5 Steps to Start Investing

I’ll admit it: I think investing is fun. I like the sense of control when I manage my money and move funds around. I enjoy shopping for different investment options and betting on my top picks. I get excited watching my cash in action -- thrilled when my investments move up, anxious when they slide down.

Does that make me a little nerdy? (It’s not the only thing -- I also wear glasses, spontaneously quote Shakespeare and enjoy science fiction.) But I’m not alone in recognizing the fun factor: According to a recent Scottrade survey, 35% of respondents ages 18 to 26 (the survey’s definition of Generation Y) consider managing investments “a fun and interesting activity,” up from 27% in 2008. And 17% of Gen X respondents -- ages 27 to 42 -- feel the same way.

Take a more active role in managing your money, and you can make more of it. For example, though I wisely decided to start investing in a 401(k) as soon as I could (with heavy nudging from my dad), I didn’t have much interest in where my money went at first -- I randomly put all of it in a single Treasury-bond mutual fund and hardly looked at the account for the next two years. Reports say I earned less than 1% each quarter.

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When my former employer was acquired by another firm, our 401(k) options were expanded and we received some interesting reading material to guide us in making these important financial decisions. I took a simple quiz (in the same style as the old Seventeen magazine quizzes I used to enjoy oh-so-much) to determine what my perfect portfolio might look like. Then, I shopped through a catalog of fund options until I found just the right ones for me. My new portfolio of stock funds suddenly started earning about 5% a quarter during the market’s peak. (Of course, the market has not been quite as kind to my investments lately, which is less fun.)

So, I invite you now to be more active with your investments. Just follow these five steps to get in the investing game:

1. Tally how much you have to play with. First, you need to look at your whole financial picture. After budgeting for your daily living expenses, your priorities should be paying down bad debt and building up an emergency fund with at least three to six months’ worth of living expenses (see How Much Cash You Really Need). Once you’re set in those areas, you can divvy up what’s left between saving for short-term goals and investing for long-term goals.

Don’t worry if that leaves you little to get started with -- as I said before, saving and investing any small amount now is better than doing nothing until later.

2. Assess your tolerance for risk. Determining your own level of risk tolerance will help you to establish the appropriate mix of assets in your portfolio. Generally, the longer your time frame, the more risk you can take in pursuit of greater long-term rewards, because you’ll have more time to recover losses along the way.

Still, having time on our side doesn’t make daredevils of all us youths. Some other factors to consider: how you were raised with money, your knowledge of investing (note: overconfidence is a problem for many beginner investors) and your reaction to hypothetical or historical investment performances. For help gauging your risk tolerance, read our article Know Your Limits -- and consider taking the sophisticated risk-tolerance assessment mentioned in the article. Or take our simpler assessment to estimate how much of your portfolio should be in stocks.

3. Shape your portfolio. Start by establishing the broad categories that will make up your portfolio -- stocks versus bonds, for instance -- and then, more specifically, large-caps versus small-caps and U.S. companies versus international firms. Diversity is a good thing.

Over the long term, stocks offer the best returns for patient investors: Since 1926, stocks of large companies, for example, have gained 10% annualized, while small-company stocks have won 12.5% annualized. Going forward, we think 8% returns are reasonable to expect on stocks.

For folks like us, who have 15 years or more to reach a long-term goal such as retirement, Nicholas Yrizarry, a financial planner with offices in Reston, Va., and Newport Beach, Cal., recommends a 100% stock portfolio -- with 65% staying in the U.S. and the rest heading abroad with up to 10% in risk-heavy emerging markets.

If you’d prefer to stay on the safer side, Lynn Mayabb, senior managing adviser with BKD Wealth Advisors, in Kansas City, Mo., suggests staking just 65% to 75% of your portfolio on stocks, mixing about 15% in alternative investments such as commodities, and putting the rest in bonds.

Beginners, especially, should stick to mutual funds to achieve diversification at a relatively low cost. (See our article Smart Strategies to Pick Mutual Funds.) Shopping for actively managed funds, you need to look for modest fees and consistently strong past results compared with similar funds -- plus a manager who has held the reins through that sturdy performance. The Kiplinger 25, our list of our favorite no-load mutual funds, offers some good options, along with suggested portfolios using Kip 25 funds.

For lower costs and added simplicity, Mayabb suggests trying exchange-traded funds (ETFs),which are low-cost mutual funds that are bought and sold like stocks and typically track an index. For example, Vanguard’s Total Stock Market ETF, as the name suggests, tracks the whole stock market and charges just 0.09% in annual expenses. (Learn more in our special report on ETFs.)

4. Pick a place. Most of us will start investing through a retirement account: Employer-sponsored accounts, such as a 401(k), will offer a certain number of investment choices selected by the company, while individual retirement accounts will open up to you a much broader universe of investments.

Or you might dare to open a separate brokerage account. We suggest a discount online brokerage that lets you buy individual stocks, bonds and funds.

5. Shop the market. Now you’re ready: Embrace your inner investing nerd, and acquire specific funds (and stocks) for your portfolio. Your brokerage or 401(k) administrator will send you quarterly reports of your accounts, and you can use their Web sites to check in more frequently. To monitor all your investment accounts in one place, try Morningstar.com’s Instant X-ray tool.

Remember to rebalance your portfolio regularly -- quarterly or annually -- to maintain your portfolio’s asset allocations, which will force you to smartly sell winners and buy laggards. You should also reassess your portfolio every few years or anytime you experience a big life change, in case your taste for risk changes. But don’t get hyperactive in managing your investments -- too much activity can cost you in trading fees and leaves you more vulnerable to making money mistakes.