The Only 7 Investment Decisions That Matter
You know that you’re “supposed” to be investing, but what does that mean exactly? It’s not like investing is something that’s taught in school, so it’s normal to have a lot of questions when you first get started.
- What should I be investing in?
- What kinds of accounts should I use?
- Isn’t the stock market really risky?
- I have no idea what I’m doing here. What if I make a mistake?
Decision #1: What you’re investing forBefore you make any actual investment decisions, it’s a good idea to clearly define what exactly it is you’re investing for. That is, what specific goal are you trying to achieve and when will you need the money for that goal? It’s really the second part of that question, when you need the money, that’s the key here. Because there’s a real difference in how you should approach investing for a short-term goal vs. a long-term goal. If it’s a short-term goal (money you’ll need within a few years, like for a house down payment), the rest of your decisions are actually pretty easy. You’re probably best just putting the money into a savings account, CD or other conservative investment. The return you’ll earn over such a short time period won’t make much of a difference and this way you’ll know the money will be there when you need it. Then you can simply decide how much money you’ll need, divide it by the number of months you need it, and VOILA! You have your monthly savings target. Automate that amount into a savings account and your short-term goal is handled. Longer-term investment goals give you a little more flexibility. With more time toride the ups and downs of the stock market and make adjustments as needed, you have the opportunity to take on a little more risk and reach for better returns. For the rest of this post, I’ll assume you’re deciding how to invest for a long-term investment goal like retirement/financial independence, since that’s where the real decisions are.
Decision #2: How much you savePeople love to talk about how to get better investment returns. They want to talk about what the market’s doing, what stocks look good, or what their investment strategy is, all in the name of getting the best returns possible. But here’s the truth: NONE OF THAT MATTERS. Well, it does a little bit, but not much. In fact, the returns you earn over the first 8-10 years of investing barely have any impact on the amount of money you end up with. That may sound funny, but it’s true. What DOES matter, a lot, is the amount of money you save. It may not be quite as sexy as talking about returns, but for that first decade of your investing life the simple act of saving more will have a MUCH bigger impact on your eventual success than trying earn better returns. In fact, you can speed up the path to financial independence by YEARS just by increasing your savings rate a few percentage points. All of which means two simple things:
- Since your early returns won’t have much of an impact on your end result, it doesn’t actually matter how good you are at investing when you first start.
- All that matters is that you get those contributions going as soon as possible.
Decision #3: Where you saveThe government has created certain types of savings accounts with built-in tax advantages, and the more you can take advantage of these accounts, the better. The tax breaks make it easier for you to save more money today AND allow that money to grow faster, both of which will help you reach your long-term goals sooner. If your company has a retirement plan, like a 401(k), 457(b) or 403(b), that’s a good place to start. And if you’re offered an employer match, then that’s DEFINITELY the place to start. That match is a guaranteed return on investment you won’t find anywhere else, so you’ll want to contribute at least enough to get that full match before looking at other options. Above and beyond that employer match, you have some more options. If your employer plan allows you to invest in good, low-cost index funds, then it often makes sense to keep putting extra money there until you reach the maximum annual contribution. But if the investment options there aren’t good, opening an IRA is another great option. An IRA is a lot like a 401(k) but you open it on your own instead of getting it through your employer. And one of the big advantages is that you can invest in pretty much whatever you want. There are some restrictions on IRA contributions if you participate in an employer plan though, so you’ll want to check those out first. There are two different types of IRAs, Roth and Traditional, with different types of tax benefits. Which one is best for you really depends on the details of your situation as well as a lot of unknown variables about the future, but here is a series of posts that can help you figure it out:
- Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors
- 5 Reasons a Roth IRA Might be Right for You
- 3 More Unconventional Reasons to Contribute to a Traditional IRA
- Health savings account
- Regular taxable account
Decision #4: What kinds of things you invest inThere’s a fancy investment term you’ll hear used a lot called asset allocation. But all it really means is how you divide your money up between different types of investments. There are a lot of different types of things you could invest in, but there are two that are most important:
- Stocks – A stock is a piece of ownership in a company. Investing in stocks give you the highest potential return but also the biggest variability in what returns you actually receive.
- Bonds – A bond is actually a loan you give to a company. In exchange they pay you interest (just like you would on your own loans) and eventually pay back the full amount you loaned them. Bonds are more conservative investments than stocks, with a smaller expected return but also less variability.
- Don’t be afraid to invest in the stock market. Yes, there will be ups and downs. But the stock market is also where you’ll find the best long-term returns, which will make it easier to reach your goals.
- BUT don’t feel like you have to follow the conventional wisdom and go super-aggressive either. It’s okay to start a little more conservatively and make adjustments as you gain experience.
Decision #5: How you diversifyHere’s another fancy investment term that you’ll hear a lot: diversification. And just like asset allocation, this one can be explained pretty simply: don’t put all your eggs in one basket. Here’s the deal. Investing is a constant balance between risk and return. 99.9999% of the time, it’s impossible to get higher returns without taking on more risk (meaning the chance that you won’t actually get those returns). Anyone who promises otherwise is either misinformed or is trying to mislead you. But there’s IS one way to lower your risk without lowering your expected return (only one!), and it’s called diversification. Diversification is simply the practice of spreading your money out over a lot of different investments instead of just a few. And there are a number of different ways you can do it. One is by investing in different types of things, like stocks and bonds. That’s really the asset allocation question from above. But you can also diversify within those bigger categories. For example, instead of buying the stocks of just a few companies, you can invest in the entire stock market. And you can go even further by investing in both the US stock market AND international stock markets as well. You can do the same kind of thing with your bonds as well. And the best part is that you don’t have to invest in a lot of different funds to be diversified. By using index funds, it’s actually possible to invest in the entire US stock market, all international stock markets, the entire US bond market and all international bond markets with just a single fund. Or 4 funds at the very most. Diversification is quite literally the ONLY way to decrease your investment riskwithout decreasing your expected return AND it’s pretty easy to do. Might as well take advantage of it!
Decision #6: How much you payHere’s a surprising stat for you: if you’re trying to predict how well an investment will perform going forward, the single most important variable you can look at is how much it costs. The lower the cost, the better your chance of getting higher returns. The reason why is pretty simple too. Every dollar you pay in fees is a dollar that isn’t earning returns and isn’t helping you reach your goals. The less you pay, the more money you actually have invested. There are a number of different types of fees to watch out for, and this post goes in-depth on all of them, but here’s a quick rundown:
- Expense ratio: The cost of owning a mutual fund or ETF. Every fund will have an expense ratio, though some will be much lower than others.
- 12b-1 fees: Another cost of owning a mutual fund, but not all of them have it. Usually it’s best to avoid funds with these fees.
- Loads: A commission paid to a salesman when you buy or sell a mutual fund. Not all mutual funds have this.
- Transaction costs: The cost to buy or sell a stock, mutual fund, ETF, etc. These costs can come up both when YOU make a trade to buy or sell something, and also when a mutual fund you own makes its own trades.
- Taxes: If you’re investing in a retirement account like a 401(k) or IRA, you don’t have to worry much about taxes. But if you’re investing in a taxable account there can be tax consequences every time you make a trade. And if you own a mutual fund that makes a lot of trades, those trades can have tax consequences for you as well.