a budget can help you control your spending and free up cash to save, invest, or pay off debt. All budgets are not created equal, however; some are overly complicated, and others require constant monitoring. A budget that is simple enough to appeal to non-accountants and yet able to provide the benefits listed above is usually best. Once you track your expenses against your budget you will get a better feel on the amount of detail necessary to help you manage your expenditures.
Step 2: Track your monthly expenditures.
Knowing how much and where you spend your hard earned money helps you track you spending habits. Observe and learn from your spending compared to you budget. Adjust your spending accordingly, paying off your debt and saving for special needs, like college, retirement, etc. There are a number of inexpensive products that help you track your expenses compare them to you budget, including Quicken, Money, and Simple Planning.
Step 3: Pay off the credit cards.
Surprised that paying off credit card debt is the third step in investing. Well, all the interest and late fees you are paying for this expensive debt is money you could be placing into your savings program and investments. Bankrate.com has a calculator to help estimate how long it will take you to pay off your credit card debt. And About.com discusses the importance of maintaining a good credit history.
Step 4: Save up for a rainy day.
Emergencies do happen. Do you have enough money set aside to cover 3 to 6 months of living expenses? If not, you should make sure you have enough money saved for any emergency situation. Quicken.com has a simple debt reduction planner and a savings calculator that may be helpful to plan your savings goals.
These funds need to be readily available should you need them. Many advisors suggest they be kept in a bank or money-market mutual fund. Another way that creates a little more return is to create a "ladder of CD's". A CD is a Certificate of Deposit, which is a savings instrument. Assume your emergency cash reserve is $24,000. Adjust your emergency cash reserve according to your needs and income levels. At your bank set up six certificates of deposit (CD) as follows:
- $4,000 in a 1 month CD
- $4,000 in a 2 month CD
- $4,000 in a 3 month CD
- $4,000 in a 4 month CD
- $4,000 in a 5 month CD
- $4,000 in a 6 month CD
As each CD matures, roll it over into a 6 month CD. After 6 months you will have 6 separate 6 month CDs maturing every month. Continue to roll them over after each one matures. Of interest, creating a "ladder" like this is one way to invest in bonds to create regular income and minimize risk.
"With a fully funded reserve, you can start putting extra money into … longer-term savings and investments." (Jane Bryant Quinn, Making the Most of Your Money, Simon & Schuster, New York, 1997, p. 172)
Step 5: Set up a disciplined savings program that pays you just like you pay your other bills.
The fundamental building block to personal prosperity is learning to live below your means. In other words, SAVING! That's it! That's the secret to becoming wealthy. Granted, there's the question of what to do with the money once you have it saved; but if you can't adjust your living expenses so that you create and maintain a regular saving plan, there's no need discussing the rest.
Living below your means applies to all income levels. Look at it this way: unless you know you're going to die within weeks (and who ever really does), you should be planning for your future. Part of that planning might as well be setting aside at least 10% of your total income to save for important expenditures like, a down payment for a home, college for your children and of course to create wealth. This takes time (years) so you must be patient; but, given enough time, it's a sure thing to make you wealthy. A great way is to have money transferred to investment (or savings) accounts on a regular monthly basis. Using this technique, you won't have to remember to contribute to your savings plan every month.
Step 6: Take full advantage of your Company's retirement savings plans.
Many companies offer 401k plans. According to 401k.org, a 401k plan is "A defined contribution plan that permits employees to have a portion of their salary deducted from their paycheck and contributed to an account. Federal (and sometimes state) taxes on the employee contributions and investment earnings are deferred until the participant receives a distribution from the plan (typically at retirement). Employers may also make contributions to a participant’s account."
Typically, your contributions are pre-tax, meaning that you do not have to pay taxes on the amount you contribute to your 401k until you withdraw the money, hopefully after you retire. Also, many companies match part or all of your contribution. That is free money. Take advantage of it. If you are not contributing to your 401k, start now. The longer you wait, the less wealth you will be able to accumulate. Make the power of compound interest work for you.
Step 7: Take advantage of all the tax-advantaged savings programs including IRAs, 529 College savings plans, etc.
There are a number of tax advantaged savings plans including IRAs, and college savings plans. An Individual Retirement Arrangement (IRA), commonly called an Individual Retirement Account, is a personal retirement savings plan available to anyone who receives taxable compensation during the year.
Husbands and wives may each have an IRA, even if one person in that marriage is not working with the annual contribution limited to the lesser of total taxable compensation or to the normal yearly amount as described by current law. Persons age 50 or older may make an additional catch-up contribution in the amount also set by law.
There are 11 types of IRAs each appropriate for a particular situation. We will describe more about each type in the future. In the mean time you can read more about them here
Imagine your child coming to you with an acceptance letter from "the" college. The one he’s been dreaming of all through high school. The one that perfectly matches her career aspirations. Perhaps even your own alma mater.
Only one thing could make you prouder – knowing that you have done your homework, too. That no matter where your child is accepted or what financial aid is offered, you have the resources to afford the college of choice.
Your child’s college tuition could be one of the largest expenditures you ever make. And, if you have more than one child, the financial commitment is even greater. The financial challenge you face is shared by millions of others.
Fortunately, saving for future college expenses now have more options than ever before. Traditional investment options—savings accounts, taxable investment accounts, annuities, and U.S. Savings Bonds—are now joined by powerful new investment vehicles including Section 529 college savings programs and Coverdell education savings accounts. These options will be discussed in the future. You can also read more about saving for college here.
Step 8: Buy your first home.
A house is one of the best investments you can make. Your payments increase your equity and the interest and real estate taxes you incur is tax deductible. And over time your house is likely to increase in value. If you want to learn more about home buying we suggest you begin here, and The New Complete Book of Home Buyingis a good book.
While we are not real estate advisors there is a common adage in real estate, namely Location, Location, Location. The location of your real estate investment is the most important consideration by far. Another point to consider when buying a house is not to buy the biggest house in the neighborhood, but rather buy one of the average or smaller sizes in the best location. If you own the largest house, then your price appreciation is held down by the less expensive homes. And buy a house you where you want to live, not just for the potential price appreciation. Just something to consider.
Step 9: Set up a diversified investment program that guides you to create wealth.
If you have carried out steps 1 through 8 then you are well on your way to financial success. Now let's address how to become a more complete investor covering establishing knowing your personality, risk tolerance, time frame and investment objectives.
The way you live your life and how you handle risk taking go a long way to define your approach to investing. If you enjoy taking risks then you will likely be able to take on more risk in your investments. If you enjoy examining companies' financial reports and research stocks, then you will likely be happy at managing your own investments. If you do not have the time to investigate many stocks to find the few good ones, then you should find other resources to assist you. Look at your self and decide you you want to handle your investments. There are investment vehicles and ways to invest that will match your personal style.
If you have trouble sleeping at night worrying about your investments then that is a good indication you have taken on to much risk. One of the greatest investors of all time, Peter Lynch said that the "key organ for investing is the stomach, not the brain." Meaning, you need to know how much volatility you can tolerate in your investments. There are many ways to mitigate risk to help you sleep at night. Up coming Investors' Insights will discuss risk management in more detail.
When you are young you have time to take advantage of compounding to help build your net worth. Saving 5-10% of your monthly pay check now will build up over time to create a nice nest egg. However, as you approach retirement, you will need to adjust your timeframe and the type of investments you should consider, becoming more concerned with conserving your capital and generating income.
Your investment objectives depend on why you are investing (retirement, buy a 2nd home, etc.), your age and position in life (25 and just starting out in your career, 65 and retiring, etc.) and your personal circumstances (have a $500,000 to invest, have difficulty saving any money). These factors help to determine your need for current income to help pay your living expenses or capital appreciation to create wealth. When you will need to access this money must also be considered.
Step 10: Learn to invest.
Learn how companies are valued. Knowing how to value a business is applicable to any business including your start up. When I look at the value of a company I like to understand two important factors. One is Return on Capital defined as EBIT/(Net Working Capital + Net Fixed Assets). EBIT is earnings before interest and taxes; Net Working Capital is Current Assets – Current Liabilities; and Net Fixed Assets is Fixed Assets – Depreciation. EBIT is used because companies can use different levels of debt and vary their reported taxes causing distortions in Net Income. Net Working Capital + Net Fixed Assets are used to figure out how much capital is actually needed to run the business. The other factor I like to understand is Earnings Yield which is EBIT/Enterprise Value. For this purpose Enterprise Value is the Market Value of Equity + Net Interest-Bearing Debt. The basic idea is to figure out how much the business earns relative to the purchase price of the business. These concepts are actually quite simple and are best explained in a book by Joel Greenblatt titled “The Little Book that Beats the Market”. You can purchase the book for less than $20 at most any book store, online store or at my website www.tradingonlinemarkets.com for less than $13.
Build a sufficient level of cash to be used for investing. Most brokers require at least $1,000 just to open an account. This is risk capital that may be lost should your investment go wrong. For every buyer who believes the price will go up, there is a seller who believes otherwise. And the professionals like nothing better to take a new investors money to get them out of a stock.
Finding good stocks is the most difficult investing endeavor. Fortunately, there are several good sources to help narrow you investigation. One of the best ways is your own experience with companies. The more you know about a company the better idea you will have about its investment prospects. Your experience and insight you gain through graduate school should give you more insight into an industry or set of companies that give you an investing edge. Another good source of potential companies is from web sites run by quality investment advisors. This includes Joel Greenblatt’s Magic Formula list available at www.magicformulainvesting.com and other good investing sites, including my own at www.tradingonlinemarkets.com
Develop your investment skills using the various stock market trading simulation games such as Virtual Stock Exchange - HOME which is free and Stock-Trak :: Portfolio Simulations which charges a small one time fee. These are great ways to practice your investing skills before you commit real money.
Once you feel you are ready and you understand the risks, proceed to open an account at a broker. Keep in mind that you must have a minimum of $1,000 to open an account at most discount brokers.
Do your homework researching your potential investments, paying special attention to the fundamentals, the price you expect to buy, your exit target and your stop loss price. Your stop loss is most important to protect you from incurring larger losses. If you want to learn more about trailing stop losses please go to Stock Selling Strategies - Trailing Stop for an article on how to limit your losses and capture your gains from winning trades.
There are a number of good web sites and books that you might consider checking out to help learn more about investing. To be good it takes work you your part. I encourage you to start learning now as it will help you with your future. I list several good web sites and books at Research if you are interested.