Today I'm going to talk about where to get started once you made that decision that you want to invest. This post provides an excellent insight on how to best direct your funds across the various investment vehicles available. If you're starting, this will be an excellent intro for you, and for those that are already investing, this could also be an excellent time to stop and check to make sure you're investing in the way that impacts your financial plan the most.

I want to start by saying that investing is important because investing is what allows us to build a financial future. Making money in a savings account does not allow for long-term growth. To truly achieve financial independence and build wealth, we need to invest. But there's a catch, investing should not start until all other areas of healthy financial habits are created.

What do I mean by that? Well, I've discussed in the past that I always recommend that individuals do not start investing until they have already done the following two items:

Eliminated high-interest credit card debt
Have set aside emergency funds in a savings account

These criteria are simple and easy enough to understand. An individual should make sure that their high-interest loans such as the credit cards are paid off, and they ought to have emergency rainy day funds set aside in a savings account before pursuing investing.

Now, some of you may already have access to a company-sponsored retirement plan like a 401(k). If you have already been contributing towards that and have been setting aside enough to maximize the match, at least then you are in a great place to bump that up.

*Capitalizing on your company’s 401(k) match is a key component to building wealth.*

The 401(k) allows individuals to contribute up to $19,500 for the calendar year 2020 and an additional $6,500 if they are over age 50. Again, if you're already at the match amount and you're ready to bump up your savings rate, the first thing you need to think about is what type of investment account you want to have.

That's right, what type of investment account do you want to have? I said earlier I get starter questions like these all the time. They either are I am ready to invest, where do I start, or I just opened a Robinhood account, but I'm not sure what to do. It's interesting because my follow-on question is usually What type of investment account is it? And the answer is often perplexed.

Look, I get it. We all, once we get to the more stable side of life, want to invest because we know we need to. But how we invest is just as important. For someone to start a taxable non-retirement qualified account before maxing out their 401k and Roth IRA's is silly.

Before you rush out and create a regular investment account, think first about what you're investing for and then think about your taxes. And I cannot emphasize this enough because, again, this is 2020, and the process of opening an investment account is relatively straightforward. Robinhood or Webull, for example, takes no more than 5 minutes to have an account created and funds transferred.

If you're investing for fun, OK, cool, but if you're investing for financial freedom and retirement, then you have to maximize your tax-qualified retirement accounts first. And after you have concluded that you are investing for retirement, and again, retirement could be whenever you want. I have young clients targeting a retirement age in their 40's while more traditional clients are targeting the usual age 67. Retirement age could even mean that you have the financial means to quit your typical 9 to 5. We'll come back to the retirement age later, but if the mentality to invest is for retirement, then you need to max fund your retirement accounts.

So, again, we have $19,500 or $26,000 depending on your age for the 401(k) plan. We also have $6,000 or $7,000, if you are over age 50, for the Roth IRA. That means for an individual that wants to max out the retirement vehicles available, the limit for this year is $25,500 or $33,000 if you're over age 50.

At this point, you have to decide, and let's use someone who is in their thirties as an example. If you're 35 years old, and you want to invest for retirement, you have to determine how much you're comfortable with saving each year. I just said that the upper limit using the conventional vehicles is $25,500 for a 35-year investor. For this 35-year-old investor, if you have the financial means to save more than $25,500, your most natural step is max out your 401(k) and the Roth IRA. Any excess after that should then go into a regular brokerage account. Easy enough, right?

For those that are investing under the limitation, using the same 35-year-old investor who wants to invest and is comfortable setting aside $20,000 a year for retirement savings, you should be taking the following steps:

Step 1: Contribute to the 401(k) plan up to the maximum match limit;

Step 2: Open a Roth IRA and contribute the annual maximum to the account;

Step 3: Invest the remainder in the 401(k) plan for pre-tax deductions.

Using the above three steps, you are going to find that you're creating two different types of tax-advantaged retirement savings accounts. You'll end up using both the Traditional and the Roth vehicle for diversification in terms of how you'll be taxed at a later time.

Now, most 401(k) plans offer both a Traditional and a Roth provision, which means you can theoretically save the majority of the full $20,000 under your employer's company-sponsored retirement plan.

For those that want just to hit the easy button and see everything come out of their paycheck, there is no problem with using both under the company plan if you are in that situation.

Are there advantages to keeping a Roth IRA if the Roth is already available within your employer's plan? Well, yes, there are. Most employers sponsored programs have a pre-selected investment selection, which usually comprises 15-18 investment options. These investments range from your usual S&P 500 Index funds to a list of various target-date funds and other equity or bond options.

401(k) plans, for the most part, do not offer individual stocks. Now, there are exceptions to this, some of the larger companies may elect for the brokerage window option, which allows plan participants to move money to an affiliated brokerage firm for additional investment selections, but not every company offers this capability. Even so, the opportunity may only allow for additional mutual funds outside of the curated list of 15-18 options.

Pairing a Roth IRA and using that as a compliment to your existing 401k plan allows you to use individual stocks instead of just the current mutual funds. We can go into a massive debate on whether mutual funds are the smarter choice or if a person is only better off investing in stocks. Still, we're not going to go into that today because that can be a very lengthy segment, and once we go down that rabbit hole, it's going to be impossible to come out of it quickly.

*A diversified portfolio should include both individual stocks and mutual funds.*

As a financial advisor, I am a big advocate for pairing stocks with mutual funds to build a diversified portfolio. Especially more so when it comes to matching a Roth IRA with an individual's existing 401k plan. When we invest via a mutual fund, it's easy enough to understand. A mutual fund is essentially a giant basket of different stocks, and the mutual fund itself generally has a mission objective. Perhaps the mutual fund is designed to mirror the S&P 500. Well, those are easy enough to understand and are super low cost in nature. But not all mutual funds are like that, you may have a mutual fund that is designed to pick across different sectors in hopes of outperforming the market, but those mutual funds can become very costly. Sometimes we're talking about expense ratios over 2%!

Stocks, on the other hand, is just one company, which is why there is a higher risk to them as opposed to investing in a mutual fund. You get instant diversification in the mutual fund because there are multiple companies, but what happens if the companies are struggling financially like what is happening now due to the coronavirus?

When it comes to 401k investing, the most common investments in my experience as a 401k financial advisor are target-date funds and the S&P 500. I manage a lot of 401k plans and see a lot of 401k plans that I analyze for optimization. The majority of Americans save within what is known as the target date fund and the S&P 500. The TDF is just a simple one-click solution that puts your money into a predetermined fund that is age-appropriate, and as you get older and closer towards age 67, it starts scaling back on risk. TDF's for the most part, have a very structured percentage allocation to domestic stocks, international stocks, domestic bonds, and foreign bonds. S&P 500 is easy enough to understand. It's the 500 largest companies in our country.

The reason why those two selections are the most common in America today is that as 401k plans underwent stringent regulatory changes, more automated features needed to be added to reduce fiduciary liability. The target-date funds were designed to eliminate the barrier to investing by creating a simple solution that is just based on an individual's age. The S&P 500 is easy to understand, and often the lowest cost investment option available.

Let's focus back on individual stock holding. I find that individual stocks are still very relevant in today's time, and although it may not provide broad diversification, it has, in actuality, outpaced the S&P 500 as a whole for the year 2020. Now, none of the following are recommendations because I don't know what your current investment objectives are or where you are in life but to give you an example and this is all as of August 19th, 2020 by the way:

AMD YTD: 123.88%
Amazon YTD: 76.45%
Apple YTD: 58.50%
Google YTD: 16.16%
Facebook YTD: 27.81%
Microsoft YTD: 34.84%
Nvidia YTD: 108.65%

*The path to financial freedom incorporates different asset categories across multiple sectors.*

These seven companies are not picked at random, and by the way, I need to disclose that I own stock in each of those seven companies. These seven companies that have seen tremendous growth YTD are all in the tech sector, but most importantly, they are all held within the S&P 500. That's right, folks. The S&P 500, which contains the 500 largest companies in the US, holds those seven companies.

However, where does the S&P 500 stand YTD? 4.46%

The S&P 500 did 4.46% because even though it may have seven big home run winners in the portfolio, it is still only a tiny portion. There are still 493 other stocks in the portfolio that have not been doing so well or are still in negative territory for the year.

The point I'm getting at is this. In a market environment layered with huge uncertainty both at the Wall Street and Main Street level, there are still winners in the stock market. If you're only invested in the S&P 500 or a mutual fund that tries to wrap a lot of companies under one package, you may find that you are not taking advantage of a volatile environment.

I'm going to switch gears for a moment and make a comparison against target-date funds. The simple, easy solution that is available in pretty much all 401(k) plans out there, and I'm just going to pick three of the major investment companies in the United States today. Your plan, of course, will vary with what target-date option you have, but you can easily log on and compare what your funds are doing if you want to follow along.

Starting with Target Date 2050 options, which are for those in their thirties and younger. Again, this is predominantly for those most growth-oriented. We have:

Vanguard 2050 with a YTD return of 2.64%
T. Rowe Price 2050 with a YTD return of 3.96%
BlackRock Lifepath 2050 with YTD return of -2.55%

*Don’t get caught accepting minimal investment returns just because there aren’t any good options in your 401(k) account.*

Again, severely lacking in performance in comparison to the seven stocks highlighted above. Now, look, here is where a lot of financial advisors will disagree, and they'll say things like

"Well, you cannot compare a mutual fund like a target-date fund or the S&P 500 fund to individual stocks. It's just not a fair comparison."

And I have to disagree and tell you that yes you can! A growth-oriented mutual fund that is designed to grow your nest egg by investing in growth-oriented companies is the same as cutting through the mutual fund and going straight to the company itself. True, you're not going to get instant diversification with seven companies, but during this type of market environment, why should you be holding the losers in a basket?

Or here's another line that I like, which is "mutual funds offer less risk because you're spreading your exposure out through many different companies. If one company doesn't perform well or goes bankrupt, you're not SOL."

And for that, I will say that they would be right if you're picking high-risk stocks like penny stocks or pharmaceutical stocks without a proven track record. But in comparison, I'm not using any of those. The likelihood that Amazon or Apple going bankrupt is exceptionally slim. I mean, you're going to need some competitor that can completely disrupt their business model and take over their entire fanbase which you and I know is, pretty dang impossible seeing how big they are.

Now, look, I'm not knocking these funds because they have poor performance in an extremely volatile and unprecedented market environment. It's bound to happen. Where I am getting at, and the picture I'm trying to paint is that even as uncertain as a market may be and as tight of a time the S&P 500 may be having, we still have growth opportunities. That is the point I'm trying to make.

Man, wow, I think I went utterly off-tangent there. This episode was supposed to highlight the tax-advantaged vehicles, but in the big picture of investing, it's impossible not to talk about underlying investments.

It is critical that you, as an individual investor, and as someone that is working on the path of financial freedom, find those areas where you can still see growth, especially during markets such as the one we are experiencing.

So to recap. When it comes to investing, and you're just starting, the best place to start is your 401k if your company offers a match. If you can save more than the 401k match, you'll want to contribute the excess to a Roth IRA. If you can max out the Roth IRA and still have funds you wish to save for retirement, you then kick up the percentage contribution on your 401k.

If your company does not offer a match, then you start at the Roth IRA first. Max, that baby out before you start contributing to the 401k plan. Roth IRA's have much lower fees and costs in comparison to a company 401k plan, which is why you want to start at the Roth IRA first.

I often get asked what percentage people should be investing in getting to retirement. The short answer is that it depends. It depends on how much you are comfortable saving, and when exactly retirement is. If you're 30 years old and you intend to work until 67, well, you have a long way to go, and you don't necessarily need to save as aggressively. If you're 50 years old and you are just starting on building your nest egg, and you want to retire in 17 or 18 years, then you probably need to be more aggressive. The financial advisory industry has adopted 10% of your annual income to be the number you need to be saving every year. However, as I said, all of the different factors, like what I mentioned above, need to be addressed.

Disclaimer: I own shares of AMD, Amazon, Apple, Google, Facebook, Microsoft, and Nvidia.

I'm Ready To Invest But Where Do I Start?

Subscribe to our Newsletter