4 Things to Know Before Investing in the Stock Market
Investing for the first time can be confusing. It takes every investor time to develop his or her unique approach. While it won't happen overnight, you can make progress by educating yourself.
This article will cover some of the most important things for new investors to know. Of course, no number of rules or guidelines can stand in for real-world experience. Like with anything, you'll naturally come to understand more about investing as you spend more time in the market, and then picking stocks correctly.
Investing Is a Long-term Process
Some stocks go up and down a lot throughout the year, and novice investors often start out by looking for the next Apple or Bitcoin. Yes, we all want to get in on the ground floor of a potentially life-changing investment. But investing for high, short-term returns typically isn't the best strategy.
With that in mind, new investors should shift their time scale from weeks and months to years and decades. This is especially true if they're entering the market with a view toward retirement. It's more important to identify reliable returns than to look for a single "grand slam" investment.
If you're having trouble with this aspect of investing, resist the temptation to check your portfolio every day or week. Long-term returns are much more important than short-term changes, and a bad quarter doesn't always indicate a bad investment. New investors are generally quicker to react to these factors than those who have more experience with fluctuations.
Just as it takes time to generate returns on your existing investment, it can also take years or decades to reach your desired contribution. People often put off investing because they don't think they have enough to get started. But it's better to make small, consistent contributions than to wait until you have thousands of dollars ready to invest.
Fluctuations Affect Returns
While you shouldn't try to time the market when investing, that doesn't mean that you shouldn't consider the impact of fluctuations. Timing the market is impossible, so it's usually better to mitigate risk than to invest all at once.
Some investors employ dollar cost averaging to help them avoid short-term losses. If you put $6,000 in an IRA in the middle of the year, for example, you could lose hundreds of dollars if the market crashes the next day.
On the other hand, the impact of that loss will be more spread out if you make a monthly $500 contribution. This approach reduces the chance that you'll time the market perfectly, but that shouldn't be part of your strategy anyway.
Some claim that dollar cost averaging isn't the optimal way to invest. That said, if dollar cost averaging is what it takes for you to not try to time the market, so be it.
Diversification Is Key
Failing to diversify is another common mistake new investors make.
Diversifying is the process of reducing risk by investing in several different companies. This reduces the impact of a significant decrease in value for any one company.
The concept of diversification also applies to other domains. If you invest in multiple businesses in the same industry, your portfolio is at risk if that industry experiences a downturn. Similarly, investing in stocks alone rather than a mix of asset classes can result in a poorly-diversified portfolio.
Most financial experts recommend adding more bonds to your portfolio as you approach retirement. Bonds tend to offer lower returns and lower risk compared to stocks, meaning they're great for minimizing short-term risk.
Retirement Accounts Offer Tax Benefits
You can get even more out of your investment by investing in tax-advantaged retirement accounts.
401(k)s and IRAs are the two most common forms of retirement accounts. They each come in standard and Roth variants. Keep in mind that retirement accounts come with certain restrictions. Early withdrawals, for example, are generally subject to a 10% penalty. They may also cause you to lose the tax benefits that made the account worth creating in the first place.
Standard vs. Roth Accounts
Standard and Roth retirement accounts offer different tax benefits. The right one for you depends on your current and future financial situations. The money you put in a Roth account is after-tax, so you won't get any tax benefits in the year you make a contribution. On the other hand, your portfolio will grow tax-free and you won't have to pay taxes on withdrawals.
With a standard 401(k) or IRA, you can generally deduct whatever you contribute from your taxable income. If you put $5,000 of your $50,000 into a 401(k), for example, you'll only pay taxes on the other $45,000. Depending on your tax bracket, that could lead to significant short-term savings.
You should generally prioritize standard contributions if you expect to be in a lower tax bracket when you make withdrawals. Since your income is currently taxed at a higher rate, you'll save money by moving some of your current income into the future.
On the other hand, a Roth account might make more sense if you'd rather get tax advantages after retiring. Keep in mind that outside of a few specific cases, you'll need to wait until the age of 59.5 before beginning to withdraw funds from your retirement account.
401(k) plans are often provided by employers, although self-employed people can access a similar account in the Solo 401(k). If your business offers a 401(k) plan, you should consider contributing up to the limit in order to receive the greatest possible tax benefits. Notice, that there is a difference between 401a vs 401k contributions.
Some companies also match employee 401(k) contributions to encourage saving for retirement. Waiting too long to consider retirement is one of the most common mistakes in personal finance. This is why it's vitally important to start putting money away as quickly as you can.
If your employer matches contributions, there's almost never a good reason not to take advantage of the full match. This allows you to achieve an unmatched return on investment immediately.
Investing in the stock market for the first time might sound complicated. Soon, however, you'll gain more confidence in your approach to investing. These are just a few of the most important things to keep in mind as you start investing.
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