These days, given my newfound passion for financial freedom, I often start up conversations about investing. Talking about financial matters is somewhat taboo, but I find it more interesting than talking about the weather. What I’ve learned through these conversations is that many people have no investment savings whatsoever, and their most common excuse is “I have no idea how to get started.”
This is a shame, because investing is actually quite straightforward. Sure, if you wanted to get into day trading, you could spend your whole life trying to master those techniques, but if you want to build wealth the proven way, through hard work, a high savings rate, and reasonable investments, you can learn enough to get started with an hour of focused effort.
The purpose of this post is to give the complete beginner the knowledge to start investing TODAY. No more excuses. By the end of this post, you should be able to set up an account, pick an investment or two, and then go reward yourself with a beer.
The first thing you need to do is to identify which investment accounts are available to you. Everyone has access to a Roth IRA, so that one’s easy. If you are a W-2 employee then you likely have access to a 401k. Variations of the 401k include the 403b (for teachers), and the TSP (thrift savings plan) for government employees. In any case, figure out which employer-sponsored account you have and then contact your HR department to figure out how to enroll. You may also have access to an HSA (Health Savings Account), but we’ll only focus on the 401k and Roth IRA in this post.
First Priority: Get the Employer 401k Match
If your employer offers a 401k match, congratulations. You’ve just won free money. Before you invest in anything else, sign up to get the match. If your employer offers a 4% match for example, sign up to put 4% of your paycheck into your 401k. When you sign up, you might be asked what specific investments you’d like to put your money into. We’ll show you how to do that later in this post.
Second Priority: Fund Your Roth IRA
In Use if or Lose It, we talked about the king of all investment accounts, the Roth IRA. There are several great brokerage firms available to set up your Roth IRA. These include Vanguard, Fidelity, and Charles Schwab. Just make it easy on yourself and sign up with Vanguard. You won’t regret it. In essence, they have a great reputation and they offer very low investment fees.
Go to Vanguard’s new account page, and follow the prompts. You’ll need to link your checking or savings account to your new Vanguard account, and then you can transfer money into your Vanguard Roth IRA. You can either put a large lump sum into your Roth IRA (like the $5500 max), or you can choose to put a defined amount in every month.
Third Priority: Fill Up the Rest of Your 401k
If you still have money to invest after filling up your Roth IRA ($5500/year), then go back to your employer and tell them to put a larger percentage into your 401k (above and beyond the match). Some plans will allow you to place a defined dollar amount in your 401k per paycheck, while others will only accept a percentage of your paycheck.
If you want to fill up your 401k (and you should), you can do the math in either case to make sure it is full by the end of the year. For example, if you get paid twice per month, then you will need to contribute $1500/month ($18,000/12) or $750 per paycheck to max out your 401k. If you get paid 50K per year (for example), then you will need to contribute 36% of your paycheck ($18K/$50K) to max out your 401k. Remember that contributions to your 401k are made PRE-tax, so your take-home pay will decrease by less than 36% in this example.
Most People Should Try to Max Out Their 401k AND Roth IRA
By the way, if you make over 50K per year, and you’re motivated to save half of your income and earn your freedom in around 15 years, then you really should be trying to max out BOTH your 401k and your Roth IRA. In such a case, the above priorities are really meaningless, and you should just do everything all at once, as quickly as possible. You want to get intense with this, right?
How to Pick Investments
After you fund your 401k and Roth IRA, you need to pick your investments. The process is slightly different for your 401k and your Roth IRA.
Picking Investments in Your 401k
Your job here is to get a list of which investments are offered by your 401k plan. There will usually only be a few dozen.
Hopefully your employer has chosen a plan which offers low cost choices, and this is the single most important item to scrutinize. You need to look for something called the “Expense Ratio” (ER). This represents how much you will pay in fees. A good expense ratio will be around 0.10% (one tenth of one percent). This means that for every $1000 invested, you will only pay $1 in fees. A bad expense ratio would be anything approaching 1% ($10 for every $1000 invested). Stay tuned for a future post on why a low expense ratio is so important, but for now, you can ponder this graph:
If you are just starting out and really want to keep things very simple, then just look for a target retirement fund. This will be named something like “Target Retirement 2040”. This is the ONLY thing you need to invest in. Target Retirement funds contain a mix of stocks and bonds, are well diversified, and will decrease risk of loss as you get closer to your planned retirement date. Even if you are planning to retire earlier (or much earlier) than the standard retirement age of 65, I still recommend that you pick a date near when you will be age 59 1/2, since this is when you can start withdrawing from the 401k without penalty.
If your 401k plan does not offer any target retirement funds, or the expense ratios for the target retirement funds are too high, then look for a total stock market index fund or an S&P 500 index fund and invest in that. You can get more complicated later, but this will be a great start.
Picking Investments in Your Roth IRA
If you are smart and opened up a Roth IRA at Vanguard, then you’re already ahead of the game because all of Vanguard’s funds are low cost.
The minimum investment for Vanguard’s Target Retirement Funds is $1000 so this is generally a good choice to start with. The expense ratio for Vanguard’s Target Retirement funds is 0.16%. As your Roth IRA grows in value (from contributions and appreciation), you may desire slightly greater control of your investments, and you may wish to transition to a simple portfolio such as the “3 fund portfolio“. This consists of:
- Vanguard Total Stock Market Index Fund
- Vanguard Total International Stock Market Index Fund
- Vanguard Total Bond Market Index Fund
Note that the Target Retirement Funds are simply a preset combination of these funds.
The advantage to breaking down your account into these separate funds is that you have some control over the percentages in each fund. Also, as your account grows in value, you can transition to the “Admiral Shares” version of each of the funds, which has an even lower expense ratio. One disadvantage of breaking down the target retirement fund into its individual funds is that the minimum investment for each of the separate funds is $3,000 ($10,000 for the Admiral shares version). You will also need to deal with the process of “rebalancing” every year or so, which will be covered in upcoming posts.
So there you have it. The basics of investing in a (hopefully) easy 5 minute read. There is MUCH more to learn about investing, but this will get you up and running with no more than an hour or two of work. Start investing NOW. No more excuses.
What do you think? Did I miss anything for the beginning investor? What do you wish you would have known when you first contributed to your 401k and Roth IRA?