You should establish your financial goals before you begin investing. Otherwise, you won’t know how much to save or how much risk you need to take or are comfortable taking. You may want to invest money for several goals, or you may have just one purpose.
Considering your investment options and desires
Numerous good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own business or someone else’s. Or you can pay down debts such as student loans, credit cards, an auto loan, or mortgage debt more quickly.
What makes the most sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down some debts, as recommended earlier in this chapter, may make better sense than investing in the stock market.
To determine your general investment desires, think about how you would deal with an investment that plunges 20 percent or 40 percent, over a short period of time. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell or make you a miserable wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.
Making investing decisions and determining your likes and dislikes is challenging when you consider just your own concerns. When you have to also consider someone else, dealing with these issues becomes doubly hard, given the typically different money personalities and emotions that come into play. Usually one person takes primary responsibility for managing the household finances, including investments. The couples who do the best job with their investments are those who communicate well, plan ahead, and compromise.
Assessing your savings rate
To accomplish your financial goals, you need to save money, and you also should know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend.
Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal; after all, your goals, wants, and needs evolve over the years. But that doesn’t mean you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.
An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.
If you’re one of the many people who don’t save enough, it’s time to do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.
To reduce your spending, first figure out where your money goes. You may have some general idea, but to make changes, you need to have the data and facts. Examine your bill-paying records and review your credit card bills and any other documentation that shows your spending history. Tally up how much you spend on getting food out, operating your car(s), paying your taxes, and everything else. After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. Earning more income may help boost your savings rate as well. Perhaps you can get a higher-paying job or increase the number of hours you work. But if you already work a lot, reining in your spending is usually better for your emotional and economic well-being.
If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now’s the time to do so. Pick up the latest edition of Personal Finance in Your 20s & 30s For Dummies by Eric Tyson, MBA (Wiley) to find out all the necessary details for retirement planning and much more.
Investing regularly with dollar cost averaging
Regularly investing money at set time intervals, such as monthly or quarterly, in volatile investments such as stocks, stock mutual funds, or exchange-traded funds is called dollar cost averaging (DCA). If you’ve ever had money regularly deducted from your paycheck and contributed to a retirement savings plan investment account, you’ve done DCA.
Most folks invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. No one has a crystal ball and can predict which direction investments will move next in the short term. DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with larger lump sums of money sitting in safe investments like bank accounts. It also makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks.
As with any risk-reducing investment strategy, DCA has its drawbacks. If growth investments appreciate (as they’re supposed to over time), a DCA investor misses out on earning higher returns on his money awaiting investment. Studying U.S. stock market data over seven decades, finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.
However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little consolation if you happen to invest just before a major drop in prices. For example, from late 2007 to early 2009, global stocks shed about half of their value. And how about those who invested in stocks in late 2019 and early 2020 only to see stocks slide by more than one-third in just a matter of weeks in March of 2020 due to the government-mandated economic shutdowns resulting from the COVID-19 pandemic?
If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practice DCA over too long a period of time,