How to start investing (even if you know nothing about how it works)
There’s a crucial, yet rarely known truth about investing: You don’t have to be rich to start investing. In fact, you get rich by investing.
Investing in the stock market is the easiest way to build wealth with best returns over time. Most of us can’t just save our way to being financially secure. If you let all your extra money sit in a regular bank account, inflation will erode its value, and you will be left with very little when you can no longer work and have to rely on your savings.
So we need to invest. While investing involves risk, the biggest risk you can possibly take is to not invest at all.
But how? It all looks really complicated and intimidating.
Yes, and some of it is deliberate. If everyone knew sound investing was actually quite simple, a lot of financial advisors and fund managers would lose their jobs. And there certainly are high net-worth individuals that would (and do) benefit from hiring a financial advisor. But most of us don’t actually need professional help to get started.
In this post I am going to tell you everything you need to know to start investing confidently, even if you are a total beginner. (I’m also including a TL;DR at the end for quick referencing.)
OK, let’s go!
3 main elements of investing
There are three main components to investing in the stock market: (1) an investment account; (2) a brokerage firm that provides this account; and (3) securities, i.e. things you buy within your investment accounts (like stocks, bonds, mutual funds, etc.) that go up and down in value as the market fluctuates.
Now let’s take a look at these one by one.
1) Investment accounts
These are special accounts where you keep your investments. Think of them as baskets where you keep your investment eggs. There are three types of investment accounts, depending on whether they offer any tax advantages, and if so, what kind.
Tax-deferred investment accounts
Tax-deferment means that you don’t have to pay any taxes on the money you invest until you choose to withdraw your money. When you do, the money you put in and all interest it accrued in the mean time are subject to tax. In other words, you don’t pay taxes before you invest, but you pay them after.
Examples are 401(k), 403(b), and traditional IRA. The main difference between these accounts are who is sponsoring the account: 401(k) and 403(b) are employer-sponsored whereas you can open a traditional IRA without employer sponsorship (that is, even when you’re not employed). All of these are retirement accounts with very limited accessibility before a certain age (currently 59 1/2).
After-tax investment accounts
This means that you pay taxes on the money you invest, but then you can withdraw your initial capital and any interest it has accrued without paying any taxes after you hit retirement age. In other words, you pay taxes before you invest, but you don’t pay any after that.
A Roth IRA is an after-tax retirement account. You can contribute up to the IRS limit each year ($7,000 for 2024 if you’re under 50, $8,000 if you’re over), which will grow tax-free and will be tax-free at the time of withdrawal.
Some employers also offer Roth 401(k)s, which work under the same principle, except contributions are made through regular (after-tax) payroll deductions and the limits are much higher than a Roth IRA.
Brokerage accounts
These don’t offer any tax advantages, however, they allow you to withdraw money at any age without restrictions, as they are not retirement accounts unlike the other two above.
2) Brokerage firms hosting investment accounts
Let’s now look at the financial institutions where those accounts are kept. Investment and brokerage firms are to your investment accounts what a regular bank is to your regular checking and savings accounts. Some of the best-known examples are Vanguard, Fidelity, and Charles Schwab (not sponsored), but there are many more.
Think of these as the shelves where you keep your baskets (clearly I don’t know much about keeping eggs, but let’s keep running with this metaphor for another minute.) While their main function is to store your investment accounts, they also provide financial services such as dedicated financial planners or robo-advisors (virtual financial advisors that use AI and algorithms to automate the investing process). You don’t have to use any of these extra functions if you want to make your own financial decisions.
Keep in mind that if your employer-sponsored 401(k) is your main investment account, you will have to go with whatever company they’re working with. This is fine—most of them are fairly comparable to one another and they offer comparable products.
3) Securities you buy inside your investment account(s)
These are your proverbial eggs, things you actually buy and sell in the market. There are three common types: (1) equity, which provides ownership to holders, (2) debt, where you loan your money with interest to corporations or the government, and (3) hybrid, which combines aspects of both.
Among the commonly used are bonds, which are debt securities with low risk and low return, and stocks, which are equity securities with higher risk and return. Most long-term and hands-off investors do not pick individuals stocks or bonds; rather, they invest in a bundle of them, called mutual funds.
Mutual funds are essentially a collection of investments managed by fund managers, professionals that take the investors’ money and use it to buy securities that they pick based on what they think bring the highest return to their investors.
Index funds are also a collection of investments, but they simply track a predetermined segment of the market, which means they are passively managed (i.e. they don’t involve someone actively picking the funds). That’s why they have much lower fees, and they still beat actively managed mutual funds most of the time (see here).
ETFs (exchange-traded funds) are another collection of investments that have been popular in the last few decades. ETFs are lower in fees compared to mutual funds and offer more liquidity since they can be bought and sold any time during the day (as opposed to index and mutual funds that can only be bought and sold at the end of the day).
REITs (real estate investment trusts) are companies that own income producing real estate and most of them are publicly traded on a stock exchange.
TDFs (target date funds) are a type of mutual fund or exchange-traded fund that periodically rebalances investments to optimize risk. They are designed to gradually shift from higher-risk to lower-risk asset classes as you approach retirement in order make sure you’re protected from excessive risk later in life.
The steps to start investing now
That’s all good to know, you probably think, but how does it translate into action? How does one actually start investing?
Here are the steps:
1) Choose a type of account.
If you’re employed and have access to a 401(k) account (or comparable, like 403(b)) with an employer match, it makes sense to start with that. An employer match, however much it may be, is actually free money. More importantly, it’s part of your compensation package so it should be taken advantage of as soon as you can.
If you already have a 401(k) account but aren’t investing up to the match, consider raising your contribution percentage at least up to the match if at all possible.
If you are already investing up to the company match, congratulations! Moving forward, you may want to consider either (1) increasing your contribution to your 401(k) by a few percentage points or (2) opening a Roth IRA and starting to contribute monthly an amount you feel comfortable with. You can make this decision based on your current tax bracket: if increasing your 401(k) contributions will help place you in a lower tax bracket, you might opt for that over a Roth IRA contribution, which will be after taxes. Conversely, if you already are in a lower tax bracket and would like to take further advantage of that, you may opt for a Roth IRA contribution instead.
It’s worth noting that there are certain income restrictions for Roth IRA contributions: for 2024, your modified adjusted gross income (MAGI) needs to be under $161,000 for single filers, $240,000 for married couples filing jointly, and $10,000 for married couples filing separately. These amounts change every year, so do a simple internet search (“Roth IRA contribution limits [year]”) to be sure.
If your income is over the contribution limit, however, there’s still a way to contribute to your Roth IRA. This is called a backdoor Roth conversion (or a mega backdoor IRA depending on where the conversion comes from) and is outside the scope of this introductory post.
If you don’t have access to a 401(k) or similar, you can open and fund a traditional IRA—contributions are either tax deductible or contributed after tax. In this case, contributions need to be made by you since they aren’t being taken out of your payroll by your employer as it is the case with a 401(k).
Finally, If you already maxed out all your retirement contributions and still have money left to invest, start investing in a brokerage account.
Summary:
If you have an employer match, start by contributing to your 401(k) up to the match.
If you have any money left to invest, increase your 401(k) contribution percentage, or start contributing to a Roth IRA. (Prioritize your 401(k) if you expect your taxes to be lower in the future, your Roth IRA if you expect them to be higher.)
If you don’t have access to a 401(k), you can open and fund a traditional IRA with tax deductible or after tax contributions.
If you already maxed out all your retirement contributions (yay! congrats!) and still have money left to invest, start investing in a brokerage account.
2) Pick a financial institution.
Just like you need to choose a bank to open a checking account, you need to pick a brokerage company to open your investment account with.
Because it is employer-sponsored, you won’t have a choice in the matter when it comes to your 401(k): you have to go with whatever company your employer works with.
I use Fidelity for my 401(k) and personal IRA, and Vanguard for my Roth IRA. They are generally pretty similar and I am happy with both. Most companies will have comparable products for the most part, so try not to overthink this step.
3) Choose your investments.
Once you open the investment account, you’re going to need to pick your investments (the eggs to fill your basket with—yes, still going with that metaphor).
For your 401(k) account, you likely have a default collection of investments that the company set for you. This may be a good choice or a terrible one depending on the financial institution you work with. If it’s not good, don’t worry. You don’t have to go with the default option, you can change it. So, the crucial thing here is to be able to tell a good investment from a terrible one.
The first thing to look for is fees associated with your chosen investments. Fees are typically a percentage taken out of your account to cover the costs of operations. They are important, especially because they’re sneakily baked into your investments as a “small” percentage. (One percent may not seem like much, but it will, in time, eat up a good chunk of your net worth.) You never get a bill, or even notice money’s leaving your account. You can think of them as little termites—they seem small but they will eat up your money if you don’t pay attention to them in the beginning.
This is where the difference between index funds and actively managed mutual funds become important. As mentioned above, actively managed mutual funds are, as the name suggests, actively managed by somebody (a fund manager) who puts together what they think to be a winning portfolio, whereas index funds simply follow a predetermined portion of the market (like S&P 500). Because the actively managed funds actually have to pay for the fund manager, the fees are higher. There’s no manager in an index fund that expects a lofty salary.
You might think, “well, I do want an actual human being to pick my investments. I’m not even sure what S&P 500 is!” To this I’d say, “what?! You still trust humans?” (Just kidding. Or am I?) Joking aside, there is at least one important reason why actively managed funds may not be such a wonderful idea: only about 15 percent of fund managers beat the indexes in any given year, despite charging 25 times more in fees. In the words of JJ Collins, “complex investments exist only to profit those who create and sell them.”
This is where low-cost index funds come in. A typical index fund tracking the American stock market charges only 0.04 or so in fees, which is significantly less than the typical fee for an actively managed fund. Index funds also alleviate risk to a great extent by covering a chunk of the market instead of a few individual corporations, but if you want to be completely hands-off and low-risk, target date funds are an excellent option: they are a type of index fund that gradually rebalances towards lower-risk options as you approach your retirement date. To get one that’s appropriate for you, simply add your desired retirement age to your birth year (e.g. 1983+60=2043 —> Go with a target date fund for year 2043).
4) Give them time to grow.
Sound investing is a long and “boring” game—it doesn’t involve going after the hot new trend, or constant buying and selling. You just need to keep buying investments, stand firm when the market drops and keep implementing this strategy while staying confident that it will eventually recover. To put it simply: don’t buy and sell. Buy and wait, and then buy some more.
The Financial Independence literature will tell you that retirement doesn’t depend on your age, but rather how big your investments are. The safe calculation is that when you can live on 4 percent of your investment per year, you are financially independent, meaning you can live on your investments without having to work ever again. This is based on how the stock market behaves over the long term, regardless of whether you stop working during a bull or a bear market. If, for example, you need $60,000/year to meet your needs, you’ll need 60,000x25=$1,500,000 to live on until you die.
Seen in this way, retirement (or as the FI/RE movement likes to call it “becoming work optional”) becomes something much more tangible and reachable, especially taking into account the power of compounding. The longer you give your investments to grow, no matter how small they may be, the more exponential their growth will become. That’s why time is by far the most important factor when it comes to building wealth via investing. The more time you have the less aggressive you have to be to reach a similar result.
This doesn’t mean that it’s too late when you’re in your 30s, 40s, or even 50s. It just means that you need to be a little more resolute than you would need to have been in your 20s. As you can read here, I didn’t start investing until a couple of years ago (because of a combination of lack of knowledge and lack of resources), and I was still able to put myself in a trajectory where I’ll be able to retire in a little more than a decade.
Other important considerations
Should I start investing now or after I have a lump sum saved?
As I said above, time is your best ally when it comes to investing, so please start as soon as you can, no matter how little the amount is. If you’re brand new to investing, just start contributing 2 percent of your income to a retirement account and see how that feels. It’s likely that you won’t even notice it—if so, try increasing it gradually, by 1 percent increments for example. Regardless of how you go about it, start as soon as you can.
Should I pay off debt first or start investing while in debt?
Taking advantage of time is important while investing, unless you have big holes in your proverbial money bucket. You can still invest while in debt, however, you need to pay attention to interest rates.
If your interest rate is: (1) less than 3-4 percent, you can pay it off slowly while putting more of your money towards investing; (2) between 4-6 percent, you can divide your money between paying off debt and investing in a way that makes you comfortable, (3) above 6 percent, pay it off as soon as possible first, then start investing (unless you have a 401(k) company match, in which case, invest up to the match if possible). With 22-29 percent APR, credit card debt is the worst of all, so make sure you pay that off as soon as you can.
Should I wait until the market recovers a little bit?
If you’re beginning to invest in a bear market, consider yourself lucky because you get to buy stocks “at a discount.” As I mentioned above, time in the market is the number one prerequisite to growing your assets, so I’d recommend you get in as soon as possible.
TL;DR as conclusion
You don’t have to be rich to start investing. In fact, you get rich by investing. While investing involves risk, the biggest risk you can possibly take is to not invest at all.
Time is your best ally when investing, so start as soon as you can. Time in the market is much more important than how much you invest.
Having said that, if you have high interest debt (above 6 percent or so) pay that off first.
Investing may look complicated, but you can actually get started pretty easily when you know a few key things.
If you have access to an employer-sponsored retirement account (like a 401(k) or 403(b)), start using that first. If your employer offers a match, invest at least up to the match to make sure you get all of that benefit. This is practically part of your compensation, so don’t miss out.
When choosing your investments, pay close attention to associated fees. A one percent fee may not look like much, but it will certainly eat into your wealth with time, as fees compound right along your investments.
The best way to avoid high fees while mitigating risk is to invest in low-cost index funds. If you want to be completely hands off (buy and forget), consider going with a target date fund. Pick a target date fund that matches your desired retirement date and move on.
When your invested assets are worth 25 times your annual living expenses, you become “work optional,” and can retire.
Want more money-related insights?
Join The Finance Rookie Newsletter for more free and bite-sized content on personal finance!
