Retirement Basics to Know Before You Start Investing
I started saving pretty early and made only a few investment mistakes that weren't unrecoverable. I could say my success was due to my high intelligence, but the truth is that it's more the result of writing about personal finance and spending much of every day reading and learning about the subject. In other words, I prepared.
Still, there are a few improvements I could have made at the start of my career that would have made the journey to financial independence easier. If I could begin the process of investing for retirement all over again, here are the steps I would have taken:
Start putting as much as possible into a 401(k) and Roth IRA. With yearly limits and income phase-outs, many people wish they made maxing out these tax-advantaged accounts a higher priority earlier in their career. The beauty of this tax break is not only will you save money on taxes either at the time of contribution or withdrawal, but none of the earnings are taxed while the money stays within the account. If you don't start putting money into retirement accounts at the beginning of your career you are missing out on decades of compounded tax-free growth.
Keep investments simple. There are a few stocks I wish I didn't buy. It's not that they were bad investments. In fact, the problem is that they were great ones. But I can't get rid of them to simplify unless I pay a sizable portion of the gains to Uncle Sam. Many people have all kinds of investments in their accounts, but it will be costly to one day consolidate to a more appropriate set of investments due to taxes. It's better to start off simple, because then you won't have to deal with investment bloat when they all become too complicated and time consuming to handle.
Learn about passive low-cost index funds, and then compare that with active management. No matter what you ultimately believe is the right approach to take, you should at least consider the merits of both strategies and decide for yourself. Figure out why it's better for you to invest in passive or active funds before you start investing. Otherwise, taxes will make switching extremely expensive.
Beef up your knowledge of investment taxes. The details are complicated, but make an effort to understand how each investment is taxed before you invest so you can put your money in the best accounts to maximize your after-tax benefit and minimize tax filling hassles. Remember to look up how your state treats different investments in addition to federal taxes to get a complete picture of potential investment taxes.
Be prepared to deal with risks when they show up. One of the most important aspects of investing is to understand the investments you own. You need to figure out the risks ahead of time so you don't panic when they show up. When should the investment be expected to lose value? What's the worst case outcome? Can you deal with that disaster scenario? If you can't stay calm when the risks happen, then the investment may not be appropriate for you.
Have a reaction plan. One of the most beneficial moves you can make is to determine how you will react when scenarios that are expected to happen play out. What do you plan to do with your portfolio when stocks drop 20 percent or more? What if your bonds lose 20 percent? Would it make sense to sell then or should you buy more? By worrying about this before everyone is screaming that it's the end of the world, you can better vet the likely outcomes and chart the most beneficial path for your situation.
Write the plan down. It's much easier to read it back to yourself and follow your own instructions than to try remembering everything when you may be losing sleep because of a nasty bear market.
Continuously read and revise your investment strategy. As you keep learning, you'll have an even better understanding of your investments. Maybe you will realize the funds you invested in long ago aren't the most ideal place to put your money now. Or maybe you will find out the investments you made turned out to be perfect, so no changes are needed. If nothing else, you'll remind yourself why you picked the investments you did, which will help you sleep at night should the market turn against you.
It's a tall order to expect any young person starting out to know exactly how to make the right financial moves, let alone invest properly. But every young adult would be better off if he or she learned how to invest before actually making investments.
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