Investing 101: 5 Essential Steps

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For many people, investing is the toughest part of personal finance. It can be confusing, intimidating, and with the recent recession still vivid in our memories, scary.

But it doesn’t have to be. Here are five steps everyone can take to invest well. (See also: 5 Killer Free Investment Tools)

1. Make Sure You’re Ready to Invest

You’re ready to invest once you’re out of debt except for your mortgage (of course, it’s fine to have paid off your mortgage as well, but you don’t have to wait until then) and have an emergency fund.

I also make an exception to my no-debt suggestion if your employer provides a 401(k) match. That’s such easy money, I’d hate for you to miss out. So if you can make accelerated payments on any debts you carry, have an emergency fund, and can contribute enough to your 401(k) to get the match, great. If not, get out of debt and build an emergency fund. Then start investing.

2. Figure Out How Much to Invest

There are lots of free online calculators available that can help you estimate how much you'll need to have in an investment account by the time you retire, and how much you'll need to invest each month in order to hit that goal.

One of the easiest-to-use calculators is on Fidelity’s web site (click on “myPlan Snapshot”). You may need to register on the site, but you won’t need to open an account.

3. Open an Account

If your employer offers a 401(k) or other type of retirement plan, this step should be easy enough. If not, consider opening a Roth IRA with an investment company like Vanguard, Fidelity, or T. Rowe Price.

With a Roth, there's no tax break for the money you put in, but any interest earned is tax free. Plus you can withdraw the money you contribute at any time with no penalty. You can even withdraw the earnings before you hit retirement age under certain circumstances.

4. Diversify Properly

You’ve probably heard that it’s important to diversify — spreading out the money you invest into different types of investments — and that’s true. It’s a way of managing risk. When one type of investment isn’t doing so well, chances are another type will be doing just fine.

One of the easiest ways to diversify is to invest in mutual funds instead of individual stocks. Mutual funds are inherently diversified because one fund typically invests in many different stocks, bonds, or other mutual funds. 

But here’s the key point about diversifying your investments: How you diversify — how you divvy up your investment dollars between mutual funds that invest in bonds vs. those that invest in stocks, for example — is incredibly important. This is known as asset allocation, and it’s been found to be the single most important factor that determines your investment success.

In general, when you’re young, you can afford to take more risk, so your ideal asset allocation might call for 90-100% equity investments (i.e., stock-based mutual funds) and 0-10% bond funds.

One of the easiest ways to invest based on the proper asset allocation is to put your money in a target-date mutual fund. Such funds set the asset allocation for you based on your intended retirement age. They then automatically make the allocation more conservative as you get older.

Most of the big brokerage houses offer such funds, as do many workplace programs like 401(k) plans.

If you prefer a more hands-on approach, determine the right asset allocation for you (scroll down to “Investing” and click on “Asset Allocation Guidelines”). Then you could either choose your own mutual funds within the various asset classes and in the right percentages or work with an investment advisor to choose the right funds.

5. Get Started

Time is one of the most important ingredients for successful investing because it's what allows you to take the fullest advantage of compound interest.

In essence, compound interest is interest earning interest. Let’s say you invest $400 per month and get a 7% return. After 10 years, you will have invested $48,000, but it will have turned into over $69,000. Not bad.

Now let's give it more time. After 40 years, you will have invested $192,000, but your account will be worth nearly $1,050,000! That's the power of compound interest. Clearly, it’s important to start investing as soon as possible.

You Can Do It

Hopefully, this brief tutorial has taken away some of the confusion or fear that often surrounds investing. If you follow the steps above, you’ll be headed in the right direction

Have you taken these steps with your investments? What investment-related questions do you have? Let me know in the comments section.