By now you’ve no doubt followed all of our advice and created spending plans, bulked up your emergency fund, reined in your debt, and boosted your credit score. Nice job! Now you have the great problem of what to do with all your extra money!
Too often, money management blogs gloss over the whole “investing” thing as if it’s something we all know how to do, when the fact is many of us are clueless about our options. We’re here today to outline some of the basics you should know to start making your money work for you (ie. how to make your money earn more money). It may sound like a magic trick, but anybody can do it and you should too and it’s never too late. The best time to start saving and investing was ten years ago, but the next best time is right now.
BUILDING A BALANCED PORTFOLIO
One piece of advice that all financial advisors will give you is to create a balanced portfolio, meaning you should diversify your investments. You do this to reduce your risk and to secure your long term gains. While high risk investments can pay out the biggest and fastest, they also fall the hardest and will cause you to lose the most. You want to balance your risk and the types of investments (called asset classes) you choose.
There are three main types of asset classes you can invest in:
- Equities (stocks, mutual funds): Equities are when you own a piece of something, like a company. These include index funds and exchange traded funds (ETFs). Individual or employer-sponsored IRAs and 401(k)s also primarily make use of equities.
- Fixed income (bonds): Bonds are like teaming up with a group of other people to make a large loan, then splitting the interest you earn from it. Bonds can be issued by corporations and by the government and are available to the public to buy into.
- Cash equivalents (cash on hand, money market funds): These are highly accessible cash sources that you can get your hands on quickly.
In general, equities are riskier and have the highest payout, while bonds and money market funds are safer and pay out less. Within your equities, however, there are also a range of options for higher or lower risk investing and these too should be diversified. Maybe you want some of your money with private companies and some with the public, some with domestic companies and some international, some companies you’ll want a lot of shares and others you only want a few.
So how much risk should you take? Well, one way to think about it is by your age and what your goals are. Typically, the younger you are, the more risk you can afford to take because you have time to ride out the market’s inevitable ups and downs, knowing in the end your investments will have time to recover.
So if you’re 30 and saving for retirement, most of your investments will be split between different equities. If you’re older and in the home stretch for retirement, you’ll want to be more cautious. In this case, your money should probably be split more like 50/50 between equities and safer bonds.
It can also be helpful to think of your tolerance for risk in levels: low, medium, and high
- Low risk: If you’re older and don’t have time to ride the waves of the market, or if you’re a little high strung and gonna freak out anytime one of your stocks drops, you probably have a low risk tolerance. You’ll want to focus on a mix of bonds and very safe equities.
- Medium risk: If you’re in the middle and can handle small losses here and there, but would sweat a big loss, you’re likely a medium risk kind of person. You know that the market fluctuates and you’ve got some time to see it through, but you don’t want to stick your neck out too far. Your portfolio will skew toward equities, but you’ll mostly stick to well established companies with a proven track record.
- High risk: The ups and downs don’t phase you at all because you’re playing the long game. You could lose thousands of dollars and still hold steady. If this is you, you’ll likely gravite toward high yielding stocks like startups and high-risk investments.
Your risk tolerance can and will change as you get older and your finances change. It’s one thing to be a 28 year old investor pouring money into the next big thing, and quite another to be 60 and looking for a secure retirement in the near future.
Do you need a financial advisor?
Maybe? It all depends on how much money you want to invest and how much time you’re willing to spend educating yourself about your options. A good financial advisor can be incredibly helpful though.
There’s a saying sometimes dubbed the “Buffet rule”: “Risk comes from not knowing what you’re doing.” In other words, if you don’t understand something, don’t invest in it. So either you take the time to fully understand what you’re doing, or hire someone to fully understand it for you.
HOW TO CHOOSE AN ADVISOR
Advisors are usually paid by commission and/or a fee structure. Typically they will take a percentage of the profits you earn off your investments and some may charge an additional flat monthly or yearly fee. Be sure to ask up front about all fees, and like shopping for a loan, you’ll want to interview at least two to three advisors before you decide to hire one. If possible, get recommendations from friends and family.
When shopping around for an advisor, you may notice they have lots of letters after their names. This can be confusing, so here’s what they all mean:
CFP – Certified Financial Planner
AFC – Accredited Financial Counselor
CFA – Chartered Financial Analyst
- CFPs, AFCs and CFAs require the most training and are the most qualified to help with a range of financial tasks such as choosing the right investments and managing your portfolio. The CFA designation is the most prestigious of the bunch and you usually won’t need to hire one unless you have some extremely complicated investing. For most people a CFP or AFC is a better fit.
CPA – Certified Public Accountant
EA – Enrolled Agent
- CPAs and EAs are good for advising on the tax implication of your investments, but shouldn’t be used to advise you on what to invest in.
CFS – Certified Fund Specialist / CMFC – Chartered Mutual Fund Counselor
- CFSs and CMFCs specialize solely in mutual funds (which are like big pools of people that buy different equities and you can throw your money into these pools and earn a percentage of their profits). You will often find CFPs and AFCs have this accreditation in addition to their general license.
Your investment options
When you first start out investing, all the new terminology can be quite confusing. Below you’ll find a handy cheat sheet that goes over your basic options for investing and how they can best work for you.
In general, if you have long term goals like retirement, you’ll opt for stocks and mutual funds which give you the highest profits over a long period of time. If you are saving for a short term goal (3 to 5 years), it’s safer to invest in bonds, CDs, or a money market.
Mutual Funds and Stocks
We’ve referenced mutual funds and stocks in this post, so let’s take a minute to fully understand what they are:
Mutual funds are a common way for people to start investing because they tend to be simpler and less risky. Essentially you are putting the burden of choosing investments onto a professional who chooses, maintains, and adjusts your portfolio. They work by using funds from a bunch of other people to increase buying power and gains.
Most mutual funds are safer and more targeted (for instance they will only buy equities from a set group of reputable businesses). This is a good option for first time investors who may not have a lot of firsthand market knowledge and want to entrust their money to someone more knowledgeable. Your earnings are automatically reinvested in the fund so your wealth keeps growing.
A stock is a share of a public corporation, and a “share” is a representation of ownership in that company. A company has a fixed amount of shares and they are made available for the public to buy in the IPO (initial public offering). The company will be valued beforehand and each stock represents a percentage of that value which can range from $1.00 to $1,000 depending on the amount of stocks and the worth of the company.
After the IPO, the stockholders are free to do what they like with their shares and they can buy, sell, and exchange them in the market, and this is how investors make money off them. Ideally, you sell your stocks when people will buy them at a higher price than you bought them for. Likewise, you will buy more stock when you think the price on it will go up in the future.
Bitcoin and other digital currencies
Bitcoin is what’s known as a cryptocurrency, meaning it’s entirely digital. Many people like using or investing in bitcoin, but you should know the basics before you consider doing this yourself. Some people like the privacy of it since there’s no bank in charge, and all buying and selling is done peer-to-peer through transaction records called blockchains. Others see it as an investment opportunity since the dollar price of bitcoin can fluctuate widely (and has been climbing in the last few years).
Bitcoins (or portions of them, called Satoshis) can be bought and sold by anyone and are available on a number of online exchanges like Coinbase or Kraken. They are also sometimes accepted as payment for online purchases. There are other cryptocurrencies like Ethereum or XRP, but Bitcoin is the most well known.
In early 2020, one bitcoin was equal to roughly $6,000, and one year later in early 2021 one bitcoin equaled around $60,000. With increases like this, it’s no wonder investors are drawn to it, but before you get on the bitcoin train make sure you do a lot more research on it and are consulting a financial advisor. And, like all the investing information we’ll give you here, you never want to put all your eggs in one basket. Spread out your wealth so if bitcoin takes a dive, you won’t be left floundering.
Tips for Saving
1. SPREAD THE WEALTH – MULTIPLE SAVINGS BUCKETS
Once you figure out how much per month you can save, you’ll want to spread out your savings in multiple “buckets” just like you diversify your investments. For example let’s say you are saving $400 a month and you break it up 50/25/25:
50% to your emergency fund ($200)
25% to retirement/investments ($100)
25% to college fund ($100)
Of course if you don’t have kids, you won’t be putting money toward college, so each saving plan will be unique to you. Or, you may hit your target for your emergency fund, then start putting that extra amount into your retirement fund.
2. MAXIMIZE YOUR MONEY
Employee Programs: Make sure you’re taking advantage of all the money-saving opportunities that are offered to you. For example, your employer may offer to match a portion of your contributions toward a retirement or 401(k) plan. There’s no such thing as free money, but this is about as close as it gets.
Pre-tax Dollars: Many programs like HSAs, FSAs, or 401(k)s let you put pretax dollars in as contributions. This is another way to get to that elusive “free money.” With this, say you will put $100 toward your HSA from your pre-tax salary, and when you receive your paycheck it will only be about $70 lower – not the full $100 since it wasn’t affected by taxes. That’s like $30 free dollars!
529 Plans: If you have kids, it is highly recommended to start a college savings plan for them, and a very easy way to do this is with a 529 Savings Plan. Each state has their own criteria for 529’s and many offer tax incentives for contributions. Look and see what your state has to offer here.
3. BEAT INFLATION
Inflation can be a tricky thing to pin down because it’s always changing. One good way to think about it is how the spending power of your dollar diminishes over time. Think back to when you were a kid and how much things cost. It wasn’t too long ago that a gallon of gas cost $0.99 and now the average price is closer to $3.00 a gallon. While the rate of inflation will always fluctuate, a good rule of thumb is to plan on it weakening the dollar by 2% to 3% a year. This means that unless your savings are making at least that much per year, you are losing buying power since your dollar now gets you less. The trick is to get as much of your money into accounts that earn at least 3% and hopefully more.
Most savings accounts earn less than 1% which means they are not a good long term solution for housing your money. That doesn’t mean you shouldn’t have one though! A savings account is a great place to keep your emergency fund so you can have money readily available. But, anything above your emergency needs should go into an account that will at least let you break even.
CDS (CERTIFICATES OF DEPOSIT)
CDs are a very low risk investment that will only earn you at best around 3.25%, but they can dip as low as 1%. The rate fluctuates just like inflation and is set by the Federal Reserve (and typically when inflation is high, CD rates are also high). With a CD, you put your money in a savings account for a set period of time (anywhere from a few months to five years) at a fixed interest rate. If you are able to get 3%, it may be worth it, but it’s best to work with a financial advisor to determine your best options.
RETIREMENT FUNDS / EQUITIES
This is what most people think about when they talk about “investing,” and retirement funds and equities are the best option for beating inflation. This could be private investments or mutual funds, or a 401(k) or IRA account through your work.
Over the course of 20 years these accounts earn 8% to 10% on average. The key with these is to start early, put in as much money as you can, and then leave it alone – don’t watch it like a hawk or you’re more likely to be reactive to short term gains and losses in the market.