How To Get Started With Investing

I recently had a reader ask if I could write about how to get started with investing, which I gladly accepted.  I love helping others, and if there's anyone reading this that is new to investing, I hope you find this useful.

Below are some tips that I believe is important if someone wants to get started with investing:

1. Build up your emergency fund first.
Everyone should first have some cash saved in case of an emergency; this amount will vary based on each individual's comfort level.  You should add up your expenses every month to get an idea of how much you spend.  I would then take either an average of those months or the month with the highest expense and multiply that by 3, 6, or 12 months (depending on your comfort level).

If you believe that you have pretty good job security, you may only need 3 or 6 months of cash saved up.  On the other hand, if you believe that your job isn't very secure, I would recommend saving 6 to 12 months of cash in case of a lay-off.

Another factor to consider is the absolute value of the cash saved.  If your monthly expenses are really low so that your total emergency fund needed is also really low, I would factor in unforeseen large one-off expenses such as large repair work needed on the home, car accident, etc.

2. Create a budget and save, save, save!
If you don't have self-control, it's very easy to swipe away with your credit card.  It's also difficult to track where your money is going unless you have a budget.  I believe that any fiscally responsible person should have a budget that tracks both income and expenses.  Even more important, the budget should break down the expenses by categories such as groceries, gas, phone, utilities, internet, insurance, mortgage/rent/real estate taxes, eating out, clothes, entertainment/vacations, etc.

After you've created a budget and filled out your monthly expense by category, the next thing to do is to differentiate between your fixed and variable costs.  Your fixed costs are the costs that you generally have no control over such as your phone bill, your mortgage/rent/real estate taxes, your internet, and your insurance.  Of course, there are ways to lower these as well, but you generally have less control over how much you can cut these expenses.  Your variable costs are the costs that fluctuate month to month based on your spending habits.  For instance, groceries, gas, utilities, eating out, clothes, and entertainment/vacations are expenses that you have much more control over.  Focus on cutting all your expenses if possible, but if not, try to find ways to reduce your variable costs.

Remember, it's not how much you make, but how much you keep.  Of course, it never hurts to make more money!

3. If you have a 401(k) plan with an employer that matches, contribute at least to the match.
It's foolish not to contribute at least what your employer matches.  You reap multiple benefits: tax deferred compounding over many years and free money.  If someone put money on the table for you to take, would you not take it?  From my understanding, most employers will match anywhere between 25% to 100% up to a certain amount.  That's an instant return of at least 25% on your investment!

4. Pay off high interest debt after factoring in taxes.
After contributing to the employer match in your 401(k) plan, if applicable, the next thing to do is pay off all your high interest debt after taking into account the tax effect.  Some interest is tax deductible subject to limitations (such as mortgage interest and student loan interest), so you should calculate your effective interest rate after taxes is considered.  If the effective interest rate after taxes is higher than the rate of return you might get if you invested your money in stocks or mutual funds, then you should pay off that debt first.

Remember, the effective interest rate after taxes is a guaranteed rate of return, whereas investing in stocks or mutual funds is not.

5. Max out your Roth IRA contributions.
I recommend maxing out your Roth IRA contributions after contributing to the match in your 401(k) plan and paying off high interest debt before contributing additional capital to the 401(k) plan.  Why?  Because the distributions are tax free when you meet the minimum holding requirement and age requirement.  Additionally, there are no required minimum distributions unlike a traditional IRA or 401(k) plan.  Your contributions are after taxes, but from then on, everything is yours to keep tax free!

If you're interested in investing in mutual funds, I recommend opening an account at Vanguard since their expense ratios are very low and they are a very reputable company.  If you're interested in investing in individual stocks, I would open an account with an online broker with low commissions.

I use Vanguard to invest in mutual funds, and TradeKing and Loyal3 to invest in individual stocks.  TradeKing has a commission of $4.95 per trade and Loyal3 has no commission.  The only downside to Loyal3 is that the selection of stocks is limited, but the upsides are that there are no commissions and you can invest with as little as $10.

6. Invest, invest, invest!
After maxing out your Roth IRA contributions, if you still have money left over, I would invest as much of it as possible.  There are so many types of investment vehicles out there, but I would stick to the ones that you understand.

Here are some ways to invest your money:

A) Buying and selling homes.
With this approach, you would buy cheap real estate, fix it up/renovate it, and sell it at a higher price (aka "flipping homes").

B) Investing in rental properties.
With this approach, you would buy rental properties with good cash flow, and collect rent checks.

C) Investing in stocks.
With this approach, you can either invest in dividend paying stocks or growth stocks.  If you invest in dividend paying stocks, you are more focused on income; if you invest in growth stocks, you are more focused on capital appreciation.

D) Investing in bonds.
With this approach, you can invest in municipal bonds or corporate bonds.  If you invest in municipal bonds, the interest income is tax exempt for Federal tax purposes.  You should consider your interest rate on the bonds after factoring in the tax effect.

E) Investing in mutual funds.
With this approach, you can invest in a basket or pool with multiple stocks or bonds.  Mutual funds also have different objectives that cater to different investors; they have mutual funds for specific sectors, for specific strategies, you name it.  Investing in a mutual fund is a good way to quickly diversify your money across many companies if you have little capital, but there is an expense ratio associated with mutual funds.  Additionally, it is difficult to do effective tax planning since you have no control over the capital gains distributions.

For me personally, there are only 3 types of investments that I'm interested in:

A) Rental real estate properties
I enjoy investing for passive income.  Why?  Because it's something that I can count on to cover my expenses without having to touch the principal.  It's also easier in calculating cash flow to determine whether or not my income will be able to cover my expenses.  With selling off stocks or mutual funds, I'm depending on capital gains and the market, which is not guaranteed.  If the stock market crashes and I need $24,000, I would be selling off a larger chunk of my portfolio than if I needed $24,000 when the stock market is doing well.

What's also nice about rental real estate properties is that I can visit it and touch it with my bare hands.  With stocks, there's always the possibility that a company might go out of business.  The downside with rental real estate properties is that you have to find a (good) tenant otherwise you will have to keep paying the mortgage/real estate tax/maintenance fees, you have to maintain the property, you have to address tenant issues, you need a large amount of capital to invest, and they are not very liquid.

B) Dividend growth stocks
Dividend growth stocks are also a great way to invest for passive income because these companies generally will pay increasing dividends year after year, which can help keep up with inflation.  They are much more liquid than rental properties, require a lot less capital to invest, and less headache.  You don't have to deal with tenants, you don't have to deal with upkeep, and you don't have to worry about paying the bills if the property is vacant.  The only potential downside is that the yield may not be as high as rental properties, and you always have the risk that the company may go out of business.

With stocks, you are an owner in a business, whereas with rental properties, you are an owner in a real estate property.

C) Mutual funds
Mutual funds are a great way to diversify your money in one investment.  I first started off investing in mutual funds in my Roth IRA account when I was younger because I wasn't familiar with dividend growth investing.  At that time, I thought stocks were very risky and I was afraid of picking bad stocks, so I invested in mutual funds to diversify my risk and also because it would be managed by an investment adviser, who is supposedly an "expert."  Recently, since discovering dividend growth investing, I have been less interested in mutual funds, and have been focusing more on selecting my own stocks to invest in.  Thus far, it has been working out for me pretty well.