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2006 Makeover, Step #3: Thinking about Investing

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This is step 3 of my 2006 financial makeover (see step 1 & step 2).

Today, we’re going to start the process of investing. I’m also going to try to give you some ammo to tell your friends who are earning money–but aren’t investing any of it. So by the end of the article, you’ll know how to get started investing and you’ll be able to mock your friends. Happy Friday!!

The Final Word on Budgeting
But first, let’s finish doing our budgets. I’ve spent a lot of time on budgets in these articles because they’re really important. In step 1, I talked about figuring out how much money you’re spending. In step 2, we went in-depth on the budget, adding irregular events and more details. By now, you should understand your spending a lot better–in fact, you should be able to take the top-down approach of saying “I’m going to spend $300 on food this month” as opposed to “I guess I spent $850 on food last month” (sob).

This is the last time I’m going to talk about budgets for a while. But before we move onto opening an investment account, I want you to make one small change to your budget. You know how much you need to live every month; this includes not only necessities like rent, but also money for going out, etc. It’s fine to add a little extra until you get a more exact monthly amount. Now, you need to decide how much you’ll save every month (“savings” here includes mid-term savings and long-term investing money).

For example, let’s pretend you make $4,000/month (I’m completely avoiding taxes in this example). If it costs you $2,500/month to live, you have to decide what to do with the rest of your money. Remember, earlier I urged everyone who’s single to save at least 20-30%, and more if possible. Now here’s what you do:

Pay yourself first. Figure out how much you’re going to save each month, and treat it like just another bill. Seriously, in your budget, add an extra expense called “Saving” and pay yourself. If you can’t pay yourself that month, then you have to either cut some costs or earn more money. This is easier than you think: You can instruct your bank to automatically withdraw a certain amount out every month.

This is why I had you open a savings account last week.

If you want more information on the logistics of doing Pay Yourself, the author of Stackbacks.com has a great PDF with details of how to set this up.

Summary: In your budget, add an extra expense called “Saving.” Figure out how much you want to save (be aggressive) and pay yourself every month. Ideally, for easy tracking, your savings account should be in a different place than your checking account.

Result: At the end of every month, your bills are paid, your savings account has grown, and you know exactly how much you can afford to spend on every category in your budget. Congratulations.

Why Becoming a Millionaire Isn’t That Hard
Investing in the stock market is a fantastic way to make money over the long term (even better than real estate). But it takes a few hours of thinking and some deep research, so a lot of people get scared off.

One of the biggest myths about investing is that you have to be supersmart to make money. This drives me nuts. The 3 most important factors are these: Do your research (yes, you have to read some numbers), be disciplined (consistently put money away), and start early. Starting early is a monster advantage. Here’s why:

If you’re 25 years old and you save $100/month until you’re 35 (for only 10 years, then you never save money again), and your dumb friend starts later–saving $100/month from age 35 to 65 (that’s 35 years compared to your 10 years)–you will have way more money (over $50,000 more) than him at age 65. Start early and you’ll be rich.

It’s not hard to become rich. But it takes work and consistent saving, and so it’s easier for a lot of people to shrug their shoulders and put it off for another day. Unfortunately, every extra year you wait to start investing makes it dramatically harder to make the same amount of money. Also note: The $300 you spend on that iPod is actually worth many thousands of future dollars. See for yourself how it works (check the chart at the end of the page).

Next Steps: Read a Little, Open an Investment Account
1. Read a few articles I’ve written about stocks, bonds, and mutual funds, where I talk about which asset classes are good and bad for us, and how to pick them. They’ll help next week when we start looking at how to invest. Post any questions you have and I’ll try to answer them here.

2. Open an investment account at a discount brokerage. I don’t care which one you choose (try Googling “discount brokerage” for the most popular ones). How do you tell which one you should get? Make sure you can get someone on the phone; that’s really important, especially when you’re starting out. Just give each of them a call and tell them you’re looking for a discount brokerage, and why are they good compared to others?

Also note that they have varying trading fees. Yes, you should compare them, but if it’s a $10 difference, don’t worry about it–go with which one makes you comfortable. However, the trading fees are important for one thing: Many of you will start investing with smaller amounts, so you don’t want to invest $100 and have 25% eaten up by trading fees. When you call them, ask them if they have student accounts or if they’ll waive fees if you automatically send a consistent amount every month (many will).

3. By next week, have your investment account set up. Bonus points if you’re ahead of the game and you already electronically transferred some investment money there (it will just sit there, earning a little interest, until you decide where to invest).

Post your questions here and I’ll try to help.

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40 Comments

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  1. First off, I’m 22, I want an IRA. Secondly, while I can contribute regularly (a couple hundred a month) I can’t contribute large amounts.

    Would it be a good idea to (after some research) pick out some no load stock index fund such as Vanguard’s S&P 500, and just put it on monthly automatic deduction every month? Let that be my entire investment for a few years and let it build up? I know there are higher fees for lower balances, so investing in lots of different index funds seems a little silly.

  2. You’re thinking the right things. I’ll cover Roth IRAs soon, so stay tuned.

  3. Good writeup. The only qualm I have is with the idea that the stock market has better returns than real estate. The referenced article gives a 10% return rate that only counts capital gains. Two important aspects of RE investment that it ignores is the current income produced by either charging rent to tenants or by saving money on rent yourself and the effect of being leveraged. When taking into account these two effects real estate provides a much higher rate of return.

  4. Your website has inspired me to work on my budgetting skills, I have made a budget/expence tracking for personal and another for bussiness purposes.

    Im interested in getting into stock, Can you recommend some good sources to learn Stock Research

  5. Also, what do you do if you are dead sure your parents aren’t saving enough and won’t ever be saving enough for a good retirement and you may well be the main support? I figured step 1 would be fund up your own retirement as fast as possible so that if you’re forced to cut back on contributions later it’s not a problem, but what would step 2 be?

    P

  6. As far as discount brokerages go, I would recommend IZone, a subsidiary of Ameritrade. Though this is for experienced investors, if you answer the questions intelligently while opening an account, you should have no problem opening an account with them. Its a bare bone service and they charge only $5 per trade. I think its necessary that we try and minimize the amount one pays towards brokerage fees thus maximizing your profit.

    http://www.izone.com

  7. http://www.izone.com says…
    “You maintain an account value of at least $5,000” under “In Exchange For” on http://www.izone.com/savings.html

  8. Your site is now my default homepage; keep up the good work.

    I have read many articles that discuss the power of compound interest, and I am always put off by the fact that a certain rate of growth is ASSUMED. What guarantees that 6%, 8%, or 10% growth will actually occur over the long haul? If you have a timeframe of 30 years or so, what is to say that we can’t have a 30 year bear market, or at least a bearish enough market for a long enough period of time to wipe out gains?

  9. Should one think about which company/area they’re going to invest before openning an investment account at a discount brokerage?

  10. You posted a great article Ramit. What actually constitutes a “discount broker”? Is it the amount they charge per trade? I currently have an account with scottrades, they charge $7 a trade, no minimum balance.

    Question number 2; can a person have more than 1 retirement account if they can contribute to it? Can I have both a 401k, IRA, and another retirement account? What about 2 IRA’s?

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