How do I know what to invest in?
Posted August 10
You're not the only one feeling overwhelmed by the tens of thousands of stocks, bonds, mutual funds and exchange-traded funds out there.
A lot of young people who are new to the investing game feel so intimidated by all the choices, that they shy away from investing altogether. But avoiding your 401(k), or keeping all your money in a savings account can cost you in the long run.
Just by following a few simple steps, you'll be earning returns like the pros (or better).
Step 1. Start with retirement accounts
Your company 401(k) plan is a good entry point. Financial planners advise you stash away at least 10% of every paycheck for retirement.
It may not sound like a lot, but the magic of compounding will surprise you.
"If a young professional, say she is 25, earns $50,000 per year, saves $5,000 each year, and places this money into her company's 401(k) balanced mutual fund or even an ETF, which earns 8% annually on average; she could end up with $1.3 million in retirement assets," said John Barnes, a certified financial planner with Barnes Financial.
That number assumes no company matches, additional contributions or salary increases.
The 5-minute 401(k) investment plan
But in reality, you'll probably earn more money over the course of your life.
A better strategy is to slowly increase your contributions over time as you get raises, until you reach the legal maximum -- currently $18,000 a year.
After that, you can invest any additional money in an IRA or a taxable mutual fund account.
Step 2. Figure out how comfortable you are with risk
Generally speaking, the younger you are, the more risk you can afford to take on.
The stock market can be volatile, but young people have a unique opportunity to take on risk because they have plenty of time to recover from market setbacks before retirement. So it's pretty common for people under age 30 to have 90% or even 100% of their savings in the stock market, said Pearce Landry-Wegener, a wealth management advisor at the Summit Place Financial Advisors.
But asset allocation -- or how you divide up your money between stocks, bonds, cash or other investments -- is a completely personal choice.
If you're not all that comfortable with risk or need money in the next few years, invest a larger chunk of your money in safer assets like bonds.
Step 3. Diversify, but keep it simple
So you know you want, say, 90% stocks and 10% bonds. Now what?
You can offset some of the stock market's risk by spreading your money around in a variety of different investments.
For newbies with a limited amount of money, investing in mutual funds or exchange-traded funds (ETFs) is the way to go. ETFs and mutual funds are securities that track a basket of stocks, bonds, commodities and indexes -- like the S&P 500 index, for instance. With just one fund, you're investing in a variety of different underlying investments.
Related: Millennials love these 10 ETF funds
And you don't need many funds to be diversified.
Mychal Eagleson, president of An Exceptional Life Financial, recommends a portfolio with just three funds: a total U.S. stock fund, and total international stock fund, and a total bond market fund.
In some cases, just one fund is enough.
For instance, some retirement accounts offer target-date mutual funds. Rather than selecting different funds to create the right mix of stocks and bonds yourself, a target-date fund will do it for you.
Pick one target-date fund around the time you plan to retire. The investment mix will change over time, transitioning into more conservative assets as you get closer to retirement.
"Set it and forget it! And don't try to get sexy with your money," said Randy Bruns, a certified financial planner with HighPoint Planning Partners. "Time in the market, not timing the market, is how you'll become a multi-millionaire."
Step 4. Keep fees as low as possible
When choosing what to invest in, don't forget to look at the fees each fund charges.
It's important to select funds with low fees to get the biggest bang for your buck, because the charges can eat away at your returns over the years.
Look for funds that are cheaper than average. The average ETF expense ratio (aka fee) is 0.24%, and the average for target-date funds is 0.71%, according to Morningstar.
"You can't control what the market as a whole does," Landry-Wedener said. "What you can control is how much of your return is taken away in fees."