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How to invest your money

Updated on July 7, 2011

Why you need to start investing now

Investing is all about compound interest. If you can invest and earn 10% profit each year, over the course of a lifetime (or from age 20 to age 60, for instance) you can accumulate a small fortune.

If you're excellent at investing and a little lucky, you could end up with a large fortune, like famed mega-investor Warren Buffett, who would be the richest man in the world if he weren't always busy giving his money away to worthy charities. He is a man who intimately understands the power of compound interest.

How do I start investing?

The first step you should take is changing your mentality towards investments. You should respect every dollar that you earn, and think of everything you spend it on as an investment for yourself or your family. Are you really getting your moneys worth out of that brand new car? If not, rethink that investment and decide whether there is a better option for you. When you start thinking about spending this way, you start spending more responsibly.

Your next step is obviously going to involve opening a brokerage account. I'm not going to advertise one over another on here, but do your homework, especially regarding fees. If they're not going to be doing much to manage your account, don't pay them half your earnings in fees.

Also, don't start investing when you've still got debt hanging over your head, unless it's at an incredibly low interest rate. If you've got a debt that you're paying 7% interest on, any money you spend on investments will have to earn at least 7% just to break even because that was money that could have been used to paid off the debt.

Have a safety fund

Open up a savings account at a bank and use that as your safety fund. You'll need this if something goes terribly wrong in the market and you need money in a hurry. If you're living on your own, this safety fund should be 6 months salary. If you think you might lose your job because your industry is failing, make that a full year's salary. If you're retired and just live on a fixed income, make it 5 year's earnings.

Max out your 401k immediately

If you work at a place that matches your 401k contributions, max it out immediately. If they match up to 10%, 10% of your salary should go to your 401k. Those matched funds mean your $1 investment is buying $2 worth of stock or other securities. If they lose 50% of their value tomorrow (which is rare), you've just broke even. If they go up by 5% tomorrow, you've made a 10% gain on your initial investment.

Open a Roth or Traditional IRA

IRA's are retirement accounts that either take pre-tax income and put it into a investment account (traditional IRA) or take after-tax income and put it into an investment account that will not be taxed when the funds are withdrawn at retirement. You should find out which IRA is right for you and get invested in one immediately, because you should be taking advantage of the tax benefits of them. You can only invest a certain amount of money in an IRA each year, which is why everyone doesn't keep all investments in an IRA. There are also some penalties for early withdrawal.


Separate between your retirement fund and your hobby investing fund

We need to get serious here. You need to protect yourself and your family with your investment funds. You might have to survive off that money when you're older, so you need to make sure it's invested correctly. Some investments belong in your retirement fund, while others belong in your "hobby" investment fund. Your retirement fund should have investments that are heavily taxed, because having them in your retirement fund (your IRA) gives you a tax shelter. Bonds and real estate investment trusts (also called REITs in the industry) are examples of securities that are taxed at normal income levels and not as capital gains. They can be great investments at the right times, but they belong in your retirement fund where you are protected from a huge tax bill.

Your hobby investing fund will be taxed at the long term capital gains level, which is good as long as you buy and hold your investments for at least a year. Day trading and other quick buy and sell strategies get eaten up by the tax man. That's why so many day traders don't stay day traders for long. You not only have to beat the market, you have to beat the market by a lot, day in and day out, just to beat the taxes.

Find the right stocks and bonds

I know you probably came here looking for some knowledge about which specific investments I recommend. I'm not going to do that. I'm not even sure if it's legal for me to do. After all, I could just be some guy trying to get you to invest in some company that I'm invested in so the stock price will go up. You've never even met me, so why would you take the stock picking advice of a stranger on the internet, or some nutcase on TV?

I learned investing from the very best, Warren Buffett and his mentor, Benjamin Graham. Graham has written the books that are considered the bibles of investing, including The Intelligent Investor and Security Analysis. If you're planning on taking up investing as a hobby (after you've taken care of the retirement stuff), read Graham and you'll have a much better chance of coming out ahead in the long run.

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