How To Start Investing the Smart Way

When it comes to personal finance and learning how to start investing, one of the most commonly asked questions is some variation of, “I want to start investing, but where should I put my money?” Let’s imagine you find yourself in the enviable position of having $1,000 “extra” dollars in your pocket. How would you decide where to invest first so that you get the biggest bang for your buck and you're building for the future you desire?

In this post I'll answer those questions by walking you through how I have chosen to invest my own money and how I made those decisions.  Hopefully this will help you by taking  some of the guesswork out of it.  

Be warned, I won’t be sharing any tips about specific stocks or investments since I’m not your financial advisor. I also won’t be sharing any “tricks” for "doubling your money in 30 days" by investing in crypto, or other high risk/high reward investment strategies. For the majority of us, they are closer to gambling, and a quick way to lose money fast. I'd recommend focusing on the basics of personal finance and investing accordingly.  

Think of me like you would a friend or neighbor

What I mean by that is, you may ask for their opinions, but ultimately it’s your decision on what you do. Treat me the same way.  With that said, here is what I do when I have money to invest, in priority order:

  1. Fund a small cushion of savings
  2. Pay down debt
  3. Build up an emergency fund
  4. Take full-advantage of retirement accounts
  5. Contribute to goal-based investment account

I know it looks simple and unsophisticated, and that’s because it is.  But this is the exact framework I use for figuring out how and where I should be investing my money.  And guess what...most savvy investors follow nearly the same process.

 And why is that? Keep reading to learn exactly what’s happening at each step and why.

how to invest

1) Fund a small cushion of savings

​The first thing I recommend is setting aside small amount of cash (around $1,000) in a savings account linked to your primary checking.  This will provide you some buffer against unforeseen expenses (think new tires, vet bills, etc.).

Setting this money aside before you start paying off your debt will keep minor bumps in the road from turning into major roadblocks.

​2) Pay down debt

The next thing I ask people who want to start investing is, “Are you debt free?”

This is because if you owe student loans, car payments, or on credit cards, the best thing you can do with your $1,000 is to “invest” it in paying down that debt. If you have a mortgage, that’s fine—but pay off all other types of debt before you think about putting your money elsewhere.  

Look, I get it: this doesn’t feel like a sexy way to use the money. But in the long run, the return on your investment will be as good, if not better, than it would be if you invested that same money in stocks or bonds.

Take for example you have a credit card that you carry a balance on. The average interest rate on a new credit card is between 16-29%  and requires minimum monthly payments. On the other hand the stock market averages anywhere from 8-12% annual returns. 

By paying down your credit card you are not only locking in a guaranteed return of 16-29%, but also simultaneously increasing your monthly cash flow by reducing the minimum payment.   Sure it’s not a stocks or bitcoin, but who cares, the goal is to increase your wealth, so go after the low-hanging fruit first!

Suggested Reading: How to Get Out of Debt: TMPF’s Complete Guide

3) Build an emergency fund

Nothing can derail your finances faster than unforeseen expenses like car repairs, medical bills, home maintenance, or job loss. Even if you’ve already paid off your debt, you’ll soon find yourself back in the hole if you’re not prepared to handle life’s ups and downs. 

how to invest

A proper emergency fund can keep you out of holes that take a long time to dig out!

So if you have extra money, the next best way to improve your financial standing is to set up an emergency fund with enough money to cover 6 months of expenses. This money can be used during major financial emergencies, such as job loss. I recommend keeping it in a savings or money market account at a different bank than your primary checking account, to make it less likely you’ll tap into it for non-emergency uses. 

If you invest your money elsewhere before you have this in place, odds are you’ll need to withdraw it down the road to help cover an unforeseen expense. So save yourself the trouble (and likely an early withdrawal penalty) by establishing these accounts before putting your money anywhere else.

​4) Take full-advantage of retirement accounts

Assuming you’re debt free and your emergency funds are in place, it’s time to start preparing for your golden years. The best way to get started is to open a tax-advantaged retirement account and contribute to it regularly. 

The term “tax-advantaged” refers to any type of investment, account, or plan that is either exempt from taxation, tax-deferred, or offers other types of tax benefits. There are many different types, but here’s where to start.  

Employer-sponsored retirement plans

If your employer offers a retirement savings plan, such as a 401(k), 403(b), 457, or 401(a), enrolling is the simplest, most effective way to start investing for your retirement. Your contributions are pre-tax, and many employers even match them up to a certain percentage of your income. You don’t want to leave this money on the table.

When you open your 401(k), you’ll have to make decisions about how to allocate the money within your account (stocks, bonds, mutual funds, ETFs, etc.). Most providers offer tools to help you make those decisions based on your age, savings goals, and risk tolerance.  I would recommend you do your research into what options you have to ensure you are ​optimizing your 401k and not leaving money on the table.  

Traditional IRA and Roth IRA

Whether or not you invest in a 401(k) through your employer, you should consider opening an individual retirement account (IRA) as well. IRAs typically offer a more robust set of investment options, as well as unique tax benefits to give your savings a boost.

There are two main types of IRAs, and they differ in regards to when you get your tax benefit:

  • Traditional IRA: The money you contribute is deductible from your taxes for the current year. So you get a tax break now—but the downside is that you’ll pay taxes when you withdraw the funds during retirement, at whatever the tax rate is then.
  • Roth IRA: Contributions are made after taxes, so they aren’t deducted them from your taxable income. Instead, you’ll realize a tax benefit in your retirement years, when you are not taxed at all for the funds you withdraw.

Just like with a 401(k), once you open your IRA you’ll need to make some decisions about how funds are allocated within it—stocks, bonds, index funds, annuities, mutual funds, you name it. If you’re new to the investing game (and you probably are if you’re reading this), consider opening your account with a robo advisor that has a good reputation for managing retirement accounts. 

Robo-advisors, also known as automated investment platforms or online advisors, are online services that provide automated, algorithm-driven financial planning services. By providing investment help at low cost and with low or no account minimums, robo-advisors are an easy way to take that extra $1,000 and put it to work for you. Check out our guide to get a sense of what your automated investment options are.  

​5) Contribute to goal-based investment funds

You probably have financial goals you want to achieve before retirement, like buying a home, sending a kid to college, or starting a side business. You can’t tap into your retirement accounts early without paying a penalty, so you’ll want to put this money somewhere else. But remember, you don’t save for every goal the same way.  You need to take into consideration details like:

  • What’s the money for?
  • When would you need to use it?
  • What’s your personal risk tolerance?

Once you’ve answered those questions, it’s easier to figure out what investment tools to use.  

Here's exactly how I do it

To save for our daughter’s education, my wife and I contribute to a 529 plan. These plans allow you to save, tax-free, for eligible educational expenses.  There are a ton of options for these since almost every State offers their own variation, which are typically available to out-of-state investors.  You could also explore options like a Coverdell Education Saving Account, which is like a 529, but with more flexible investment options.

If I want to save for a goal that’s less than 5 years out, I set up a standard savings account,  labeled specifically for each goal. The reason I use a savings account is so I don’t have to worry about fluctuations in the stock market impacting my savings.  I know that I won’t get much of an annual return, but I view this as more a short term holding account. Feel free to look for high-interest savings account, but most of them are in the range of 0-2%, which isn’t going to change your world if you’re only keeping money there fora short time.

If I’m saving for something that’s 5+ years out, I use a few different investment tools, which currently include:

  • A brokerage account where I invest in low-cost S&P ETFs and a robo-advisor where I set my risk tolerance and stay mostly hands off.  I refer to this as my "war chest".  I know that calling it a "war chest" sounds dorky, but I like it.
  • A “passive income” brokerage account where I invest in dividend stocks, that will over-time create a small, but consistent stream of dividend cash flow.  This is a long-term strategy, since it requires a significant investment before you start seeing  much of a passive income stream.  
  • Once I have enough funds in my "war chest", I use those funds to purchase a new rental property, further diversifying my investments and increasing my monthly cash flow.  I currently have one rental, and I hope to add another in the near future!
Money_Management_Lvl7

The picture above is from a post about the system I've developed over the years to manage my family's finances.  If you want to learn more about it, and  how to incrementally develop a system to automate and manage your money, it's definitely worth giving it a read.

Conclusion

So that’s the exact approach I take for investing.  So when someone asks me how to start investing, I always take them through those same 5 steps.

  1. Fund a small cushion of savings
  2. Pay down debt
  3. Build up an emergency fund
  4. Take full-advantage of retirement accounts
  5. Contribute to goal-based investment accounts

I acknowledge it’s not the most flashy or exciting strategy for investing, but I personally don’t get that excited about investing anyhow.  My excitement comes from the outcomes those investments enable for me and my family.

So what’s your framework for investing?  What would you do first?  Last?

Leave a comment below and let me know!

About the Author

Hello, I'm Ryan. Besides writing about personal finance my other passions include spending as much time as I can with my amazing family, running around my neighborhood, and continuing to refine my skills as a product manager. You can also follow me on twitter @TMPF_Ryan.

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