Step #1: Create A Plan
If you don’t have a plan, how do you know where you are going? Better yet, how do you know you even succeeded? You don’t. When it comes to investing, having a plan is crucial. Most investors jump around from investment to investment. They never see any real increase in their portfolio values so they give up investing. They think the stock market is rigged against them. What most of these investors fail to have is a plan. If they had a plan to follow (and they followed it) they would be successful.
By having a plan, you can assess if you are on track to meet your investment goals. If you find your are not, and investment plan helps you to make changes along the way.
Here are the questions you should ask yourself when putting together your investment plan. Don’t worry, creating your plan isn’t difficult to do.
Why Are You Investing? The first question you need to ask is why you are investing in the first place. Is it for a house, a vacation, wedding, early retirement, child’s college education, etc.? If you plan on investing for more than one goal, this is OK. Write down the various goals but keep them separate and answer the following questions.
What Is Your Time Horizon? In other words, how long will it be until you need the money you are planning to invest? For retirement, you would tend to have a long time horizon, up to 40 years depending on your age. But for a house or vacation, your time frame is going to be much less.
The general rule of thumb is to invest in stocks for any goal that is more than 5 years away. Any goal shorter than this should have money invested in bonds or in cash instruments. Think certificates of deposit or savings accounts. Below is a chart for you to follow so you know where you should invest your money. It is based on when you will need to money you are saving:
time-horizon
What Is Your Risk Tolerance? You have your goal and you know when you need the money. Now you have to figure out how to invest it. I mentioned above that if your time frame is greater than 5 years, you should invest in stocks. But just how much of your portfolio should be in stocks? This is where you have to be honest with yourself.
You want to find an allocation that helps you reach your goal, but one that you are comfortable. We all want to sleep at night, right? Aren’t sure what your allocation should be? I suggest you read my post on understanding risk tolerance. Also check out this questionnaire from Vanguard that will help determine your risk tolerance.
One note about taking a risk tolerance questionnaire. Make sure you focus more on the amount of money you could lose versus the amount you can gain. We all will take more risk to earn extra money. But we discount how we will feel if we lose money. When the stock market drops, we freak out because we didn’t assess our risk tolerance correctly. This is why you need to be honest with yourself. There are no wrong answers when it comes to your risk tolerance.
You will find most of you should be investing in a 60% stocks and 40% bond portfolio. This allocation will allow for you to earn a good rate of return on your investments. It will also allow you to sleep at night.
Should you find that 60% of your money in stocks is too risky, then reduce that to a 40% stocks and 60% bonds portfolio. You don’t want to go much lower than this if you are young. The reason is over the long term, bonds will not offer the return that you need to reach your goals.
How Much Do You Need? Of course, you need to know how much money you need to save if you ever want to reach your goal. For a house or a vacation, the amount you need to save is easy to determine. You know how much a vacation will cost you or how much of a down payment you need for a house.
For retirement, it’s a little bit harder. Here is a rough calculation for you to perform that will give you an idea of how much money you need to save:
Figure out how much you spend on a monthly basis now
Subtract out any obvious costs that you won’t have when in retirement. This includes things such as supporting young children or life insurance premiums
Add an extra 10% as a cushion
Multiply the leftover amount by 12 to annualize the number
Multiply the annual number by how long you will be in retirement for (95 minus your retirement age)
It’s not an exact number, but I would rather have too much money than be broke at age 75.
How Much Can You Save? Once you know how much you need to save, you need to figure out how much you can save each month. Don’t give up or become frustrated if you realize you can’t save as much as you need to save to meet your goal. You have time on your side.
Regardless if you can save enough each month or not, you should make it a priority to create and follow a budget. I know some of you hate the idea of a budget, but hear me out.
By creating a budget, you can see where all your money is going. This can be a real eye-opener for most people. When we created our budget, we were amazed at how much we were spending on eating out. We enjoy eating out, but didn’t realize just how much we were spending until we created a budget.
After you create and follow your budget, you can better assess your spending and saving. Who knows, you might even be able to save more money! More on this below.
Now, how do you get started with a budget? You can go the manual route or the automated route. For the manual route, check out this post which highlights great excel spreadsheet templates.
For the automated route, you can go with You Need A Budget. There is a learning curve to YNAB but many swear by it. And if you want to buy it (it does cost money), by clicking on the link above, you save 10%. Note that YNAB is changing to an online model with a monthly subscription price. The discount above only apples to the software download.
Back to saving more money. Once your budget is set up and you see where your money is going, you can start looking for ways to save more. Can you cut your monthly expenses? Can you turn a hobby into an income stream?
When it comes to cutting expenses, I recommend starting with the big expenses first. Look at insurance, mortgage, etc. and then focusing on the smaller expenses. For me, I shop around our insurance coverage each year. Most years we stick with the same insurer. But every couple of years, we switch. We end up saving $200 on average. Not bad for 30 minutes of work.
As for income, work hard so that you become invaluable at work and can earner higher raises. At the end of the day, you can earn a lot more money than you can cut out of your budget.
Creating An Investment Plan: Real Life Example
Here is a step by step example of how creating an investment plan would work. The information in the parenthesis are the steps in creating an investment plan.
Why Are You Investing? Bob wants to save for retirement. He is tired of waking up to an alarm every day and spending 8 hours there doing something he doesn’t enjoy. Plus the 1 hour commute stresses him out. He wants to quit his job and work on a hobby that will bring in a little money each month.
What Is Your Time Horizon? Bob will need the money in 30 years. He would like to retire sooner, but after thinking things over, 30 years allows him to save and invest and not have to worry how much money his hobby earns each month.
What Is Your Risk Tolerance? Bob is a middle of the road type of guy. He doesn’t like a lot of risk. As such, he is investing in a portfolio of 60% stocks and 40% bonds.
How Much Do You Need? Bob estimates his monthly expenses are $3,000. Multiplied by 12, his annual expenses are $36,000. He plans to retire at 65 and live to 95 (this should be your ending age as well). He takes his $36,000 and adds in 10%. He then multiplies that by 30 years to get a final number of $1,188,000 (how much he needs).
Finally, Bob has to determine how much he should save. He backs into this number by using this calculator.
He enters in the following values into the calculator:
Starting Balance: $1 (or how much you already have saved for your goal)
Interest Rate: 8% which is the historical average return of the market (assuming a 60/40 portfolio; if you have a lower percentage of stocks, drop this to 5%; don’t use a number higher than 8% to be safe)
Compounded: Monthly
The above numbers will stay the same as he runs his calculations. For the “Number of Years” field, he enters how long he has until he needs the money. Finally, he enters an estimated amount for the “Monthly Deposit” field. He then clicks on the calculate button.
He guesses at the “Monthly Deposit” number and recalculates until he gets a result that meets his needs. In his case, he needs to save $800 per month. (Don’t get scared by this number. We’ll see in Step #3 that this amount isn’t that much.)
Would you be OK with a mechanic working on your car before you even tell them why you are there? No! You want to tell them why you are there in the first place so they can ensure your car gets fixed and is reliable.
The same holds true with investing. You can’t just start picking investments and think all will be fine. You have to first figure out your goals and create a plan. Take the time to figure out your goals so you can put your money where it makes the most sense in a way that aligns with your plan.
Step #2: Open Your Account
I know, it’s basic, but hey, we need to cover it. You have all sorts of options when it comes to investment accounts. You can choose a place like Vanguard, which I love, but you need to have a decent amount of money at the start. To open a new mutual fund you need $3,000 which many don’t have. Because of this, I recommend a handful of online brokers here.
I use Vanguard, Betterment and Schwab. I love Schwab for its large selection of no load/no fee mutual funds. I can invest in these with much less money than Vanguard. For example, $500 is the minimum for most funds.
For Schwab funds, you only need $100 to start. Schwab also offers a handful of exchange traded funds (ETFs) that you can trade without paying a commission. What’s not to love about that?
When it comes to Betterment, I can’t say enough good things. You can skip half of the work in the investment plan creation step when investing with Betterment. Why? Because they do it for you. In 10 minutes you can open an account, select a goal and set up an automatic transfer and you are done.
Just as awesome, you’re diversified from the start and the fees are super low. In other words, if you just want to start investing with the least amount of work possible, Betterment will do all the work to make you a stock market millionaire. It’s exactly like the commercial below, if Carbonite were Betterment:
Of course, there are other options as well. If you want a hands on approach and want to invest in stocks, then M1 Finance is for you. With M1, you can invest in stocks completely free.
Step #3: Set Up Automatic Transfers
Once you have your account open, you need to set up a re-occurring transfer into your account each month. All the investment options I listed above allow for ongoing transfers. If you want to become a stock market millionaire, you need to invest in the stock market on a regular basis. You can’t just invest $1 and wait for it to become $1 million.
I say that because if you invest $1 and it grows at 8% annually, it will take 173 years until you become a stock market millionaire. I hope you see the problem with that.
But, if you invest $100 monthly and earn 8% annually, it will take you just 53 years to become a stock market millionaire. Now we are talking!
The great thing is that I can show you how to reduce that time even more. Do you want to know how to become a stock market millionaire in just 30 years? Here’s how. Save $667 per month and invest it in the stock market. Before you get choked up on that number, hear me out.
The average U.S. income is $40,000 per year (here is the median U.S. household income). If you contribute 10% of your salary into your 401k, you are saving $333 each month. That leaves you with just $334 to invest after tax. (I didn’t include employer matches in this since some people don’t get employer matches. If you do, then you’ll be a stock market millionaire in less than 30 years.) Set up an automatic transfer to your investment account monthly for $334.
Let’s say you want to know how to become a stock market millionaire in less than 30 years. Here is a chart that I created. It shows you how much you need to save per month based on your current age to reach millionair
The key takeaway from
Step #3 is to invest as much as you can on a regular basis.
I would rather be a little less comfortable now and save a lot than not save anything now and end up having to work the rest of my life. The more you invest, the quicker you will become a stock market millionaire.
Step #4: Pick Low Cost Investments
Many people don’t realize that they pay fees annually on their investments. Every mutual fund and ETF that you invest in, you pay a fee on. You never see the bill for it because the fee comes out of the return of the fund itself. So, if your mutual fund charges a 1% management fee and it returned 5% this year, it returned close to 6%. You only earned 5% of that return. You might be thinking 5% is good because you’re going to be a stock market millionaire based on Step #3 alone!
While this is true, you can get to millionaire status quicker by picking low fee investments. And you’ll end up with more money too. Here is an example of how costly investment fees are.
Let’s say you have $1,000 invested in a mutual fund that has a management fee of 1.25%. This is about the average for a stock mutual fund. In 30 years after earning 8% annually, you will have paid just shy of $1,200 in fees. In contrast, if you pay 0.30% in management fees, you will have paid about $350 in fees.
Some may be looking at the difference of $850 and not bat an eye. If this is you, you need to read my post on compound interest and then come back. While $850 on the surface might not seem like much, it is. That $850 comes from your investment account. If left alone, it would be able to compound upon itself and your balance would grow even faster.
Put another way, by investing in a higher fee mutual fund, you cost yourself close to $3,200. Fees come to $1,200 and $2,000 is from opportunity cost).
As your investment balance grows, so do the fees you pay. If you have $50,000 invested, you are paying almost $60,000 in fees over 30 years by investing in a mutual fund that charges 1.25%. If you instead invest with a fund that charges 0.30% over 30 years you will have paid just $17,000 in fees. By choosing an investment with a lower fee, you would have $43,000 more! Fees matter. Let me say it again: Fees Matter.
On last point about fees: don’t fall for the idea that the higher fee you pay means a higher return. Investing doesn’t work this way. Would you rather have someone wash your car for $10 or $5? Assume there was no guarantee that your car would be cleaner in either case, what would you say? Many would still choose the $10 wash. Why? Because they perceive an added value out of the $10 car wash.
With investing, many investors make this same mistake. They think a fund that charges a higher fee does so because it has a secret formula to earn a higher return. It doesn’t. There is zero in common between high fees and high returns. None. Zip. Zilch. Zero. Save your hard earned money and pick investments with the lowest fees possible.
You have to pay attention to the management fees of what you are investing in. You should not be paying over 1% in any circumstance for an investment. There are many low cost mutual funds and ETFs that you can invest in that will not cost you and arm and a leg. Vanguard and Betterment are excellent when it comes to low fees. Schwab is good too if you pick the right investments. That is your money. Don’t give it up so easily.
If you need help constructing a portfolio, read my post on model portfolios. It will help with picking mutual funds and ETFs to invest your money in.
Step #5: Diversification
Risk and reward are related when it comes to investing. The higher return you want to achieve, the more risk you are going to have to assume. It’s the nature of the beast. By diversifying your investments, you take away some of the risk. This allows you to earn a little bit higher of a return.
Here is how diversification works. Stocks tend to earn a higher annual return than bonds and are also more volatile. What this means is that stock prices tend to rise and fall quicker and in larger amounts than bond prices do.
If you invested in just stocks, you could earn as much as 51% in one year or lose as much as 37% in one year. With bonds, you could earn as much as 17% in one year or lose as much as 11% in one year. Most investors wouldn’t like it if they had to choose between these two.
This is where diversification comes into play. If you were to create a portfolio of 50% stocks and 50% bonds, your potential one year gain drops to 32% while your potential loss drops to -17%. The numbers get even better when we extend the time horizon out to 20 years.
Of course, diversification doesn’t stop there. There are all sorts of stocks you can invest in. Small cap, large cap, growth or value stocks, domestic or international, etc. For bonds, you can invest in long-term or short-term bonds, government or corporate bonds, or even junk bonds.
All this diversification has an impact on your returns. The goal of diversification is to allow you to earn the highest return with the least amount of risk.
Realize that there are limits to diversification – you can get to a point where you are too diversified. Plus, you can’t diversify away 100% of the risk in the stock market. There will always be risk present.
When it comes to diversification, I go into great detail showing you the importance in this post. I encourage you to read it so you can understand the power of getting the right mix of investments. Doing so will give you the most return for the least amount of risk.
But the bigger question is, how do you know if you are diversified right now? And how do you go about making some changes to help you get to an ideal mix?
You have two options: an automated one and a manual one. Let’s look at the automated one first.
Automated Option: Personal Capital. You create a free account and link up your investment accounts. You will get a chart that shows your current asset allocation. In just a few minutes you will know what moves you have to make to become better diversified.
Manual Option: When it comes to a manual approach, your best option is an excel spreadsheet. You can create your own from scratch or use this one that I created. You could even just use mine as a template and edit it to make it your own as well. The benefit of going this route is having complete control over it, so you can make it exactly how you want it. The downside of course is it requires your time to update it.
Step #6: Don’t Chase Returns. Stay Invested.
This may be Step #6 but it is important. Chasing returns doesn’t work. When you chase returns, you cost yourself money through commissions and trading fees. At the end of the day, you end up in a worse position than you would be in had you just stayed invested. This is why the average investor only earns a 2% return.
Chasing returns is akin to Wile E Coyote chasing down the Road Runner. He does every possible thing to catch the Road Runner and every time he comes up empty. Same idea applies here. If you want to be a stock market millionaire, you can’t chase returns. Don’t be Wile E Coyote.
Another reason why chasing returns doesn’t work is because we base investment decisions off of past performance. Even though investments tell us not to. Back during the dot-com boom, I made this fatal mistake.
I invested in a tech mutual fund that earned over 60% in the prior year. The year I invested in it, the bubble burst and I lost close to 60% of my investment. I never chased returns again. For me, slow and steady always wins the race when it comes to investing.
After the stock market collapse of 2008 many investors fled the stock market. Some investors have come back into the market; many investors have not come back at all. Those that didn’t come back have missed out on one of the greatest bull markets ever. The market is up over 130% as of this writing from the lows in 2008. You would have made all your money back, plus some had you just stayed invested.
When I was working for a financial advisory firm, most of our clients portfolios were back to pre-crash levels by 2012. They were scared during the crash, but they knew they were better off staying in the market.
You have to stay invested in the market, in both good times and bad. The market will drop. But it will also rise. Over the short-term, the market can be volatile. Just look back to the summer of 2011. I’ve never seen anything like that in my life. But over the long-term, the general trend of the market is positive. Look at any chart for proof. The market pushes higher over time.
With that said, I know it can be hard to stay invested when it seems as though the sky is falling. Especially when the media over-hypes the situation and makes it seem as though the world is coming to an end.
You have to do your best to keep your emotions in check and tune out the “noise” as I call it. Turn off the television, don’t read the stories in the newspapers, magazines or online. Remember that Wall Street makes money by making you trade. The more you trade, the more money they make.
Fear and greed are the two most dangerous things to an investor. You have to learn how to manage these if you want to be a stock market millionaire.
When you are feeling most worried, refer to your plan you created in Step #1. Review why you are investing the way you are and what your goal is. For most, it is a long-term goal, so don’t get upset over things happening in the short-term.
Finally, always remember we make things out worse in our head than they turn out to be. The worst case scenario rarely becomes reality.
Step #8: Track Your Progress
Unless you track your progress, you will never know if you are on track for meeting your long-term goals.
Over time as the market moves, you might see that you are investing in more stocks than bonds. This means you are taking on more risk than you are comfortable with. By tracking your investments, you can correct this so that you stay on track.
Likewise, maybe you now have more bonds than you planned on holding. This too can be a problem since bonds tend to have a lower rate of return than stocks. If you are investing too much in bonds, you run the risk of not earning the return you need to meet your goal.
To balance your holdings at the correct allocation, you will need to rebalance. This means selling holdings that have grown in value and buying those that have decreased in value. On the surface this might sound counter-intuitive. After all, why sell the holdings that are making you money?
By rebalancing, you are guaranteeing that you buy low and sell high. You take the emotion out of investing and this is a major factor in your success with investing.
Here is a quick example of rebalancing: Let’s say your ideal portfolio is 60% stocks and 40% bonds. At the end of the year you see you have 70% stocks and 30% bonds. You would sell off 10% of your stock holdings and use the proceeds to buy more bonds.
Now, when it comes to your retirement accounts, you can buy and sell without worry. There are no tax consequences from placing trades within these accounts. But things get tricky in taxable accounts since you have to pay taxes on any gains you realize when you sell.
Here are the guidelines I use to rebalance:
I review my holdings twice a year – usually at the end of June and the end of December
I look for holdings out of balance by 5% or more. This means if my 60/40 portfolio is 62/38, I don’t bother rebalancing
For my retirement accounts, I buy and sell without question as taxes don’t factor in
For my taxable accounts the process is a little different. I skip the buying and selling and add new money to the assets that I need a higher proportion of. So, if my 60/40 portfolio was 70% stocks, 30% bonds, all new money I invest would go towards bonds. This is until I got my portfolio back to 60/40.
Finally, as time goes on, you may realize that you need more or less money that you originally calculated. As a result of tracking your investments, you can make any necessary changes to your investment plan.
When it comes to tracking your investments, the easiest way to track is through Personal Capital. Just link your accounts and you’ll get detailed analysis from Personal Capital. Of course, they offer a lot more too.
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