The Ultimate Guide to Personal Finance – Part 4:

Start to invest –
simply and effectively

I'm about to share the investing advice I wish I had when I first started learning about money. Back then, I tried to “beat the market,” and lost half of my very first college scholarship check.

So if you've ignored your retirement account until “later” or thought about picking stocks based on how “hot” they are at the moment, this section is for you.

You'll learn how to invest your money for the long-term (without worrying about stock prices every day) – all clearly laid out and easy to understand.

Why most people don't invest

(and they'll never be rich)

A lot of us are simply scared to put our money in the market. And for the most part, we have every reason to feel that way.

On one hand, you have media moguls who scream financial crisis at even the slightest dips in the market to drive up their ratings.

On the other hand, we've just come out of one of the biggest stock market crashes in generations. Some of us have even watched our families and friends be forced to keep working instead of retire on time.

All that really is scary. But, if you believe the market will recover (which it has) and grow over the long term, you need to be investing consistently.

Other reasons people don't invest? “I don't have time” and “I don't want to lose money”.

I get it. Nobody just LOVES spending time managing their money and, certainly, nobody likes losing it.

But I've taken the pains to research investment strategies that don't take lots of time to maintain and can still pay off in a major way.

One quick note: when it comes to investing, nobody can guarantee returns, and if they do, you should probably run the other way.

But if you believe that the market will – over the long-run – continue to recover and grow, you should keep investing.

(Or start by setting up your accounts today)

Consistency is the key and we'll talk about how you can do that with minimal effort using a complete investing system. And trust me there's no better time to start then today.

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The biggest investing myth

(and best time to start)

One of the biggest myths about investing is that you have to be a super smart, stock-picker to make money.

This drives me nuts because it's simply not true.

The 3 most important investment factors | The Ultimate Guide to Personal Finance
3 most important factors for investing: 1. do your research, 2. be disciplined, 3. start early
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I want to hammer home the last bullet because starting early gives you 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 30 years compared to your 10 years) – you will have way more money (over $50,000 more) than him at age 65.

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.

Start early and you will be rich.

The importance of investing now…

You're not getting any younger

What if you had started investing $10 per week five years ago, receiving an average 8 percent return? Guess how much you'd have?

It turns out that by now, you'd have thousands of dollars – all from investing a little more than $1 per day. Think about that $10 a week – where did it go, anyway?

If you're like most people, it probably slipped through your fingers on random things like cab rides and lunches. Despite wild rides in the stock market, with a long term perspective, the best thing you can do is start investing early.

If you invest this much per week… After 1 year, you'll have… After 5 years, you'll have… After 10 years, you'll have…
$10 $562 $3,295 $8,136
$20 $1,123 $6,589 $16,271
$50 $2,808 $16,473 $40,678

And the number one money-related regret for older people is not investing early!

I'm not a old man yet, but when I see these numbers, it's tempting to run around with a cane and a vodka tonic in hand, screaming at young people. Not only do we fail to invest our money, but we don't even know why it's important!

Age of employee Percentage who participate in a 401(k) Percentage of pay they contribute Median balance of their 401(k) My comment
18 – 25 31.3% 5.6% $1,280 Too busy watching The Hills.
26 – 41 63.1% 7.2% $14,730 These people have realized that perhaps saving money is important
42 and up 72.0% 8.3% $44,330 These older folks are wishing they could go back in time and beat themselves for not saving more, like Biff in Back to the Future II

Key takeaway

(even if you're not super young)

No matter what stage of life you’re in, the most important thing and my goal is to get you started and make it easy to maintain your investments.

By doing just those two things you'll be on the way to getting rich.

And setting up your investment accounts is an excellent first step toward actually investing (we'll cover how you can below).

But, the first thing to note is that you don't have to be rich to open an investment account.

Most account providers actually waive the minimums if you set up automatic transfers (which is what we're all about).

Investing is NOT about stock picking

Really it's not. Nobody can reliably pick stocks that will outperform the market over the long term. Thinking you can beat the market is an easy way to make mistakes and become overconfident in your abilities.

Even “experts” cannot guess where a stock will go next. Just turn on CNBC and watch the dazzled looks on the pundit's faces when they make a wrong call on a stock.

Plus, having to pay attention to the latest hot stock or every micro-change in the market is risky and involves a lot of guesswork.

I prefer investing in low-cost, diversified funds consistently, rather than chasing stocks and relying on guesswork to get through.

That's the same strategy recommended by Nobel Laureates and billionaire investors, like Warren Buffett.

With this strategy, you can effectively trick yourself into investing because it requires no work on your end.

Setting up your accounts

The magical benefits of retirement accounts

Many people mistakenly think that retirement accounts are just places for you to save money until you're 65.

Actually, they offer you humongous benefits if you agree to save for a long-term horizon. Let's compare regular (taxable) investment accounts with retirement accounts.

Regular investing accounts

When you open up an account at ETrade, Scottrade or whatever, you're generally opening up a regular investing account, which is also called a taxable account.

This means that when you sell your stocks, you'll pay taxes on your gains – and if you sell your stocks in less than a year, you'll pay a huge amount (regular income-tax rates, like 15% or 30%).

Let's not get bogged down in the details, okay. As we talked about early, buy-and-hold investing wins over the long term. And because of the way taxes are structured, you pay a penalty for trading too frequently.

But there's an even stronger advantage to holding your money for longer – say, until retirement.

Retirement accounts

Retirement accounts, quite simply, give you huge tax/growth advantages in exchange for your promise to save and invest for the long term.

Now, this doesn't mean that you have to hold the same portfolio for 30 years. You can buy and sell shares of almost anything as often as you want. But with a few exceptions, you have to leave the money in your account until you get near retirement age.

Here's how the
magical benefits work:

In a retirement account, you get big tax benefits. While 10% or 20% may not seem like much in 1 year, when you compound that over 30 years, it becomes a gigantic amount.

In fact, if you were to start a retirement account next week, two things will happen: (1) You will be more financially prepared than 99% of your peers, and (2) you will be rich.

Yeah, I said it: If you start a retirement account in your early 20s or 30s and fund it regularly, you will be rich.

Let's look at a simple comparison of investing in a retirement account vs. just investing in a regular, taxable account:

Don't worry about the exact amounts. Just notice the difference in how much you earn - especially at the end.

A retirement account - whether it's a Roth IRA, 401(k) or something else - lets your money grow at an accelerated rate with hardly any extra work from your end.

Now let's get into the details.

Mastering your 401(k)

(How to get free money and get rich)

A 401(k) is a type of retirement account. If you work for a company, chances are you already have a 401(k) offered to you.

Here's how a 401(k) works: You put pre-tax money into the account, meaning you haven't paid taxes on it yet.

Let's look at why that's important. In regular, taxable investment accounts, you pay taxes on your income and then invest it.

So for every $100 you make, you might actually only be able to invest $85 of it. 15% (or whatever, depending on your tax rate) goes to the tax man.

A 401(k) is different. You can invest the entire $100 and let it grow for about 30 years. That extra ~15% turns out to make a huge difference as it gets compounded more and more.

401(k) matches

There's an extra benefit, too: Your company might offer a 401(k) match.

For example, a 1:1 match up to $2,000 means that your company will match every dollar you invest up to $2,000; therefore, investing $2,000/year really means you're investing $4,000/year. Woah.

Real numbers: Why you should always invest in your 401(k) | The Ultimate Guide to Personal Finance

This is free money and you absolutely, positively need to participate if your employer offers a 401(k) match. It doesn't matter what kind of debt or expenses or whatever you have – if your company offers a match, do it.

So what exactly happens when you contribute money to your 401(k)?

Basically, it goes into an investing account where a professional investing company manages it. You can choose from a bunch of different investing options, like aggressive, mixed, international, etc. Honestly, it's like McDonald's for investors: anyone can do it. The hardest part is making the first phone call to HR to get it set up.

Summary of the 401(k) advantages:

There are a lot

You get to put pre-tax money to work (i.e., money you haven't paid taxes on yet, so there's more of it to grow).

Your company might offer an insanely lucrative 401(k) match, which you must take.

And it's not that hard to set up – your company does most of the work. In fact you can instruct them to automatically withdraw a certain amount from every paycheck.

Don't worry about switching jobs: if you leave your company later, you can take your 401(k) with you.

And be aggressive with how much you contribute to your 401(k) because every dollar you invest now is worth many more times that in the future.

401(k) restrictions

The 401(k) isn't tax-free, though. There are a few restrictions.

  • First, the government has to get its tax revenue sometime, so you'll pay ordinary income tax on the money you withdraw around retirement age. (Remember, though, that all that money has been growing “tax-deferred” for ~30 years.)
  • Second, you're currently (in 2015) limited to putting $18,000/year in your 401(k). Third, and this is important, you'll be charged a big penalty of 10% if you withdraw your money before you're 59.5 years old.

This is intentional: This money is for your retirement, not to go out drinking on Saturday.

You can call up your HR representative on Monday and get enrolled in your 401(k).

Start an automatic-payment plan so money is taken directly from your paycheck.

Mastering your Roth IRA

If you want real wealth in your retirement, you absolutely need a Roth IRA. It's another type of retirement account.

And every person should have a Roth IRA. It's simply the best deal out there for long-term investing.

Remember how your 401(k) uses pre-tax dollars and you pay income tax when you take the money out at retirement?

Well, a Roth IRA is different than a 401(k). A Roth uses after-tax dollars to give you an even better deal. With a Roth, you put in already taxed income into stocks, bonds, index funds – whatever – and you don't pay when you withdraw it.

Here's how it works:

When you make money every year, you have to pay taxes on it. With a Roth, you take this after-tax money, invest it, and pay no taxes when you withdraw it.

If Roth IRAs had been around in 1970 and you'd invested $10,000 in Southwest Airlines, you'd only have had to pay taxes on the initial $10,000 income.

When you withdrew the money 30 years later, you wouldn't have had to pay any taxes on it. Oh, and by the way, your $10,000 would have turned into $10 million.

Think about it.

You pay taxes on the initial amount, but not the earnings. And over 30 years, that is a stunningly good deal.

Roth IRA Restrictions

Again, you're expected to treat this as a long-term investment vehicle.

You are penalized if you withdraw your earnings before you're 59.5 years old. (Exception: You can withdraw your principal, or the amount you actually invested from your pocket, at any time, penalty-free. Most people don't know this.)

There are also exceptions for down payments on a home, funding education for you/partner/children/grandchildren, and some other emergency reasons.

And there's a maximum income of $181,000 to make full contributions to a Roth. But you can read about those later.

What's the big takeaway from all those restrictions and exceptions? I see 2 things:

First, you can only get some of those exceptions if your Roth IRA has been open for 5 years. This reason alone is enough for you to open your Roth IRA on Monday.

I want you to research it this weekend, and I want your Roth IRA opened by next week.

Second, starting early is crucial. I'm not going to belabor the point, but every dollar you invest now is worth much, much more later. Even waiting two years can cost you tens of thousands of dollars.

Currently, the maximum you're allowed to invest in your Roth IRA is $5,500 a year (updated in 2008). I don't care where you get the money, but get it. Put it in your Roth and max it out this year.

These early years are too important to be lazy.

Open your Roth IRA

It's easy. You can go through your current discount brokerage, like E*Trade or Scottrade.

I created a video to help you show how to choose a Roth IRA

I recommend an independent service like Vanguard.

Next steps, call them up, tell them you want to open a Roth IRA, and they'll walk you through it.

Special note: These places have minimum amounts for opening a Roth IRA, usually $3,000. Sometimes they'll waive the minimums if you set up an automatic payment plan depositing, say, $100/month.

Shop around though.

Once your account is set up, your money will just be sitting there. You need to do things then:

First, set up an automatic payment plan so you're automatically depositing money into your Roth. How much?

Try doing as much as you're comfortable with, plus 10%.

Second, decide where to invest your Roth money. I recommend low-cost, diversified index funds as the best option or target date funds.

Here's a quick illustration of the power of continually adding money to your investment account:

401(k) or Roth IRA

The simple answer is both: These accounts, while conceptually different, work together pretty well.

Here's how I think about it.

First, I would max out any 401(k) match that my company provides. Second, I'd max out the $5,500 for my Roth IRA. Third, I'd max out the rest of my 401(k), up to $15,000. Finally–if your employer doesn't offer a 401(k), you're not employed yet, or you still have money left over–I'd open a regular, taxable investment account and put money there in stocks, index funds, etc.

Why max out your Roth IRA before your 401(k)?

Well, there's a lot of dorky debate in the personal-finance world, but the basic reasons are taxes and tax policy: Assuming your career goes well, you'll be in a higher tax bracket when you retire, meaning that you'd have to pay more taxes with a 401(k). Another common reason for the Roth is that tax rates are considered likely to increase.

Remember: Your 401(k) money is taxed at the end, while Roth IRA money is taxed right away and then grows tax-free.

What to do today.

When it comes to money, it's very easy to end up like most people – just doing nothing.

So let the fools debate.
For you, just get your accounts open.

Next steps

There's a ton to cover here about making the most out of these accounts. I go into even more detail in Chapter 7 of my New York Times best-selling book, I Will Teach You To Be Rich.

You can get the entire chapter, free, below. In it, I cover the nitty-gritty of maintaining your investment accounts easily, asset allocation, and rebalancing your portfolio to maximize return.

I Will Teach You To Be Rich book cover

You can download the chapter for free here:

Start to invest – simply and effectively | The Ultimate Guide to Personal Finance