How To Invest Money

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You worked hard to save some money and that has paid off – you’ve managed to save $5,000. Pretty awesome! So, do you invest your money?

Alignment with your financial goals (both short-term and long-term) is crucial. You want to grow the money you saved and make it work for you.

Here’s how to figure out the best approach for you.

Financial Goals

Your financial goals are like a blueprint of the life you want to live. When you have extra money (through savings, windfall, investment gains, lottery, etc.), you need to make sure you have an action plan.

If you want to achieve financial freedom (which I’m guessing is the case), the first step is to pay off your debt

You see, the reason you get into debt in the first place is that it served your need/want at some point. The only option you had was to borrow money so you did it.

Now, you’re in this vicious cycle of monthly payments that you need to make against the borrowed money plus pay the interest. As long as you can make the payments, it’s good.

But, when times get tough, you could be in serious trouble.

So, the first step is to put that $5,000 toward your credit card debt, student loans or any other form of debt. If you want to learn more about ideas on debt repayment, please check out my article, how to pay off debt,

By addressing your debt first, you are doing yourself couple favors:

• Paying off the amount you borrowed and this would be called responsible borrowing
• Not paying more interest on the amount borrowed by paying off debt quicker – called smart borrowing
  

Risk Tolerance

Next, you need to determine your risk tolerance to invest money.

Why?

Because your risk tolerance is going to decide the investment options you choose. You do not want to invest in investment vehicles that are above your pay grade from a risk tolerance standpoint.

The hard-earned $5,000 that you saved can grow at 7%-8% annually (market average historically) and that add ups in the long run.

From a risk appetite standpoint, not everyone is the same and so you need to figure out your comfort zone.

If you need help figuring out your risk tolerance level, Charles Schwab has helpful resources to get you started.

What Is Risk Tolerance?

In simple words, risk tolerance is your ability to tolerate the degree of variability in investments. It is important because if there are huge fluctuations in the market and you panic, it could hurt your finances significantly.

The timing of buying and selling your investments is key and understanding your risk tolerance is only going to serve you better.

Let’s look at the 3 types of risk tolerances.

Conservative Risk Tolerance

Investors that do not like volatility and can’t stomach the constant ups and downs of the market have conservative risk tolerance.

Conservatives do not like investments that are not liquid and prefer guaranteed returns. This reduces the investment options available and the pace at which your money grows is slower than the other 2 types of tolerances.

If you are conservative with your risk tolerance, you can invest your money in a savings account, money market account, in a certificate of deposit (CDs) or US treasuries.

Moderate Risk Tolerance

If you want to invest money with moderate risk tolerance, you can balance your portfolio by including investments that are a little more aggressive than a savings or a money market account.

The idea is to figure out how which investment best suits your style and then pick one.

For a balanced approach, you should include mutual funds and fixed income bonds along with conservative investment options mentioned earlier.

Aggressive Risk Tolerance

To invest money with aggressive risk tolerance, you need to have some expertise with investing. The reason being, the risk levels are high and if it does not align with your income streams and financial goals, you might want to stay away from this approach.

In this approach, you can invest in growth based stocks, volatile stocks and even options contracts. Also, you can derive complex strategies and hedge (protect your downside risk) using a combination of stocks and options.

Remember, the higher the risk, the higher the gain and(or) loss.

Once you understand your risk appetite, you can create your investment strategy and start defining your investment options.

Now, let’s look at some of the common investment options that you can choose from to invest money.

1) 401(K)

One of the most popular options to invest money is by using your employer-sponsored 401(k) plan. Most companies offer 401(k) as a benefit so this is the first investment option to consider.

So why should you consider this option?

If your employer is offering a 401(k) plan, your contributions are matched by the employer. The most common type of matching involves employers matching employee contributions up to a percentage of annual income.

For example, if your monthly paycheck is $4,000 and you decide to invest 10% in 401(k) plan, that will be $400 toward your plan.

If your company matches partially (say 50%), you will receive an additional $200 from your employer into your 401(k) account.

Some employers offer 100% matching and in that case, you will receive $400 from your employer into your 401(k) account.

However, there are contribution limits set by the Internal Revenue Service (IRS) and for 2019, the maximum you can contribute under 401(k) is $19,000 annually. The employer matching amount does not count toward the $19,000 limit which works in your favor.

2) Exchange Traded Funds (ETFs)

ETFs are a collection of securities. This means that instead of investing in one stock or bond, you can buy a single ETF and diversify your investments in multiple stocks, bonds or other combinations.

Think of ETFs as investment vehicles that can spread your risk across multiple investment options. If you have a conservative or moderate risk appetite, this is a great option to invest money and earn decent returns.

ETFs can be traded (bought and sold) just like a stock in the open market on a stock exchange.

Apart from risk diversification, another advantage is that you can invest in industry-specific (Healthcare, IT, Finance, Consumer Staples, etc.) ETFs to grow your money.

On the flip side, ETFs trading is less liquid compared to stocks so it might take a little longer to fill your orders.

Investing in ETFs has certainly grown over the years. Below is a chart from Bloomberg showing the growth in equity funds.

3) Stocks

A stock is also known as an “equity” or “a share” in the financial market. It is a type of security that gives the buyer the opportunity to own a proportion in the issuing company.

In exchange, the issuing company gets money based on the number of stocks purchased.

Stocks are one of the most commonly traded securities in the financial market. They are very popular both with banks and retail investors (like you and me) because of the ease of transacting.

Stocks can be traded on exchanges like DOW, NASDAQ and NYSE and both the buying and selling happens online.

Investing in stocks yields higher returns in lesser time than most other forms of investing (depending on a lot of factors though). For this reason, investing in stocks is extremely popular across the globe.

There are 3 types of stocks you can choose from to invest money: Growth, Value, and Income.

I’ve written a detailed article on these 3 types of stocks to help you make the right decision.

4) Individual Retirement Accounts (IRAs)

If you’d like to earmark funds for retirement, then you can invest in IRAs. Investments within an IRA include financial products like stocks, bonds, mutual funds, ETFs, etc.

The two most commonly used IRAs are Traditional and ROTH IRAs.

Traditional IRAs

For the most part, traditional IRAs can be tax-deductible. This means that you can put money in the traditional IRA and deduct it while filing for your taxes.

The IRS will not charge you tax on the amount you put toward the traditional IRA account.

Upon retirement, when you withdraw money from this account, IRS will tax you on the amount you withdraw.

The age limit for avoiding the penalty for early withdrawal is 59 1/2. As of 2019, for a single person (or as the head of the household) with a modified adjusted gross income (as defined by Investopedia) of $64,000 or less, the IRA contributions are tax-deductible.

If you are married and filing jointly, the limit is $103,000 or less.

ROTH IRAs

On the flip side, Roth IRAs are not tax-deductible. This means that you invest in this account with your after-tax dollars.

The benefit here is that your contributions and investment growth are tax-free.

There is no tax on the amount of interest or profits you make on the invested dollar. Upon retirement, when you withdraw money from this account, IRS will NOT tax you on the amount you withdraw.

5) Bonds

Bonds are classified as debt instruments – meaning you are going to loan money to a company and in return, they pay you interest periodically (usually semi-annually)

Bond has a maturity period, and once the bond hits maturity, you get the initial amount loaned to the company, back.

Investment in bonds is less risky than stocks. A bond’s value will not fluctuate sporadically every day. Interest rates are a key factor in the determination of the bond’s value.

A bond’s value will either rise or fall depending on the direction of interest rates. Bonds are a great investment for those who like safer and conservative investment tools.

It provides the much-needed balance to your portfolio and brings in regular interest payments that you can re-invest.

So, how do you make money by investing in bonds?

• The first option, hold the bond until the maturity and keep collectively those interest payments
• When the bond’s market value rises, you can sell it and pocket the difference between your buying and selling price

Unlike stocks, you cannot trade bonds through the exchanges. Bonds are bought and sold through brokers (referred to as over-the-counter OTC). This does make it a little challenging to buy and sell bonds.

But, there is enough opportunity to add a steady income flow to your portfolio so I would encourage you to go that extra mile!

Your first and best option is to reach out to your brokerage firm for investing in bonds.

According to US News, here are the best Corporate Bonds to invest.
According to US News, here are the best Fixed Income funds to invest.

Summary

If this is your first time diving into the investment world, it might all seem overwhelming. But do not worry. I’ve got you covered!

Follow the steps laid out in this article and figure out the following to help you get started:

• Be crystal clear of your financial goals (both short and long term) and make sure your investment options align with your goals
• Determine your risk tolerance (appetite) so you do make poor, untimely, rash and uninformed decisions – above all, you do not have sleepless nights
• You can choose one investment option or combinations depending on whether you are conservative, moderate or aggressive with your investment strategy and risk-taking abilities
• Always rely on data and facts and avoid making investment decisions through emotions
  

Please share your experience, thoughts, tips, and ask away any questions in the comment section below!