The first step to becoming an investor is choosing a broker-dealer and filling out the necessary paperwork.
Before choosing your account type and creating an asset allocation plan, first take stock of your current situation - your age is likely to affect the amount of risk you are able to take with your investments.
Finally, select the funds you would like to invest in and wait patiently to see results.
One of the questions I'm most frequently asked has to do with what's needed to begin investing. Some folks want to know how much money they need to begin. Others have a strong desire to buy a few stocks they heard about. And then there are people who have spent a long time thinking about getting underway, but never had the courage to take any steps in that direction.
The process of getting started in investing is simple and straightforward. It's a matter of filling out some basic forms, having funds available to move into the investment account, deciding what to buy, and then turning that decision into action. The logistics are easy. What's more difficult is developing the discipline to create and follow an asset allocation plan that will best serve your needs.
Where to start
Let's focus on the mechanics first. To begin, you need to select a broker-dealer to execute the transactions. Firms such as Fidelity Investments, Charles Schwab Corp., TD Ameritrade, E-Trade and Vanguard are among the names that come to mind quickly. All have websites and online forms to be filled out as well as 800 numbers to call if you have any questions or need help. For all these firms, the commissions and other costs will be similar and the range of investment opportunities will be broad. The forms you will have to fill out require basic information such as name, address, Social Security number and telephone number.
Traditional versus Roth IRAs
For most folks, the choice of account type will be either a standard taxable account or a retirement (tax-deferred) account such as a traditional IRA or Roth IRA. A traditional IRA is funded with pre-tax contributions, which are tax deductible.
A Roth IRA is funded with after-tax money. When funds are withdrawn from a traditional IRA, later on taxes will be payable on the amounts withdrawn. When funds are withdrawn from a Roth IRA, there is no tax liability. But with a Roth, you must wait five years from January 1st of the year in which the account was opened to take advantage of that benefit. For both types of IRAs, there are contribution limits each year.
For traditional IRAs, there are also required minimum distributions (RMDs) that must be taken each year after reaching the age of 70½. There are no RMDs for Roth IRAs. No distributions are to be taken from either type of IRA before reaching 59½ or there will be a 10% penalty.
Create an asset allocation plan
Assuming that the account has been opened and sufficient funds have been transferred to ensure that securities to be purchased will be properly paid for, the next question is what to buy. That depends on several factors, including time horizon, investment experience (if any), risk tolerance and need for current income.
A 20- or 30-year-old with an extended time horizon will have dramatically different parameters from someone who is soon to be retiring. The younger investor will generally have many years to look forward to, should be able to comfortably deal with the ups and downs along the way, and will not need current income from his or her investments.
The soon-to-be-retired investor, on the other hand, may or may not be comfortable with market fluctuations, will have less time to recover from market turbulence, and at some point will probably want to have current income from the investments. Either way, a well-constructed plan will be essential. The critical part will be the asset classes and percentages that will add up to a portfolio.
For the younger investor, a portfolio that consists entirely of equities, both U.S. and international (including emerging markets), may well be appropriate. For the older investor, there should be an allocation that includes U.S. equities, international developed market equities, emerging market equities, fixed income (primarily bond funds, both open-end and closed-end) as well as alternative investments such as covered call funds, covered put funds, long-short funds and perhaps precious metals, too. All of these are available through exchange-traded funds.
As the time horizon gets shorter and risk exposure is dialed down, an increasing segment of fixed-income holdings as well as alternative investments should be added. These other asset classes act as shock absorbers, helping to moderate the inevitable volatility of the equity investments. In addition, well-selected fixed-income investments will help to provide the current income that will probably be needed during the period of retirement. Once an asset allocation plan has been developed, it's time for the selection of securities.
Choose investments
For most investors, the most efficient initial approach will be to select a few broad-based funds. For both U.S. and international equities as well as fixed-income, there are a number of funds that will do the job. These can be either open-end mutual funds (the most common variety) or exchange-traded funds. There are several key differences between open-end mutual funds and exchange-traded funds.
First, open-end funds are priced once each day after the close of market trading. Orders placed during the day are executed after those funds are priced. Exchange-traded funds, however, trade all day long while the stock markets are open. Most have been created to track specific indexes of stocks or bonds and most track fairly closely to the value of those indexes. What's more important is the fact that the expense ratios of exchange-traded funds are generally much lower than those of open-end funds. So if the expenses are lower, the returns will be higher. That, of course, assumes that the funds have similar holdings.
One could begin with Vanguard's Total Stock Market ETF (VTI), International Stock Index ETF (VXUS) and Total Bond Market ETF (BND). As assets grow, it may be worthwhile and more interesting to diversify among a broader group of asset classes. Be aware that most of the major broker-dealers have no-transaction fee lists of mutual funds and exchange-traded funds. No transaction fee means no commissions. It's always worthwhile to look these over to see if what you plan to buy is on these lists or if there are acceptable substitutes.
When getting started, it would be a good idea to set approximate percentages for each asset class. You might want to begin by splitting the assets into thirds for the funds mentioned above. If funds are being added regularly, the contributions should be allocated among segments to keep the percentages in line. At the end of each year, the investments should be re-balanced - i.e., readjusted so that segments that have become larger will be scaled down and those that have shrunk are beefed up.
Keeping asset class percentages in line by rebalancing is an important part of the process, whether following the simple example above or shepherding a far more elaborate portfolio. What absolutely should not be done is beginning to invest by buying one or two "hot" stocks or funds you heard about at a cocktail party, through the media or via some online source. That's the time bomb approach, which must be avoided.
Similarly, it's essential to ignore rubbish from the media that talks about "10 Stocks to Buy Now" or similar. That includes strong conviction buys from brokerage houses or investment advisory services.
Focus on the long term
Don't forget that successful investing requires patience, typically at least a market cycle of three to five years or more. The probability that proper analysis and selection of securities will be rewarded increases as time passes. Whatever happens in the short term is largely driven by changes in investor psychology. For successful investing, focus on the climate, not the weather.
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Investopedia 2018.