“How much should I invest and where should I invest it?”
The question may be straightforward, but the answer isn’t quite so cut and dry. How much any person or family should invest depends on several factors, including their income, goals, and current financial stability.
However, there are some good practices for investing that you can work to implement regardless of your budget.
Should I be investing 10% of my income?
Many experts say that a good rule of thumb is to invest 10-15% of what you earn. While that’s a great starting point, personal finance is never as simple as a one-size-fits-all formula.
New investors often wonder about the balance between saving vs. investing, asking questions like “How much of my savings should I invest? Should I invest all my money, or should I split my excess income between savings and investments?”
In order to answer those questions, we first have to look at the differences between saving and investing.
|Savings Account||Investment Account|
With those differences in mind, your first course of action should be to build up an emergency fund in a traditional savings account. That way, you’ll have money available in case something happens, like your car breaks down or you have to replace the refrigerator in your home.
If you’re paying off high-interest debt, such as credit cards or private loans, then a $1,500 to $3,000 emergency fund is a good place to start. Once you’ve at least paid off your high-interest debt, aim for an emergency fund of 3 to 6 months worth of your living expenses.
How much should I invest in my 401(k)?
Once you have an emergency fund, the next place you should focus your investment efforts is your 401(k). Many employers offer to match employee 401(k) contributions up to a certain percent.
For example, a 2% match means that if you contribute 2% of your salary to your 401(k) account, your employer will throw in an additional 2%. However, if you continue to add to your account, your employer will not match contributions above the set limit.
Say you make $50,000 with a 2% 401(k) match. If you contribute $1,000 to your 401(k) — 2% of your annual salary — your employer will add an additional $1,000. If your current employer offers a 401(k) match, then you’re turning down free money by not contributing to your account.
However much your employer offers to match in 401(k) contributions is the minimum you should invest in that account. If it’s 1% of your salary, then you should be contributing a bare minimum of 1%. If it’s 3%, you should contribute at least 3%.
Employer matching in a 401(k) is literally free money for your future and an immediate 100% return on your investment. If you can’t afford to contribute the maximum amount your employer matches, find places to make cuts in your budget and increase your contributions.
Talk to your boss or the human resources department for details on your company’s 401(k) program.
How much should I invest in stocks and other accounts?
Once you have an emergency fund and you’re maxing out your employer match for your 401(k), what comes next?
This is where the hard-and-fast rules end. The next step varies depending on your situation, goals, and where you are on your financial journey. There’s no right answer for everyone.
At this point, you might want to consider opening an individual retirement account (IRA). When it comes to IRAs, there are two types to choose from.
A Traditional IRA works much like a company 401(k) in terms of taxes. In other words, you don’t pay taxes on the money you contribute today. You’ll only pay taxes once you withdraw the funds in the future.
A Roth IRA is the opposite. You pay taxes on your contributions today, but then you withdraw money tax-free in the future. This is ideal if you expect to be in a higher income tax bracket later on. Since income tends to increase with age and experience, that’s often the case.
You can open an IRA online or at your local bank in just a few short minutes. Keep in mind, there are limits to how much you can contribute to individual retirement accounts per year. Once you’ve reached this limit, you might want to consider opening a brokerage account and investing in the stock market.
While there’s no one right amount to invest, it can be helpful to set goals in terms of a percentage of your income. For example, let’s say your goal is to invest 10% of your annual salary. If you make $50,000 per year, you would aim for $5,000 towards your investment accounts.
However, you always have the option to increase this number. Once you’re comfortable investing 10% of your income, challenge yourself to invest 13%, then 15%, 20%, and so on. The more you invest now, the faster you’ll reach your financial goals.
How much should I risk with my investments?
The amount of risk you should take depends on your goals, risk tolerance, and investment timeframe.
For example, a 24-year-old who plans to retire at 60 has 36 years to invest. Since they won’t need their money for several decades, they can afford to take on more risk today. On the other hand, someone who is 55 has a much shorter investment timeframe. Therefore, they’ll want to take on less risk in order to protect their money.
Regardless of your age, one of the best ways to protect your investments is to create a diversified portfolio. In other words, you’ll want to own a variety of different types of investments. That way, your success isn’t dependent on just one thing.
For example, you wouldn’t want to invest entirely in software companies because they each face many of the same risks. A swing in the technological landscape could wipe all of your investments off the map.
A diversified portfolio means investing in companies across a variety of industries.
In addition to the types of investments you choose, you’ll also need to decide how much to invest in each type of asset. The three main asset classes are stocks, bonds, and cash.
Each one comes with its own set of risks and potential returns. Generally speaking, however, greater risk equals greater reward.
If you’re younger and have more time to build up your savings before retirement, you might prefer an asset allocation of 85% stocks and 15% bonds. As you get older, your allocation will likely shift to fewer stocks and more bonds to shield against drops in the market.
Is investing 10% of my income really enough?
Again, the amount you should invest depends on your current financial situation and goals.
Thanks to the snowball effect of compound interest, the earlier you start investing, the less you’ll need to save overall. Saving 10% of your income could be plenty if you start investing early enough. On the other hand, if you waited to invest and are catching up, you may need to save 15% or more in order to reach your goals.
Should I invest monthly or yearly?
Whether you invest monthly or yearly comes down to personal preference. For most people, however, monthly is the better option. That way, you can build investing into your monthly budget.
Investing monthly also gives your money more time to work for you. If you start setting money aside in January, but only invest it once yearly in December, the money you save in January, February, March, and so on won’t earn a return until after December when it’s invested.
The exception is if you plan to receive and invest a lump sum, like a holiday bonus or tax return. Even so, it’s still a good financial practice to build saving into your monthly budget.
How Much Should I Invest? That Depends on You.
Knowing exactly how much to invest can be tricky. Like everything in personal finance, it depends on your budget, goals, and financial situation. The most important takeaway is that it’s never too early to start investing. If you haven’t started already, now is the perfect time.
Even if you can only swing a few dollars a month, you can begin to build a habit that will change the rest of your life.
The post How Much Should I Invest and Where Should I Invest It for the Greatest Return? appeared first on DollarSprout.