Getting started as an investor is a daunting task. According to the 2022 Investopedia Financial Literacy Survey, 57% of U.S. adults invest, but only one in three say they have advanced investment knowledge. Getting started can be an especially daunting task for methodical individuals who are wary of embarking on such a significant endeavor before they have sufficient knowledge, expertise, and confidence.
On the other hand, consolidating everything a beginner investor needs to know into a short list necessarily runs the risk of omitting many important points.Indeed, if you pressed any successful investor to replicate this exercise, they would likely be very different in what they included in their top 10 list.
That said, we offer a helpful checklist that will help you get started on your journey to becoming a successful investor. We have chosen to highlight key personal attitudes and an overarching strategic framework that we believe will help you become a wise investor.
Key Takeaways
- Make a plan, prioritize savings, and understand the power of compound interest.
- Understand risk, diversification and asset allocation.
- Minimize investment costs.
- Learn classic strategies, be disciplined, and think like an owner or lender.
- Never invest in something you don't fully understand.
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1. Make a financial plan
The first step to becoming a successful investor is to start with a financial plan that includes goals and milestones. These goals and milestones include setting a goal to save a specific amount by a certain date.
Examples of goals in question include having enough savings to buy a home, pay for your children's education, have an emergency fund, fund a start-up business, or have a comfortable retirement.
Additionally, while most people are thinking about saving for retirement, a more desirable goal is to achieve financial independence as early as possible. There's a movement dedicated to this goal: Financial Independence, Retire Early (FIRE).
It's possible to create a solid financial plan on your own, but if you're new to the process, consider enlisting the help of a professional, such as a financial advisor or financial planner, ideally a Certified Financial Planner (CFP®). Finally, don't procrastinate: Create a plan as early as possible, update it regularly as your situation and goals change, and make sure it's a document you can keep up to date.
FIRE Movement
The FIRE (Financial Independence, Retire Early) movement advocates accumulating wealth rapidly, well before traditional retirement age, to increase life's options sooner.
2. Make savings a priority
To be an investor, you need money to invest. For most people, this requires setting aside a portion of your paycheck each month. If your employer offers a savings plan such as a 401(k), it can be an attractive way to automate your savings, especially if your employer matches all or a portion of your contributions.
When developing your financial plan, in addition to taking advantage of your employer-sponsored plan, consider other options for automating your savings. Wealth building typically involves aggressive savings at its core, followed by smart investments aimed at growing those savings.
And the key to saving aggressively is living frugally and spending prudently. In this sense, a wise addition to any financial plan is to create a budget, track your expenses closely and regularly review whether your spending makes sense and brings enough value. There are a variety of budgeting apps and budgeting software packages available, or you can create your own spreadsheet.
3. Understand the power of compound interest
By saving and investing regularly and systematically, and starting this habit as early as possible, you can take full advantage of the power of compound interest to grow your wealth. Although the current extended period of historically low interest rates has somewhat weakened the power of compound interest, all else being equal, it now takes longer than before for interest- and dividend-bearing investments to double in value, making it even more important to start saving and building wealth early.
4. Understand the risks
Investment risk has many facets, such as default risk for bonds (the risk that an issuer will not meet its obligations to pay interest or repay principal) and volatility for stocks (which can cause prices to rise or fall sharply). Furthermore, there is generally a trade-off between risk and return, or risk and reward. That is, to get a higher return on an investment, you often need to take on more risk, including the risk of losing all or part of your investment.
An important part of the planning process is determining your own risk tolerance. How much you are prepared to lose if your future investments decline in value, and how much continued price fluctuation you can tolerate in your investments without becoming overly concerned, are important considerations in determining what types of investments are best suited to you.
danger
At the most basic level, investment risk involves the possibility of total loss, but there are many other aspects to risk and its measurement.
5. Understand diversification and asset allocation
Diversification and asset allocation are two closely related concepts that play an important role in both managing investment risk and optimizing investment returns. Broadly speaking, diversification involves spreading your investment portfolio across a variety of investments. If some investments produce below-average returns or losses, the hope is that other investments will produce above-average returns or gains. Similarly, asset allocation has a similar goal but focuses on spreading your portfolio across major investment categories such as stocks, bonds, and cash.
Again, your ongoing financial planning process should involve regularly revisiting your diversification and asset allocation decisions.
6. Keep costs low
While you cannot control the future returns of your investments, you can control your costs. Moreover, costs (such as trading costs, investment management fees, account fees, etc.) can significantly limit investment performance. Similarly, taking mutual funds as an example, higher costs are no guarantee of better performance.
Cost matters
Investment costs and fees often play a significant role in determining investment results.
7. Understanding classic investment strategies
Some investment strategies that beginner investors should be well aware of include active versus passive investing, value versus growth investing, and income-focused versus gain-focused investing.
While smart investment managers can beat the market, few can do it consistently over the long term, which is why some investment experts recommend low-cost passive investment strategies that try to track the market, primarily with the help of index funds.
In the realm of equity investing, value investors favor stocks that appear relatively cheap relative to the market, as measured by metrics such as price-to-earnings (P/E), and expect these stocks to have upside potential and limited downside risk. In contrast, growth investors see greater opportunity to profit from stocks that are experiencing rapid growth in revenues and profits, even if they are relatively expensive.
Income-oriented investors seek steady dividends and interest because they need ongoing cash to spend, and/or see this as a strategy to limit investment risk. One variation of income-oriented investing is to focus on stocks that offer dividend growth.
Profit-oriented investors care little about the income stream from their investments and instead seek out investments that are most likely to provide price appreciation over the long term.
8. Be Disciplined
When making long-term investments based on a well-thought-out and well-constructed financial plan, be disciplined. Don't get excited or upset by temporary market fluctuations or sensationalist, panic-inducing media market reports. And don't always take market experts at face value unless they have a long-term, independently verified track record of predictive accuracy, which there are very few of.
9. Think like an owner or lessor
Stocks are shares of ownership in a company. Bonds are loans that investors make to an issuer. If you want to be a smart long-term investor rather than a short-term speculator, think like a future business owner before buying stocks and like a future lender before buying bonds. Do you want to be a part owner of that company or a creditor to its issuer?
10. If you don't understand it, don't invest.
Given the proliferation of complex and novel investment products and companies with complex and novel business models, today's novice investor is faced with a plethora of investment choices that they may not fully understand. A simple and sensible rule of thumb is to never make an investment that you don't fully understand, especially when it comes to risk. A corollary is to be very careful about investment fads, many of which may not stand the test of time.
Avoid the unknown
Avoid investments you do not fully understand, as there may be huge hidden risks.
What should I know before investing?
Before investing, it is important to know what your goals and objectives are. Knowing what you are aiming for, whether it's to fund retirement, buy a home, or start a new business, will allow you to choose investments that will help you reach your goals. It is also important to know the basics about investing, such as risks, fees and expenses, and investment strategies, to understand the investments you are considering.
What are the four main types of investments?
There are many types of investments, but there are four basic types: stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Stocks are shares of ownership in a company. Bonds are essentially loans made by investors to issuers who promise to pay back the principal at maturity and pay interest for the life of the bond. Mutual funds are funds in which multiple investors pool their money to buy stocks and other securities, while ETFs are similar to mutual funds but trade on a national stock exchange.
Is $100 enough to start investing?
Many aspiring investors think they need a lot of money to start investing. But many investments have low barriers to entry, giving new investors a chance to get started. You can start investing with less than $100. For example, you can buy stocks or fractional shares, use a robo-advisor to invest based on your goals, contribute to a retirement plan, or invest in mutual funds. The options are plentiful.
Conclusion
For new investors, choosing the right investment or investment strategy can be a daunting task, and advice on how to proceed is as varied as the types of investments available to choose from. Despite the myriad recommendations, educating yourself and having a solid understanding of your investments and goals is key to making informed decisions that are more likely to produce favorable results.
Appendix: Classical Readings
If there's one book that every new investor should read, it's this Abnormal mass delusions and crowd madness By Charles Mackay. Written in 1841 by a Scottish journalist, this book is an early masterpiece on crowd psychology. The first three chapters, “The Mississippi Plan,” “The South Sea Bubble,” and “The Tulip Mania,” all deal with financial frenzies that ultimately led to disaster and are precursors to many of today's financial schemes, bubbles, and frenzies. As such, these chapters are quoted by many of today's financial writers.
