If you're like many Americans watching the recession unfold, you've probably started to look at your finances more closely. Maybe you've started saving - the personal savings rate by American households has risen from below 1% in 2005 to a recent peak 6.9% in May of 2009 before settling down at around 3% at last measure. Now you're wondering: what about investing my money? How do I start if I don't have a lot, and how do I limit my risk? Here are seven steps to become an investor, the low-risk way.
In Pictures: Learn To Invest In 10 Steps
- Determine Your Needs
When thinking about investing, you should first think about how liquid your money needs to be, or how quickly you should be able to access it. How likely are you to have to withdraw it again? Some investments are more liquid (like savings accounts) or easy to convert to cash than others (bonds, for example, often have a fixed term). Liquidity is a large factor in choosing investments, so examine your financial situation carefully before forging ahead.
- Identify Your Investment Goals
What is your goal in investing? Is it to fund a retirement, your child's college or next year's vacation? Identifying these goals will help you determine your risk tolerance, since you'll know how long you'll be investing your money for. Long-term investments have different considerations than short-term ones. (Find out how to reach your long-term goals without becoming a tightwad; read 10 Simple Steps To Financial Security Before 30.)
- Understand Your Risk Tolerance
Once you've identified your goals and how long you're planning to invest your money for, you should determine your risk tolerance. Here's a quick rule of thumb: the higher the return, the higher the risk. If you want to earn 15% on your stock investment, you also have to be willing to swallow the loss if your stock goes south (remember the recent stock devaluation following the housing crisis?). Here's where your goals come into play: a long-term investor can simply ride out these ebbs and flows of the stock market, but someone who needs that money to pay for their daughter's college tuition this year would be financially devastated.
If you are worried about risk, consider investments without a loss of principal - meaning you can't lose the money you've invested - like bonds or certificates of deposit. These investments have a much lower return than stocks, but they may help you sleep better at night. (Learn more about your risk tolerance, read Personalizing Risk Tolerance.)
- Special Risk Consideration: Inflation
An important factor to consider when becoming an investor is risk of inflation. Let's say you're saving for your retirement, and you want to invest low-risk. You've found a certificate of deposit that pays a fixed 3% interest, with no loss of principal - not bad, you think. But what about inflation? Let's say inflation is at 3% (about average) - that means your investment really just managed to keep pace with inflation. For short-term investments, that's OK, but if you're hoping to retire someday, this inflation risk may be more pressing than the fluctuations of the stock market. Think about the term of your goal, and your comfort level with risk before making any decisions on investments. Be sure to factor in inflation when projecting your investment returns - inflation is an unfortunate but guaranteed part of life. (Learn more by reading our Inflation Tutorial.)
- Start Small
Only have a little money to invest each month? That's actually a good thing: investing monthly (called dollar-cost averaging) helps you even out the natural ebb and flow of investments that happens throughout the year. That $50 a month leaving your bank account on payday that you barely notice will add up to $600 a year, plus your return on investment. Starting small also helps you get used to investing and how it works, and will quickly reveal your comfort with risk.
- Do Your Homework
So how do you decide where to invest your money? Do your homework. Spend some time learning about different investment forms and how they perform, minimum investment required and so on. Some mutual funds will waive or reduce their initial investment requirement if you make regular deposits. Find out how each investment has performed in the last year, five years, and ten or more years. You can then match your liquidity needs, goals and risk tolerance that you've determined in previous steps to the right investment.
- Check Up (But Don't Obsess)
Once you've started investing, check on your account's performance regularly. Don't get too caught up in the daily or monthly fluctuations of your investment's return; remember your investment term and goal. If your investment keeps underperforming compared to its counterparts, go back to the drawing board and find somewhere else to invest. Include your investments as you check on your budget periodically.
The Bottom Line
All investment comes with some form of risk. With these steps, you can ensure that you're minimizing your risk by being an informed investor.
Feeling uninformed? Read this week's financial news highlights in Water Cooler Finance: Buffett's Armed and Greece Keeps Falling.