Staying invested for the long-term has historically paid off. The market reflects the overall growth in the economy and rewards long-term investors, even though temporary dips will always occur.
After seeing huge stock market drops, you may have wondered if you’re investing money the right way. Or you may still be on the sidelines, not sure how or when it will be a good time to get in the game. Here’s what to know about each investing rule.
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1. Clarify the purpose of your money
There’s one rule of investing that you should always remember: Never expose money to more risk than is necessary to accomplish your goals. So, take a step back and be clear about why you’re investing in the first place. Determine when you’ll need to spend the money you plan to invest, because that determines what you should do with it.
Historically, a diversified stock portfolio has earned an average of 10%. But even if you only earned an average of 7% on your investments, you’d have over $1.3 million to spend during retirement if you invested $500 a month for 40 years.
But if you save $500 a month in a bank account with an average return of 0.5% over 40 years, you’ll only accumulate about $250,000. So, if your long-term goal is to have a nest egg that allows you to pay for retirement, keeping money in a safe place—like a savings account or a low-yield CD—simply won’t get you there. Also, consider that in the past couple of years, the inflation rate has been more than 2%. So, if you’re not earning at least that much, you’re really losing money.
The reality is that not taking enough investment risk can be the riskiest move of all! You could fall short of your goals or run out of money during retirement. Whether you avoid risk intentionally or have simply been procrastinating investing, the result could be devastating to your financial future.
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2. Know the difference between saving and investing
Saving is putting money aside without exposing it to any or little risk, such as in a savings account, money market deposit account, or a certificate of deposit (CD). Investing is committing money to an endeavor or account with the expectation that you’ll make a certain amount of profit or income. The risk is that you’ll receive less than what you expect. Or worse yet, there’s a possibility that you could lose your entire investment.
The timing for spending money determines what you should do with it. Money that you want or might need in less than five years should not be exposed to market volatility because its value could drop at the exact moment you need it. So, even though safe, low-yield options—such as a bank savings or a money market deposit account—are poor choices for your long-term goals, such as retirement, they’re perfect for your short-term goals and emergency savings.
Before you do any investing, your first financial priority should be to accumulate emergency savings. Ideally, everyone should have a minimum of three to six months’ worth of their living expenses tucked away in an FDIC-insured bank savings account. If that amount seems unattainable, start by saving a reasonable amount, such as $500 or $1,000. Then build it while you invest for the future at the same time.
The ideal scenario is to invest a minimum of 10% to 15% of your gross income for retirement, plus an additional 10% for emergency savings. If saving and investing a minimum of 20% of your gross income seems like more than you can afford, start tracking your spending carefully and categorizing it. You’ll find opportunities to cut back and save more.
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3. Start early and small
Starting early allows your money to compound and grow exponentially over time—even if you don’t have much to invest. Compare these two investors, Jennifer and Brad, who set aside the same amount of money each month and get the same average annual return on their investments:
- Begins investing at age 35 and stops at age 65
- Invests $200 a month
- Gets an average return of 8%
- Ends up with just under $300,000
- Begins investing at age 25 and stops at age 65
- Invests $200 a month
- Gets an average return of 8%
- Ends up with just under $700,000
Because Brad got a 10-year head start, he has $400,000 more to spend in retirement than Jennifer! But the difference in the amount Brad contributed was only $24,000 ($200 x 12 months x 10 years).
So never forget to start investing as early as possible. It’s a huge mistake to believe that you don’t earn enough to invest and can catch up later. If you wait for a windfall, you’re burning precious time.
Even saving or investing just $20 a month is better than nothing. And if you’re starting late, don’t stress about it—just get motivated to start right now. For most of us, building wealth is a slow journey that involves putting small amounts of money aside on a regular basis. Setting up your accounts and automating contributions is a powerful step in the right direction.
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4. Don’t try to beat the market
While it might sound boring, you should aim to be an investor who makes average returns. That’s because chasing high returns, reacting to short-term market volatility, and buying into media hype generally doesn’t work.
Investors think their choices must be right if other people are doing the same thing. The media says buy, so most investors get in the market. And when everyone else is in a panic and selling, that’s what most people do. When you invest emotionally you could end up buying high and selling low, which is the exact opposite of how you make money.
Yes, short-term investment returns can vary dramatically from day to day and month to month. But over the long term, market returns always revert to the average. So, stick to a long-term, buy and hold investment strategy for funds you won’t need to spend for at least 10 years.
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5. Be diversified to cut risk
Many people are surprised to learn that it’s better to own more investments than less. This is a proven investing strategy called diversification. It allows you to earn higher average returns while reducing risk, because it’s not likely that all your investments could drop in value at the same time.
For instance, if you put your life’s savings into one technology stock and it tanks, you’re in trouble. But if that stock only makes up a fraction of your portfolio, the loss is negligible. Having a mix of investments that respond to market conditions in different ways is the key to smoothing out risk.
For most investors, who don’t want to make a career out of stock picking, buying individual stocks is a bad idea. It’s risky because stock prices can be volatile and fluctuate wildly. Trying to find one or two winning stocks is gambling, not smart, strategic investing.
But it’s easy and affordable to build a diversified portfolio by purchasing shares of a low-cost mutual fund or an exchange-traded fund (ETF). Funds bundle combinations of investments in stocks, bonds, assets, and other securities into packages that are convenient to buy because they’re made up of many underlying investments.
Diversifying doesn’t increase investment returns all by itself. But it does allow you to reduce investment risk, and give you more safety and control, without lowering your return. If the price of one stock in a fund takes a dive, it’s no big deal because you own hundreds or thousands of other stocks that may be holding steady or going up.
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6. Focus only on what you can control
Since drops in the stock market are natural and unavoidable, simply stay focused on what you can control. Remember why you’re investing in the first place: to build wealth for long-term goals, such as retirement.
Watching the markets go on a roller coaster ride can feel frightening. But taking extreme actions when your emotions are running high, like selling investments right when their value drops, is the opposite of what you’re trying to achieve.
What happens to the financial markets in the short-term only matters if you need to liquidate your investments in the short-term. That’s why you should never invest money that you might need to spend within the next 5 years. Instead, make solid investments that will grow over the long-term, and never get rattled when you see volatility in the stock market.
Stay calm, turn off the news, and ride it out. If you maintain a buy and hold strategy that’s focused on future growth, you have ample time to recover.
And if you haven’t started investing, don’t beat yourself up about it. The key factors you can control are opening an account and starting small. If you’re living paycheck to paycheck, figure out how to cut your spending so you can come up with more money to invest.
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7. Use tax-advantaged accounts for faster results
One of the best ways to invest money is under the umbrella of a tax-advantaged account, such as a workplace 401(k) or 403(b). If you don’t have a retirement plan at work or are self-employed, you have options too, such as an IRA, SEP-IRA, SIMPLE IRA or a Solo 401k.
Retirement accounts help you build wealth and cut your tax bill at the same time, which can turbocharge results. Traditional accounts allow you to defer taxation until retirement. Roth options require tax on contributions, but allow tax-free withdrawals in retirement.
Additionally, many employers offer additional retirement matching funds, which is free money that no eligible participant should turn down. But even if your employer doesn’t offer matching, I’m still a fan because contributions come from consistent, automatic payroll deductions. And you can take all your money with you—including your vested matching funds—if you leave the company.
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8. Choose investments based on time horizon
Your “horizon” is the amount of time you have before you’ll need to begin spending your nest egg. For instance, if you’re 40 years old and plan to quit working and live solely on investment income when you’re 65, you have a 25-year investment horizon. This is important to consider because, in general, the longer your horizon the more aggressive you can afford to be.
Start by figuring out how much stock you should own because that’s typically the riskiest type of investment. Here’s an easy shortcut: Subtract your age from 100 and use that number as the percentage of stock funds to own in your retirement portfolio. For example, if you’re 40, you might consider holding 60% of your portfolio in stocks.
This investment allocation target is a not hard rule because everyone is different. If you have more than 10 years before retirement, choosing funds made up primarily of stocks, or labeled as growth funds, is the best way to get an optimal return on your investment. Options vary depending on the investing company and type of account, but good choices include mutual funds, index funds, and exchange-traded funds (ETFs).
Many accounts offer target date funds that invest based on the year when you plan to retire. For example, if you want to retire in 2040, the name of the fund would be something like “Target Date 2040 Index Fund.”
Target date funds are very convenient because they automatically rebalance on a periodic basis to achieve growth in the early years, but then become more conservative as you approach retirement.
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The bottom line
The saying time is money is the absolute truth when it comes to building wealth for your future. Investors who start late usually have to make huge financial sacrifices to accumulate enough money to reach their goals — or they’re forced to work much longer than they want to.
Getting in the habit of investing consistently sooner, rather than having to invest more money later, is the secret to investment success.
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