Stock Watch

Start Investing in 3 Simple Steps

Now is a wonderful time to be entering the stock market as a first-time investor.

By Elizabeth Ody, Associate Editor, Kiplinger's Personal Finance

October 28, 2008

Editor's note: This story has been updated in 2009.

Lately I seem to be fielding the same questions over and over again from the twentysomethings I know. "Isn't it true that you're supposed to buy stocks when they're down?" they ask me. "So should I start investing in stocks now?"

To answer them once and for all: Yes, you should buy stocks when they're down. And yes, that absolutely means you should be buying stocks now.

If you, too, have recognized the benefits of buying now, it speaks highly of your investing smarts. Investing when stocks are down means you can buy a greater number of shares for the same amount of money. Because each share represents an ownership claim on a company, purchasing more shares means you literally own a bigger piece of Coca-Cola, Apple or whatever stock you're buying. And stocks tend to recover sharply and quickly after an extended period of being trashed. In 2003, not long after the last bear market ended, Standard & Poor's 500-stock index returned 29%.

It's worth noting just how opportune a moment this is to jump into the stock market for the first time. As of the market's March 17 close, the S&P 500 stood 50% below its all-time high, reached on October 9, 2007.

This might not sound like a convincing sales pitch for investing in stocks, but long-term, the picture is much rosier. Historically, the stocks of large U.S. companies have gained 10% per year, on average. And the stock market has never lost money over a 20-year period. Moreover, the market's pitiful performance over the past decade makes it more likely that stocks will deliver at least average returns for many years to come.

Stocks may continue to fall or to bump along the bottom for months. But you can jump in today at least knowing that, wherever the market goes the next couple of years, you were able to get in a lot closer to the bottom than most people. The important thing is that you do jump. After all, Warren Buffett, the most famous investor of our time, has said that when it comes to investing, his only regret is that he didn't start sooner.

Here are three steps for getting started.

1. Decide how much to invest.

Given the rough economy, you shouldn't start investing until all your other financial ducks are in a row. Pay down any high-interest loans, such as credit-card debt, before you start putting cash into stocks (see Have You Heard the Wake-up Call?). Be sure, as well, that you're investing enough money in your 401(k) to fully capture any matching contributions your employer offers. And at all times, you should keep an emergency fund of at least three months' worth of expenses in cash or a cash equivalent, such as a money-market mutual fund or a high-yielding savings account (see Why You Need an Emergency Fund).

Think about when you'll want to access this money. Don't sink into stocks cash you'll need in the next five years for, say, grad-school tuition or a down payment on a car, because the market could take time to turn around. But don't despair if that leaves you little to work with. You can buy top-notch investments with as little as $250 to start.

2. Pick an approach.

A mutual fund is the best vehicle for newbies because someone else handles the grunt work of picking stocks, and because you can buy a fully diversified portfolio with a modest amount of money.

A foolproof way of earning at least average returns is to buy a low-cost index fund that tracks an established market benchmark. Vanguard Total Stock Market (symbol VTSMX) offers a cross section of the entire U.S. stock market by holding shares of some 3,500 companies. The fund's 0.15% expense ratio -- the sliver the fund company skims off the top of your investment each year -- is rock-bottom for mutual funds, so you get to keep more of the hard-earned returns on your investment (an expense ratio of that size means that the fund company extracts $1.50 a year for each $1,000 you have in the fund).

On the downside, the Vanguard fund requires at least $3,000 to open an account, and it doesn't give you exposure to foreign stocks. To do that, you'll have shell out more to buy an international index fund. Or, you could invest in Vanguard Total World Stock (VTWSX), an index fund that invests in both U.S. and foreign stocks, although its 53% allocation to foreign stocks is a bit higher than what most experts would recommend.

If you know when you'll need to access your money, then consider a target-date fund. The managers at these funds do the work of diversifying among U.S. stocks, international stocks and bonds for you. And they rejigger your portfolio so that, as you near a set date, your money moves gradually out of stocks and into bonds, which are less volatile.

The T. Rowe Price Retirement series is the best option among these types of funds. The funds invest in other Price funds and tend to have higher allocations to stocks than other target funds do. You could buy T. Rowe Price Retirement 2015 (TRRGX) if you're aiming to put a down payment on a home in six or seven years. Or if you plan on keeping that money tied up until you retire, you could invest in T. Rowe Price Retirement 2055 (TRRNX). You can get started in one of those funds with $2,500.

There are fine options if those initial minimums are unaffordable for you. For as little as $250, you can invest in the Hodges Fund (HDPMX), Amana Growth (AMAGX) or Amana Income (AMANX). Putting aside their low initial minimums, we would recommend all three funds on their own merits. They don't have the one-stop-shop appeal of the Price funds or the cost benefits of Vanguard's funds, but the important thing is that you get started.

3. Set up an account and go!

Once you've decided on the best approach, you need to determine how you want to invest in these funds. There are two basic approaches. You can set up an account with an online broker and then invest in the funds available through the broker's fund "supermarket." Most of the better online brokers offer plenty of no-load funds (those that don't levy sales charges) without layering on extra transaction fees.

Fidelity is our all-around favorite online broker (see Best of the Online Brokers), although the minimum to open an account is $2,500, and you have to pay a transaction fee to purchase the Vanguard index funds or the T. Rowe Price target-date series. Charles Schwab lets you open an account with $1,000 or with no minimum if you set up automatic monthly transfers of at least $100 to your account. (Schwab, incidentally, offers a handful of domestic and international index funds that require an initial minimum investment of just $100.).

To avoid paying a transaction fee on Vanguard and Price funds, invest directly with the companies, using either one's user-friendly Web site. Similarly, to benefit from the ultra-low minimums of Amana and Hodges, you'll have to invest directly with them. Go to each company's Web site to download a prospectus and application.

Once you're set up with your first mutual fund shares, set your investments on autopilot by linking your brokerage account to your checking account and adding a bit to your fund every month. Then sit back and watch the kitty grow.

• Got a question? E-mail me directly at investing@kiplinger.com. Want to be heard? Leave a reader comment below.

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