Investing in stocks is the best way for most people to create wealth. Rather than sitting around in a bank account collecting dust, money in the stock market grows slowly but surely over time.
With a solid strategy and small starting investment, you can start down the path to financial security today. To help you get started, this guide will go over the best strategies for investing and gaining the highest returns. First, let’s briefly review why investing in the stock market is a smart move for anyone with a little extra savings.
Why Should You Invest in the Stock Market?
This guide won’t tell you that investing in the stock market will guarantee you a sudden windfall of cash. Most people aren’t going to stumble upon a company in its nascent stages that turns out to be the next Facebook.
If you were picturing yourself as the Wolf of Wall Street raining hundred dollar bills down on your party guests, then I’m sorry to disillusion you. The stock market doesn’t work that way for most people.
That’s not to say that investing in stocks can’t have huge benefits, though. In fact, investing, especially at a young age, can set you up for financial security later in life. Beyond retirement, smart investments can provide for your long-term goals, like paying for your kids’ college tuition or buying your dream coffee farm in Costa Rica.
Passive, low-risk investments make your money grow over time. Thanks to the power of compounding, your initial investment will expand into valuable savings that you can draw on later in life.
While I recommend a long-term approach for most investors, there are a few different strategies for investing in the stock market. The one you choose largely depends on what type of investor you are. To help you make that determination, I’ll go over the three main types below.
Most investors should be Savers, preparing for the long winter of retirement ahead.
What Kind of Investor Are You? 3 Types
In order to choose the best investment strategy for you, you first need to do a little soul-searching. You should consider what your goals and motivations are – both financial and psychological – and what category of investor you fall into.
I’ve identified three main categories: Savers, Traders, and Gamblers. Read on to consider the type of investor with which you most strongly identify.
Type 1: Savers
Are you willing to wait to see returns on your investment? Do you want to save for retirement or some other long-term goal? Would you rather have a great car tomorrow than an okay car today?
If this sounds like you, then you fall into the Saver category (most people, by the way, are Savers). You want to invest a portion of your income in low-risk stocks with steady returns. In the long run, you’ll see your investment increase significantly as a result of compound annual growth.
You’re playing the long game, and you’re going to win.
Type 2: Traders
Do you know how to look at a company’s income statement and balance sheet and calculate its lagging one year price-to-earnings ratio? What about its book-to-price ratio? Do you know what the term “amortize” means?
If you have exceptionally strong financial literacy skills, then you may fall into the “Trader” category. Traders take an active approach to investing. They pay close attention to market trends and decide how to move around their stocks.
Traders know a lot about the stock market and might even advise others about how to invest. It’s quite rare for someone who’s not a finance professional to fall into this ‘Trader’ category.
Type 3: Gamblers
The third type of investor is the Gambler. Gamblers are excited about trading stocks. They don’t want to take a passive, hands-off approach, but would rather trade on a daily or weekly basis.
Gamblers don’t necessarily want a steady rate of returns of 15% per year. Rather, they want to play with risks and returns.
If this sounds like you, or if you suspect you might fall into this category, then I would advise you to reevaluate your approach. If you don’t mind losing a certain amount, then a certain period of gambling could be worth it for the excitement and learning experience. In the long run, though, this strategy tends to be overly risky without much payoff.
As you can tell, I believe that the majority of people, at least those starting out in investing, benefit from taking a Savers approach. Before breaking down how to invest in stocks, let me explain why I believe most people should make low-risk, passive investments in the stock market.
Gamblers prefer to take a riskier approach to investing in the stock market.
Why Should Most People Be Savers?
I’ve defined Savers as people who invest in low-risk stocks for the long-term. Rather than risking their money trying to beat the market, they take advantage of compound annual growth and the benefits of long-term passive investing.
One common type of this low-risk investment is an index fund, which I’ll explain in more detail below. According to Warren Buffett (you might have heard of him), “a low-cost index fund is the most sensible equity investment for the great majority of investors.”
Buffett has also said that active investing for most people is a “zero sum game.” Your losses – from trading costs and decreases in the value of shares – balance out or even exceed any gains.
If you team up with an active manager, then you’ll also be burning through money paying for her marketing fees. While this manager risks your money, you could have been earning more with passive investment.
This is not to say that experts can’t be successful with active investing or that there’s no fun to be had by gambling on the stock market. I’ll go over how to invest in stocks for each type of investor, but spend the most time on type one, the Savers.
Read on to learn how to invest in stocks, step by step.
Soon, you too can casually check the Dow Jones on your iPhone (and not just bring it up accidentally while looking for the flashlight).
How to Invest in Stocks: Best Approach for Savers
Savers take a passive, long-term approach to stock market investment. Below I’ll discuss my best strategy and advice, along with the step-by-step process for what to do next. You’ll be turning your money into more money in no time.
There are three guiding principles when making your investments.
Principle 1: Keep Initial Costs Low
Paying expensive fees to brokers or trading companies can eat away at your savings right off the bat. By investing in low-cost stocks, you won’t see your savings immediately decrease before they’ve even started to grow.
Principle 2: Invest in Exchange Traded Funds (ETFs) and Index Funds
Both exchange traded funds (ETFs) and index funds are types of mutual funds with low cost and low risk. They contain a mix of stocks, bonds, and assets, and investors choose them so that their performance replicates the movement of the market as a whole.
The opposite approach of investing in ETFs and index funds would be selecting single stocks, which is much riskier. Single stocks have “idiosyncratic risk,” or the risk that their company will decrease in value and you won’t get compensated by higher returns. As Warren Buffett said, index funds (and ETFs, I would add) are the way to go for most investors.
Principle 3: Diversify Your Portfolio
Finally, diversifying your portfolio, or spreading your investments around to a lot of different companies, is a strategy that brokers use to reduce risk. It follows the classic maxim of “don’t put all your eggs in one basket.”
Given these three principles of successful financial planning, what concrete steps can you take to start investing today?
Don’t put all your investment eggs in one basket! What if you lost the basket?
Where to Make Your First Investment
My advice for making your initial investment is simple: invest in Vanguard. Vanguard shares my guiding advice that “clear goals, a long-term investment philosophy, a balanced portfolio, and low costs create a path to your financial goals.”
One of the world’s largest investment companies, Vanguard allows you to make personal investments with a minimum of $1,000. You can easily set up an account on its Personal Investor page. Once there, you’ll need to enter personal information, like your Social Security number and bank account information. The account creation page looks like this:
Once you open your Vanguard account, you’ll have to make some choices about where your money goes. Below are my recommendations.
How to Invest Your Money
For those willing to undertake slightly more risk, I would recommend investing 40% in U.S. stocks, like VTI, 40% in international stocks, like VEU, and 20% in bonds, like BND.
For those looking to reduce risk as much as possible, I would suggest 20% U.S. stocks, 20% international stocks, and 60% bonds. Once you make your initial investment, you can let your money sit and grow. If you’re investing in retirement funds, like Roth IRAs or 401Ks, then you can’t take out your money for at least ten years.
For those first starting out in the stock market, knowing how much to invest is a challenge. You can start a Vanguard account with as little as $1,000, but a minimum of $5,000 is recommended. Read on for guidance on how much money you should be investing in the stock market.
How Much Should You Invest in the Stock Market?
When you establish an account with an investment company like Vanguard, patience is the name of the game. You’ll see the biggest payoff the longer you let your investment grow.
Consequently, you shouldn’t invest any savings that you anticipate needing in the next few years. Nor should you invest all of your income that you need for basic living expenses.
There are two rules of thumb to follow when figuring out how much money to invest.
Follow these two rules of thumb to feel good about your investments.
Rule of Thumb #1: Only Invest Money You Won’t Need In the Short-Term
As you now know, your investment can grow more and ride out cycles in the economy better if it stays in the market for a long time. Therefore, you shouldn’t invest any money that you’ll need in the near future. If your car is about to break down, then you should hold onto whatever you’ll need to replace it.
Beyond any specific upcoming purchases, you might also save an emergency fund for the next six months or so. It’s always good to have a safety net in case you lose your job, or your neighbor’s terrier digs up all the rainy day gold you buried in your backyard.
Rule of Thumb #2: Invest About 10% of Your Income
You need some of your money for important things like food, rent, and your HBONow subscription that you’ll cancel at the end of this season’s Game of Thrones. At the same time, you shouldn’t spend all your money on fancy restaurants, a penthouse apartment, or an HBONow prescription when Game of Thrones isn’t even airing new episodes.
If you’re thinking of investing, chances are that you can spare 10% of your income to put into the stock market. You may have to cut down on baseline spending, but you’ll be saving for your future.
As financial author, Dave Ramsey said, “Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.”
As I mentioned above, you can set up an account with Vanguard with a minimum of $1,000. A starting investment of $5,000 is even better. If you can continue to add to your account, then try to put in about 10% of your income.
In closing, what do you, as a Saver planning for the future, need to remember about investing in stocks?
Investing in Stocks: Key Takeaways for Savers
You don’t have to have an in-depth understanding of market trends – or even know how to read the glowing numbers on the Times Square market ticker – to make money in the stock market. The best approach is a long-term one in which you invest your money in low-cost ETFs and index funds with the help of an investment company, like Vanguard.
Diversify your portfolio, so that you aren’t putting all your eggs in one potentially volatile basket. Make sure you’re only investing money that you aren’t going to need for something essential in the next few months or years. By letting your money grow over a decade or more, you can reap the benefits of compound annual growth and weather any downturns in the market.
If you can set aside about 10% of your income to start investing, do so! The earlier you invest, the more savings you’ll have later in life. Compound annual growth is a force to be reckoned with. At only a 5% annual rate, the difference between investing $5,000 per year when you’re 25 versus when you’re 35 can total over $30,000.
While this guide is mainly geared toward Savers who are just starting out, let’s go over a few strategies for Traders who are investing in stocks. I’ll go more into detail about how to invest actively in a future article, but the information below will give you an initial idea.
Traders tend to be professionals who follow the market and invest in individual stocks.
How to Invest in Stocks: Traders
Traders make money from the stock market by making good stock picks. They have insight into market trends and are willing to ‘play the game’ and bet on certain stocks. Traders who make the most money are able to buy when prices are low or discover under-reported stocks that later shoot up in value.
The two main strategies that traders use to invest are small cap stock picking and technical trading.
Strategy 1: Small Cap Stock Picking
Small cap stocks are those that are only valued at a measly $250 million to $2 billion (pocket change, right?). This valuation is a lot less than stocks from big corporations, often referred to as large cap or blue chip stocks.
These stocks have both big risk and big growth potential. Traders do their own number crunching to try to root out undiscovered small cap stocks. They look at a company’s income statement and balance sheet and calculate a “fair price” for its shares. If the market is selling the shares for below this fair price, then they would buy them up.
Of course, this system is nowhere near foolproof and entails a certain degree of risk. Small cap stock picking also requires an in-depth understanding of the stock market and close attention to market trends. It may be possible to succeed with this approach with a lot of hard work. The next approach of technical trading, however, is virtually impossible to do without professional experience.
Strategy 2: Technical Trading
Technical trading involves a lot of transactions at fast speeds. It’s conducted electronically using complex algorithms that initiate trades when certain market conditions are met.
Those who conduct technical or high frequency trading are often experts who produce their own algorithm. Typically, traders with faster execution speeds beat out those with slower speeds.
Most stock market trades are likewise conducted electronically; the shouting bankers on the floor of the NYSE aren’t conducting all of the stock market exchanges face to face. Technical trading, though, takes this trading to a whole new level.
Both of these strategies, small cap stock picking and technical, high frequency trading, require considerable economic know-how, as well as a lot of time and effort to engage with the ebbs and flows of the market. I’ll go more into detail about active investing in another guide. For now, let’s consider the last type of investor, the Gambler, and how she should proceed when investing in stocks.
If you’re going to gamble on the stock market, treat it like a weekend in Vegas. Set a spending limit, be prepared to lose your money, and have fun with it!
How to Invest in Stocks: Gamblers
If you’re interested in short-term investments, rather than long-term growth, then you may want to “gamble” in the stock market. Rather than setting up an account with a larger investment company like Vanguard, you could manually choose each of your investments and monitor them daily or weekly to decide whether to keep, trade, or sell.
For the average person, this approach tends to have more losses than it has gains. At the same time, it can be an exciting and educational experience. I would suggest that anyone taking this approach treat it the same as a weekend in Las Vegas.
What I mean by that is that you should set aside a certain amount of money that you don’t mind risking. Then play around with it and see what happens. Just don’t invest more and more if you end up losing that initial investment. That’s how you fall down the rabbit hole of debt and regret.
If you’re handpicking short-term investments to see how you make out, then you should be prepared to lose your investment. As long as you’ve made this initial contract with yourself, then have fun with it! The $1,000 or so that you invest in the experience of the stock market might be just as enjoyable for you as using that same amount of money elsewhere.
In closing, let’s go over the key points to remember for investing in the stock market and putting yourself on the path to financial security and independence.
This is where the magic happens.
Investing in the Stock Market: Final Thoughts
If you could let your money grow over time, why wouldn’t you? Investing in the stock market allows you to do just that.
By putting your money into long-term investments with a diversified portfolio, you can reap the benefits of compound annual growth over time. While financial experts might take a more active approach to the stock market, the majority of people will make the most money with smart planning and patience.
Although it may not sound exciting, I agree with Nobel Prize-winning economist, Paul Samuelson for the majority of investors: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
With a starting investment of just $1,000 or more, you can start planning for your financial future today. By reducing baseline spending and allocating 10% or more of your income into investments, you will allow your assets to work for you.
Then, when you’re putting your kids through college or selling your home-grown Costa Rican coffee beans, you’ll be glad that Past You made such smart financial decisions.