There's no time like the present to start investing your extra money, even if it's as little as $100. But among stocks, bonds, mutual funds, ETFs and more, it can be difficult for young investors to decide how to invest their cash. Follow these seven steps to get started investing.
1. Make sure you are ready to start investing
Before you consider investing, first make sure you've set aside at least six months' worth of expenses in an emergency fund. You should also start a retirement portfolio and contribute at least enough to get your maximum employer match.
Once you've done that, you can start investing any discretionary income.
2. Understand your options
Every investor needs to understand his or her choices before deciding what to invest in. New investors may feel overwhelmed by the sea of options, but here are the basics:
- Stocks - Shares of public companies. Stocks are typically more risky to invest in because shareholders only earn money when the company increases its value. Some companies offer dividends, which are payments to shareholders.
- Bonds - Shares of government or corporate debt. When you purchase a bond, you are essentially lending money. They have fixed interest rates and are generally low-risk.
- Mutual funds - Groups of stocks or bonds that are professionally managed. Mutual funds are a great way to diversify your portfolio, but they come with operating and shareholder fees.
- Exchange-traded funds (ETFs) - Groups of assets that are traded throughout the day, like stocks. They offer diversification and are less expensive than mutual funds.
- Index funds - Types of mutual funds that follow stock indexes, such as the S&P 500. Like ETFs, they also offer diversification and affordability.
Within these categories there are even more choices. Assets can be classified by valuation (value, blend or growth), market capitalization (small, medium or large), and location (foreign or domestic). There are also alternative assets, such as private equity, real estate and hedge funds, which you probably shouldn't consider investing in on your own. Contact a financial adviser to learn more about these options.
3. Invest in low-cost ETFs and index funds.
Particularly when investing for the first time, you want the highest returns on your investments. For this reason, experts suggest 20-somethings diversify their portfolios with low-cost index funds and ETFs.
"Young investors can get a great start by beginning with a few basic funds, like broad total stock market and total bond market funds," says Anika Hedstrom, a financial adviser from Medford, Oregon.
Hedstrom adds that all investment decisions should be made based on your personal risk tolerance.
"Too much risk may keep you up at night; select an allocation that is appropriate for you," she says.
4. Watch the fees
Although funds offer investors a way to diversify, they come with expense ratios, or operating costs. They're expressed as percentages because they represent the fraction of an investor's assets the fund's manager takes as a fee. To get the best bang for your buck, look for funds with low expense ratios.
Additionally, you could be hit with inactivity fees for infrequent trading and account transfer fees when you move your money around. Do your research ahead of time and avoid these extra costs.
5. Keep taxes in mind
Like it or not, your investments are subject to taxes in some form, so it's smart to plan for them in your budget. Different types of assets are taxed differently, so educate yourself about the levies associated with your investments.
If you are investing through a retirement account such as a 401(k) or Individual Retirement Account (IRA), your contributions are tax-deferred. This means that you won't pay taxes on that money until you take it out of those accounts during retirement. However, by opting to contribute to a Roth IRA or 401(k), you'll pay taxes now but enjoy tax-free withdrawals during retirement.
"Typically young people are in the lowest tax bracket they will be in their lives when in their first job," says Joe Alfonso a certified financial planner from Lake Oswego, Oregon. "It is therefore less of a tax benefit to save on a pre-tax basis."
6. Do you research: Use a fund screener
These tips will help you get started, but if you need additional guidance, consider using a fund screener such as the ones provided through Morningstar, TradeKing, ETF.com or other trading platforms. Fund and stock screeners allow investors to filter assets by price, market capitalization, dividend yields, price-to-earning ratio and more. If you've done your research, these metrics can help you categorize your options and decide where to invest.
When you've considered these factors and made your decision, it's time to actually do the investing. Online brokers are a common way to trade because they provide platforms and tools to aid in investing but aren't nearly as expensive as traditional brokerage accounts. Compare your options for online brokers here.
Online management services such as Wealthfront, Betterment and Future Advisor are another resource for young investors. Nicknamed robo-advisers, they offer low fees, diversified portfolios, periodic rebalancing and tax-efficient investing. Compare your options for online management services here.
At the end of the day, experts recommend keeping it simple.
"Using these large building blocks, it does not take more than a few funds to create a highly diversified portfolio that requires little ongoing maintenance other than periodic rebalancing to stay within your chosen risk profile," Alfonso says.