Just the Basics
The vast amount of information about investing, the wide array of investment choices, and the risk are intimidating and can prevent you from taking those first steps. It doesn't have to be that way. You only need to know a few basics in order to begin investing in your future.
First, some assumptions. This article assumes you have your credit card debt under control. It makes no sense to invest in stocks, bonds, or mutual funds if you have thousands of dollars in credit card debt at interest rates in excess of 10%. You don't have to be completely debt-free, but you should be making serious inroads into your debt each month, and you should be paying very low interest rates on that debt.
This article also assumes you have an emergency fund of at least three months worth of basic living expenses (preferably six months worth) in case of a job loss, disability, etc. And finally, this article assumes that if your employer offers a 401(k) plan, you're maximizing your contribution and diversifying your investments in the plan.
Where Do I Find the Money to Invest?
The first question for many people is "where do I get the money to invest?" There are plenty of stock mutual funds that allow you to invest with $500 or less. Use your next bonus at work, or your income tax refund, or put in some overtime for extra cash. If you just can't come up with $500 to start your portfolio, many funds will allow you to skip the initial lump sum investment if you sign up for automatic monthly withdrawals of $25 to $50 from your checking account.
How Do I Choose an Investment?
You're ready for some long-term investments. How do you choose? The first step is to know what your goals are. Are you saving for a house? A college education? Retirement? The type of investment you choose will depend on the amount of time available before you need the money. Stocks are considered long-term investments, and it's best to plan on holding stocks or stock mutual funds for five years or longer. If you need the money sooner than this, you may reduce your return by cashing in when the stock's value is down.
How Do I Determine My Risk Tolerance?
Next, you need to know your risk tolerance. If you hide your money under your mattress because you don't trust the bank, then you're probably not going to feel comfortable investing in volatile technology stocks. CNBC's Investment Risk Test can help you determine what level of risk you can tolerate.
How Do I Choose an Investment?
How do you decide where to put your money? Most experts recommend spreading your money over several different types of investments to reduce risk, because typically one type of investment does well when another doesn't. For example, usually when returns on stocks and stock mutual funds are high, returns on bonds are low, and vice versa. By having money in both types of funds, you're more likely to get a decent combined return if one category takes a downturn. Your asset allocation should be tailored to your risk tolerance and the number of years before you'll need to withdraw the money from your investments.
For beginning investors, I recommend stock mutual funds instead of stocks in individual companies. Why? It's all about risk. A well-chosen stock mutual fund is less risky than an individual stock because mutual funds invest in many companies, thus spreading out the risk. If one company does poorly, the fund as a whole may still have a good return. If you buy stock in one company and the company does poorly, you lose money.
Where Do I Find Information About Stocks and Mutual Funds?
Once you're ready to start choosing a fund to invest in, there are many excellent Web sites to help you. My personal favorite is Morningstar, the respected mutual fund rating company. Their powerful Fund Selector allows you to search for mutual funds based on what's important to you. For instance, if you want a list of funds that allow initial investments of $500 or less, you can click on the appropriate box, leave all the other boxes as is, and you'll get a list of funds that accept initial investments of $500 or less, with their YTD return, expense ratio (the amount of administrative and other expenses that the fund manager deducts from your return each year), their Morningstar rating, and more. Click on an individual fund name and get detailed information about that fund.
Once you've chosen a fund you feel comfortable with, call their 800 number and request a prospectus (a description of the fund, its investments, and the returns it's earned in the past) and an investor's kit. Fill out the form, send in your money, and voila! You're an investor.