How to Invest

Whether you have 20 or 200,000 to invest, the objective is the same: to make your money grow. The means, however, vary dramatically based on your available money and your investing style. Invest effectively and you could conceivably live off of the earnings from your investment!

Part 1 of 4: Setting Yourself up for Success1

1. Build your emergency fund. If you don't have one already, it's a good idea to focus your efforts on setting aside 3 to 6 months of living expenses just in case — i.e. an emergency fund. This is not money that should be invested; it should be kept readily accessible and safe from swings in the market. You can split your extra money every month, sending part of it to your emergency fund and part of it to your investing fund.

   • Whatever you do, don't tie up all of your extra money in investments unless you have a financial safety net in place; anything can go wrong (a job loss, an injury, an illness) and failing to prepare for that possibility is irresponsible.
2. Pay off any high-interest debt. If you have a loan or credit card debt with a high interest rate (over 10%) there's no point in investing your hard-earned cash. Whatever interest you earn through investing (usually less than 10%) won't make much of a difference because you'll be spending a greater amount paying interest on your debt
   • For example, let's say Sam has saved 4,000 for investing, but he also has 4,000 in credit card debt at a 14% interest rate. He could invest the 4,000 and if he gets a 12% ROI (return on investment — and this is being very optimistic) in a year he'll have made 480 in interest. But the credit card company will have charged him 560 in interest. He's 80 in the hole, and he still has that 4,000 principal to pay off. Why bother?
     
     
   • Pay off the high interest debt first so that you can actually keep any money you make by investing. Otherwise, the only investors making money are the ones who loaned it to you at a high interest rate.
3. Write down your investment goals. While you're paying down any debt and building your emergency fund, you should think about why you're investing. How much money do you want to have, and in what period of time? Your goals will affect how aggressive or conservative your investments are. If you want to go back to school in three years, you'll want to play it safe with your money. If you're saving for retirement as a 30-year-old, you can afford to roll the dice a bit more. In short, different investors have different goals. These goal affect their investment strategy. Are you looking to:

   • Hold onto money so that it's just above inflation?
   • Have money for a down payment in 10 years?
   • Build a nest egg for retirement many years in the future?
   • Build a college fund for a child or grandchild?
4. Determine whether you want a financial planner. A financial planner is like a coach who knows the playbook: they know what plays to call in what situations, and what outcomes to expect. While you don't need a financial planner in order to invest, you'll quickly realize that having someone who knows market trends, studies investment strategy, and diversifies your portfolio is a very good person to have on your team
   • Expect to pay your financial planner either a flat fee or anywhere from 1% to 3% of your total money under management. So if you're starting with 10,000, expect to pay 300 annually. Be aware that many top financial planners will only advise clients with portfolios in excess of 100,000, 500,000, or $1 million.
   • Does this arrangement seem like a lot to shell out for advice? It may at first blush. But not when you realize that good financial planners help you make money. If a financial planner takes 2% of your 100,000 portfolio but helps you make 8%, you're netting roughly 6,000. That's a pretty good deal.

Part 2 of 4: Mastering Investing Basics

1. Know that the riskier the investment, the higher the potential payoff. That's because investors demand higher payoffs for taking greater risks — very much like an odds maker. Very low-risk investments, like bonds or certificates of deposit, usually come with very little return. The investments which offer the highest returns are usually much riskier, like penny stocks or commodities. In short, very risky bets carry with them a high chance of failure and a low chance of fantastic returns, while very conservative bets carry a low chance of failure and a high chance of small returns.
2. Diversify, diversify, diversify. Your investment egg is perpetually at risk of shriveling up and dying with improper management. The goal is to keep it alive for long enough so that it gets plenty of opportunities to grow and multiply. A well-diversified portfolio limits your exposure to risks so that your investments have the necessary time to create real gains. Professionals diversify both the types of investments they own — stocks, bonds, index funds — and the sectors they invest in.
   • Think of diversifying like this. If you own only one stock, your entire fate is in the hands of how well it performs. If it performs well, then good; but if it doesn't, you're screwed. If you have 100 stocks, 10 bonds, and trade in 35 commodities, you're better set up for success: if 10 stocks were to fail, or all of your commodities were to suddenly become worthless, you'd still weather the storm.
3. Always buy, sell, and invest for a definable reason. Before you decide to invest one penny, lay out the reason(s) why you're choosing the investment that you are. It's not enough to see a stock steadily gaining over the past three months and want in on the action. That's gambling, not investing; you're relying on chance instead of following a strategy. The most successful investors always have a theory about why their investments are in good position to succeed, even if the future is uncertain.

   • For example, ask yourself why you're planning on investing in an index fund like the Dow Jones. Go on. Why? Because betting on the Dow is essentially betting on the American economy. Why? Because the Dow is a collection of 30 leading US stocks. Why is that good? Because the American economy is recovering from recession and major economic indicators look hopeful.
4. Invest — in stocks, especially — for the long run. A lot of people look at the stock market and see the opportunity to make a quick buck. While it's certainly possible to make a killing on stocks in a short time, it's not very likely. For every person who makes a lot of money investing for a very short time, 99 lose a lot of money in a very short time. Again, when you pump money into an investment for only a short period of time hoping for a monster return, you're speculating instead of investing. It's only a matter of time before speculators make a bad call and lose it all.

   • Why is day-trading on the stock market not a strategy for success? Two reasons. Market unpredictability and fees.
   • The market is essentially unpredictable in the short term. Timing what a stock is going to do on a daily basis is next to impossible. Even great companies with excellent prospects can have down days. Where the long-term investor has the upper hand over the short term investor is predictability. Stocks have historically returned about 10% in the long-term. You can't be nearly as certain that you'll return 10% during any given day. So why risk it?
   • Each buy or sell order also comes with fees and taxes. Simply put, investors who buy and sell every day incur way more fees than investors who just let their pot of money grow. Those fees and taxes add up, eating into any profits you may reap.
5. Make investments in companies and sectors that you understand. Invest in what you understand, because you're better positioned to know when it's doing well and when it's not. A corollary of this is something that the famous American investor Warren Buffet once said: "...buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." Some of the famous investor's best-returning assets include companies like Coke, McDonald's, and Waste Management.
6. Hedge. Hedging is the equivalent of an investment backup plan. Hedges are meant to offset losses by investing in the scenario you don't want to happen. It sounds counter-intuitive to simultaneously bet for and against something, but if you think about it, it substantially lowers your risk, and lower risk is good. Futures and short selling are great hedging options available to the investor.
7. Buy low. Whatever you choose to invest in, try to buy it when it's "on sale" — that is, buy when no one else is buying. For example, in real estate, you'll want to purchase property when it's a buyer's market, which is when there is a large number of houses for sale in relation to the number of potential buyers. When people are desperate to sell, you have greater room for negotiation, especially if you can see how the investment will pay off when others don't.

   • An alternative to buying low (since you never know for sure when it is low enough) is to to buy at a reasonable price and sell higher. When a stock is "cheap," such as 80% or more below its 52 week high, there is always a reason. Stocks don't drop in price like houses. Stocks typically drop in price because there is a problem with the company, whereas houses drop in price not because there is a problem with the house, but because there is a lack of overall demand for houses.
   • When the entire market drops, however, it is possible to find certain stocks that fell simply because of an overall "sell-off." To find these good deals, one must do extensive valuations. Try to buy at a discount price when the valuation of the company shows its stock price should cost more.
8. Weather the storms. With more volatile investment vehicles, you may be tempted to bail. It's easy to get spooked when you see the value of your investments plummet. If you did your research, however, you probably knew what you were getting into, and you decided early on how you were going to approach the swings in the marketplace. When the stocks you hold plummet in price, update your research to find out what is happening to the fundamentals. If you have confidence in the stock, hold, or, better yet, buy more at the better price. But if you no longer have the confidence in the stock and the fundamentals have changed permanently, sell. Keep in mind, however, that when you're selling your investments out of fear, so is everyone else. Your exit is someone else's opportunity to buy low.
9. Sell high. If and when the market bounces back, sell your investments, especially the cyclical stocks. Roll the profits over into another investment with better valuations (buying low, of course) and try to do so under a tax shelter that allows you to re-invest the full amount of your profits (rather than having it taxed first). In the U.S., examples would be 1031 exchanges (in real estate) and Roth IRAs.