How to invest in the stock market and why you should start today
Picture from Dubrovnik,Croatia
In the last few months, many have noticed that groceries and other goods have increased in price, and a dollar does not buy what it did even a few years ago. The cause is inflation, defined as a general increase in prices and a fall in the purchasing value of money. Inflation on average increases by 2% per year; therefore, if you do not invest your money, you are missing out on building wealth and losing money in the process.
Many people do not invest in the stock market either because they don't think they have the money or get analysis paralysis and don't know what to invest in. I will do my best today to debunk these two theories and empower you to start investing today.
The easiest way to begin investing in the stock market is through your job's 401k plan. Money is withdrawn from your paycheck before taxes and placed in your 401K plan each pay period. The best way to contribute to your 401K is to set up an auto-withdrawal from your company in equal amounts; that way, it takes little effort, and you avoid the temptation to spend it. The employee contribution limit is $19,500 per year and if you are 50 and older is $26,000 per year, but any amount will help your future. Since this money invested is pretax, it will decrease the amount of taxable income and save you money each year when you file your taxes. Another benefit is that some companies will match a percentage of your salary up to a maximum amount per year if you invest a certain amount. This is free money given to you by your company.
Plitvice Lakes National Park
Once you start contributing to your 401K, it can be overwhelming because there are many investment options. First, you must decide how much you will allocate to stocks and how much money in bonds. The rule of thumb is to invest your age in percent of bonds and the rest in stocks. For simplicity, you can invest in multiples of 10, so if you are 34, you can do 30% bonds. Bonds are traditionally more conservative than stocks, with fewer fluctuations in price during a bull market or a market crash. Bonds have a historically lower rate of return on your investment. Still, as you can imagine, as you near retirement, you should have most of your money in bonds to not be as affected by a market crash altering your retirement plans.
Now that you have decided how much money to allocate to bonds, we move towards the stock portion of your portfolio. Historical earnings can not predict future results, but over the last 100 years, index funds have outperformed most actively managed funds. Index funds are investments made of stocks that almost identically resemble the companies and performance of a market index such as the S&P 500, Dow Jones, or the Nasdaq. An actively managed fund is when a manager or managing team makes decisions on how to invest. Index funds have produced 8-10% historical returns per year and provide extremely low expense ratios. These expense ratios are the fees removed from your account per year to manage the account; in contrast, actively managed account fees are much higher.
Deciding which index funds can be straightforward, and I will explain a few of the most common as described in Boggleheads Guide to Investing, which represents the investment advice of John Bogle, who started the Vanguard Group an investment firm with trillions in investments. You can have a two-fund portfolio, in which you invest in a Total Stock Market Index Fund and Total Bond Market Index Fund. In doing so, you are investing in the entire U.S. equity market, with both growth and value stocks, and broad exposure to U.S. investment-grade bonds. Another option is to invest in a three-fund portfolio, adding a Total International Stock Index Fund to the previous. The Total International Index Fund invests in non-U.S. stocks, including those in developed and emerging markets. The three fund portfolio will have your age in bonds and an equal percentage in U.S. and International Index Fund. International stocks don't always rise and fall simultaneously with the domestic market, so owning both can minimize volatility.
With your 401K account now invested, it is important that you do not forget to rebalance your 401K account once a year. To rebalance your account, you buy or sell stocks to keep the exact percentages you decided upon. If you do not rebalance, you could end up with far more money in one index fund than another and deviating from your desired risk.
Dubrovnik, Croatia from above
Remember your 401K is a long-term retirement investment, as money cannot be withdrawn without penalty until you are 59.5 years old. There will be fluctuations in how much you make in your account throughout your lifetime, but it is crucial to stay the course and continue to invest every year. Do not panic sell as historically; large losses preceded the most significant gains in the stock market.
In summary, no one can predict the future, but what is for sure is that most will rely on their 401K for retirement. It is best to start early, even if you can not contribute the maximum, to allow the amount of money invested to compound. It is almost always a bad idea to pull from your 401K early as you will not only pay the penalty but miss out on more significant future earnings because you have removed from the principal. Always take advantage of free money by maxing out your 401K when possible. Do not be overwhelmed with the many investment possibilities; stay simple, and rebalance at least once a year.
