You want to learn how to start investing. Congratulations! Taking this first step is one of the most important things you can do for yourself and, in many cases, your family. Implemented wisely and with enough time to let compounding work its magic, it can lead to a life of financial independence as you spend your time pursuing your passions, supported by passive income from things such as dividends, interest, and rents.
In this article, I want to explain some of the ways many new investors begin their journey.
Decide Which Types of Assets You Want To Own
At its core, investing is about laying out money today expecting to get more money back in the future. Most of the time, this is best achieved by acquiring productive assets. Productive assets are investments that internally throw off surplus money from some sort of activity. For example, if you buy a painting, it isn’t a productive asset. One hundred years from now, you’ll still only own the painting, which may or may not be worth more or less money. On the other hand, if you buy an apartment building, you’ll not only have the building but all of the cash it produced from rent over that century.
Each type of productive asset has its own characteristics and pros and cons. Here is a quick rundown of some of the potential investments you might make as you start your journey:
Business Equity – When you own equity in a business, you are entitled to a share of the profit or losses generated by that company’s operating activity. Whether you decide to own that equity by acquiring a small business outright or buying shares of a publicly traded business through the purchase of stock, business equity has historically been the most rewarding asset class for investors. So much so that it has been wisely observed that a good business is a gift that keeps on giving.
Fixed Income Securities – When you buy a fixed income security, you are really lending money to the bond issuer in exchange for interest income. There are a myriad of ways you can do it, from buying certificates of deposit and money markets to corporate bonds, tax-free municipal bonds to a variety of U.S. savings bonds.
Real Estate – Perhaps the oldest and most easily understood asset class investors may consider is real estate. There are several ways to make money investing in real estate but it typically comes down to either developing a property and selling it for a profit or owning something and letting others use it in exchange for rent or lease payments.
Intangible Property and Rights – Personally, I adore this asset class when it is done right because you can create things out of thin air that go on to print money for you. Intangible property includes everything from trademarks and patents to music royalties and copyrights. I’m particularly fond of the latter. Over my lifetime, my copyrights alone have generated a lot of money that I was able to use for other purposes, including redeploying the cash to buy stocks, taking vacations, or donating to my family’s charitable foundation.
Farmland or Other Commodity-Producing Goods – Although it often involves real estate, investments in commodity-producing activities are fundamentally different in that you are either producing or extracting something from the ground or nature, often improving it, and selling it for what you hope is a profit. If oil is discovered on your land, you can extract it and take cash from the sales. If you grow corn, you can sell it, increasing your cash with every successful season. The risks are significant—bad weather, disasters, and other challenges can and have caused folks to go bankrupt by investing in this asset class—but so, too, can be the rewards.
Decide How You Want To Own Those Assets
Once you’ve settled on the asset class you want to own, you next need to decide how you are going to own it. To better understand this point, let’s look at business equity. If you decide you want a stake in a publicly traded business, do you want the shares outright or through a pooled structure?
Outright Ownership – If you opt for outright ownership, you are going to be buying shares of individual companies directly so that you see them somewhere on your balance sheet or the balance sheet of an entity you control. In this instance, you become an actual shareholder in a company and even have voting rights. Owning shares of a company may give you access to dividend income and your net worth can rise along with the company’s.
Pooled Ownership – You mix your money with other people and buy ownership through a shared structure or entity. This is most commonly done through mutual funds. In an article called How a Mutual Fund Is Structured, I walked you through the framework of an ordinary open-ended mutual fund. Some wealthy investors invest in hedge funds. For investors without large sums of money, things like exchange-traded funds and index funds make it possible to buy diversified portfolios at much cheaper rates than they could have afforded on their own.
Decide Where You Want To Hold Those Assets
After you’ve decided the way you want to acquire your investment assets, you next have to decide how you want to hold those assets. Let’s examine the options.
Taxable Accounts – If you opt for taxable accounts, such as a brokerage account, you will pay taxes along the way but your money is not restricted. You can spend it on whatever you want, however, you want. You can cash it all in and buy a beach house. You can add as much as you want to it each year, without limit. It is the ultimate in flexibility but you have to give Uncle Sam his cut.
Tax Shelters – If you invest through things like a 401(k) plan at work and/or a Roth IRA personally, there are numerous asset protection and tax benefits. Some retirement plans and accounts have unlimited bankruptcy protection, meaning if you suffer a medical disaster or some other event that wipes out your personal balance sheet, you can walk away with your investment capital still compounding for you beyond the reach of creditors. Some are tax-deferred, often meaning you get a tax deduction at the time you deposit the capital into the account to select investments and then pay taxes in the future, often decades later, allowing you year after year of tax-deferred growth. Others are tax-free, meaning you pay taxes on your money now but will never pay taxes on either the investment profits generated within the account nor on the funds once you withdraw the money later in life. Good tax planning, especially early in your career, can mean a lot of extra wealth down the road as the benefits compound upon themselves.
Trusts or Other Asset Protection Mechanisms – Another way to hold your investments is through entities or structures such as trust funds. As you learned in What Is a Trust Fund?, there are some major planning and asset protection benefits of using these special ownership methods, especially if you want to restrict how your capital is used in some way.
In addition, if you have a lot of operating assets or real estate investments, you may want to speak to your attorney about setting up a holding company.
An Example of How a New Investor Might Start Investing
With the framework out of the way, let’s look at how a new investor might actually start investing.
First, assuming he or she is not self-employed, the best course of action is going to be to sign up for a 401(k), 403(b), or other employer-sponsored retirement plans as quickly as possible. Most employers offer some sort of matching money up to a certain limit. It makes sense to take advantage of this. For example, if your employer gives a 100% match on the first 3% of salary, and you earn $50,000 per year, that means on the first $1,500 you have withheld from your paycheck and put in your retirement account, your employer will gift you an additional $1,500 in tax-free money that is entirely yours.
Even if all you do is park it in something like a stable value fund, it’s the highest, safest, most immediate return you can earn anywhere in the stock market. To leave free matching money on the table is almost always an enormous mistake.
Next, our investor would probably want to fund a Roth IRA up to the maximum contribution limits permissible. That is $5,500 for someone who is younger than 50 years old and $6,500 for someone who is older than 50 years old ($5,500 base contribution + $1,000 catch-up contribution). If you are married, in most cases, you can each fund your own Roth IRA.
After this was done, a good investing program would probably involve building up a series of cash reserves including an emergency cash reserve. Too many inexperienced investors have a lack of respect for cash. It’s not meant to be an investment, as you learned in Saving vs. Investing. That’s why it’s important that you work to have adequate savings on hand before you even consider adding additional investments. For more information on how much you should be saving, read How Much Should I Be Saving.
On a related note, you should also read How Much Cash Should I Keep In My Portfolio?. Remember that cash is not only a strategic asset, it can dampen volatility and, during ordinary interest rate environments, provide decent yields, too.
Once this is completed, you’d probably want to start working on paying off all of your debt. Pay off your credit card debt. Wipe out your student loan debt. If you want to be extremely conservative, pay off your mortgage, too.
After that is done, you’d want to return to your 401(k) and fund the remainder beyond the matching limit you already funded and whatever overall limit you are allowed to take advantage of that year.
Finally, you would then begin to add taxable investments to your brokerage accounts, perhaps participate in direct stock purchase plans, acquire real estate, and fund other opportunities.
Done correctly over a long career, with the investments managed prudently, it would be almost a mathematical impossibility not to retire far more comfortably than the typical worker. It is simply the nature of compounding.
Consider Hiring a Financial Planner or Other Professional
If you need help, you may consider doing what many investors do and working with a registered investment advisor, financial planner, or other professional. Finding the right one for you can be a bit of trial and error but it’s an important relationship so you need to get it correct. Some financial advisors charge a flat fee for consultation, while others charge a percentage of the assets they are helping to manager.
