Opening your first investment account can get you one step closer to financial security. You might have a savings account for emergencies or short-term goals, but investing is key to growing wealth.
When you invest your money — in stocks, mutual funds or real estate — you have the opportunity to earn higher returns than the annual percentage yield your bank might pay on a savings account or CD. And when you have a longer time frame for investing, you have more of an opportunity to take advantage of the power of compounding interest.
Here's what you need to do before start investing and building your portfolio.
1. Outline your goals.
Before opening your first investment account, ask yourself: what do you hope to accomplish? You may have short-term goals, such as investing a set amount of money each month consistently. And then you may have long-term goals, like socking away enough money to retire early or banking a couple of million by your 60s. Get clear on what your overall goals are. Then, break each of those goals down into smaller, actionable steps. This gives you a plan to follow as you invest.
2. Gauge your risk tolerance
Risk tolerance is another way of saying how much risk you're comfortable taking with your money when you invest. Everyone's risk tolerance is different; generally, investing experts agree that the younger you are, the more risk you can afford to take on. The reasoning goes that if the market dips and you lose money in your 20s or 30s, your portfolio has plenty of time to recover if you're not planning to retire for a few decades.
Different factors can affect your risk tolerance, including your age, how long you have until you retire, how much money you have to invest and your goals. If you're not sure how much risk you're okay taking, completing a risk tolerance questionnaire can help you figure it out. Brokerage accounts — which are financial companies that offer investment accounts — often have risk tolerance questionnaires you can fill out online. It's a good way to get a starting point for deciding what to invest in.
3. Research your account options
Investment accounts aren't one-size-fits-all and it's helpful to know what type of account you want to open. For example, you might open a:
- Traditional Individual Retirement Account (IRA)
- Roth IRA
- IRA for self-employed individuals
- Taxable brokerage account
So what's the difference?
The first three investment accounts on the list are specifically designed for retirement. A traditional IRA allows you to deduct your contributions from your taxable income. Your money grows tax-free and when you make withdrawals in retirement, your investment earnings are taxed at your regular income tax rate. IRAs for self-employed workers follow the same rules.
A Roth IRA is different. These accounts don't offer a tax deduction but you get something else: tax-free withdrawals in retirement.
With IRAs, you get tax breaks but you're limited on how much you can invest in them. As of 2019, the annual contribution limit is $6,000. (Unless you're 50 or older; then you get another $1,000 added to the limit.)
A taxable brokerage account, on the other hand, has no cap on contributions. You can invest as little or as much as you like.
The downside? You don't get any tax breaks. And you'll pay capital gains tax on earnings if you sell an investment.
But a taxable account may be the way to go if you're able to invest more than $6,000 a year. Even better, you could open an IRA and a taxable account to super-charge your savings.
4. Compare brokerages to find the right fit
Once you've assessed your goals and risk tolerance and decided which type of investment account to open, the last step is choosing a brokerage. Here's where you have to dig in and do some research.
Specifically, you want to look at the:
- Range of investments a brokerage offers
- Management fees for individual investments
- Fees the brokerage charges
- Minimum amount to open an account
The range of investments offered is important for diversification. Diversification means having a mix of different types of assets in your portfolio. This is a smart strategy for managing risk.
Every brokerage is different in terms of what they offer. Brokerage A, for example, might focus exclusively on exchange-traded funds or ETFs, which are mutual funds that trade on an exchange like a stock. Brokerage B, on the other hand, might offer ETFs but also add mutual funds, bonds or bond funds and individual stocks into the mix.
While you're looking at the choices for investing, look closely at the fees you'll pay. With mutual funds or ETFs, for example, focus on the expense ratio, which is expressed as a percentage. This number tells you the annual cost of owning the fund.
Stocks don't have an expense ratio, but the brokerage may charge you a trading fee to buy and sell them. Brokerages can also charge other management or administrative fees. Any fee eats into your returns so be sure you get a full rundown of the costs before opening your investment account.
Look at the minimum required to open your first account as well. There are some brokerages that let you start investing in a taxable account with as little as $1, while others might require $1,000 or $2,000 to open an IRA. Make sure the one you choose fits your budget for investing.
And finally, consider how easy it is to add to your investment account. Setting up automatic transfers from your checking account, for instance, is an easy way to level up your wealth-growing efforts.