Laura answers a listener's question about how to invest extra money the way wealthy people do.
Laura answers a listener's question about how to invest extra money the way wealthy people do.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Sarah, who says, "I'm starting my first real job with benefits soon, and I should have a little money left each month to start investing. I want to make it grow as fast as possible. My question is, how do wealthy people invest their money?"
Thanks so much for your question, Sarah. While you can invest money in endless ways, I'll review the best place wealthy people grow their money, and so can you!
Welcome back, everyone, and thanks for joining me on episode 859! I'm Laura Adams, an award-winning author, finance spokesperson, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're getting value from the free content we love creating, consider submitting a 5-star rating or review on Apple Podcasts, Spotify, or wherever you're listening! If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
Should you save or invest?
Sarah, before you do anything with your extra money, you must know its purpose. For instance, should you save it for emergencies or significant purchases you want to make within a year or two? That's essential for managing hardships like losing your job or paying unexpected out-of-pocket medical bills.
Emergency savings should never be invested because there's a risk that its value could decline. Your emergency money is for potential short-term needs rather than long-term growth. A good rule is to keep at least three to six months' worth of your living expenses in a liquid, FDIC-insured high-interest savings account.
So, always fund a cash reserve with at least $500 or $1,000 at a minimum before becoming an investor. Then, you might continue building your emergency fund while simultaneously investing some amount.
Funds dedicated to your longer-term goals, such as retiring or buying a home down the road, should be invested for growth. That means taking some calculated risk so your balance gets higher returns.
READ ALSO: The right amount of emergency money to keep in cash
Where do the wealthy invest?
There is more than one place where wealthy people invest their money. Many millionaires and multi-millionaires have multiple sources of income, such as rents, royalties, capital gains, interest, and dividends. But few wealthy people don't have some or a lot of money in the stock market.
All the jargon and data associated with the stock market can make it feel inaccessible or overwhelming. But I'll break it down so you know what wealthy investors do and can easily replicate it.
The stock market is a generic term for various exchanges where investors buy and sell shares of publicly traded companies such as Amazon, Apple, and Google. Different stocks trade on different marketplaces, like the New York Stock Exchange (NYSE), NASDAQ, and the S&P 500, all electronic systems.
In addition to stocks, you can purchase funds on the stock market, such as index and exchange-traded funds, which bundle hundreds or thousands of individual stocks into one investment. That gives you broad diversification, which I'll discuss more about in a moment.
Investing in the stock market is one of the easiest ways to become wealthy if you follow some simple concepts I'll cover here. So, let's review why the stock market is where the wealthy put their money, and you should, too.
What are the advantages of the stock market?
While the stock market might not be the only place to invest, if it's the only place you put money, it can make you extremely wealthy. Consider the following six advantages of investing in the stock market.
1. Receiving higher returns.
Over the long term, stocks have outperformed other mainstream investment options. Since the 1920s, the average market return of the S&P 500 has been about 10% per year. Returns since the 1950s have been slightly over 10%. But the average means some years have higher returns, and some have less.
The stock market doesn't rise every year, but it goes up more often than it goes down, which is why we see a nice upward trend over time.
Since stock market returns are tempered by inflation, getting an average annual return of 6% to 7% is a fair assumption when you buy and hold stocks for the long term. However, If you trade in and out of the market frequently, you can expect to earn less due to taxes, commissions, and poor market timing.
2. Investing small amounts.
One of the best aspects of the stock market is that it's available to anyone, even if you don't have much to invest. For instance, one share of the SPDR Portfolio S&P 500 ETF (SPLG) costs about $65. However, if you only have $50 to invest, you can buy a fractional share of most ETFs, giving you less than a full share.
Compared to many other investments, like purchasing real estate, angel investing, or starting a business, which require significant upfront capital, investing in the stock market is incredibly cheap! That makes it easy to start and increase your wealth slowly over time.
Most people, including the wealthy, put money in the stock market using a dollar-cost averaging strategy. That means you contribute a fixed dollar amount regularly, like monthly or every time you get paid.
For example, you could invest $300 a month in an index fund that's made up of a broad range of stocks. When the value of the fund goes up, your $300 buys fewer shares. And when the fund price declines, your $300 purchases more shares. That smooths out your risk and allows you to develop a habit of investing no matter how much or little money you have.
In addition, there are few transaction fees with stocks and funds. You must open an investing account to buy and sell shares, but there are many platforms that charge $0 or have a selection of no-fee funds.
3. Becoming a business owner.
As I mentioned, stocks or stock funds give you ownership in companies that can grow, increase in value, and pay dividends. With even a small investment, you become a part-owner of one or many companies and share in their profits and growth.
That allows you to generate income without the cost, responsibilities, regulations, and liability of starting your own company, hiring workers, and managing staff. Compared to the intense work, skill, and upfront money required to launch your own business, owning stock market companies allows you to be lazy and still earn an excellent return on your investment! Who doesn't love that?
4. Having liquidity.
Stocks and various stock funds are highly liquid; you can buy and sell them anytime through a brokerage account. That's a huge advantage compared to investments like real estate or a business where cash can be locked up for years.
The ability to turn stock market investments into cash anytime you need it is a terrific benefit. While you can't dictate a stock or fund's share price when you sell it, someone will always be willing to buy it from you.
5. Getting diversification.
It's easy to own diversified investments when you own part of the stock market. That's critical for reducing potential risk. For instance, owning an index fund comprised of a broad swath of companies ensures they aren't correlated or move together when economic conditions change. That helps smooth out risk over the long term.
For instance, if you only own a home or one technology stock, changes in the US housing market or the tech industry could cause your investment portfolio to plummet. However, when you own different stocks, some may lose value, and others will increase, helping your overall portfolio.
You can diversify on many levels, such as asset classes, like stocks, bonds, real estate, and cash. With stocks, you can diversify across company sizes, such as large-capitalization, mid-cap, and small-cap stocks, sectors, and geographies.
The easiest way wealthy investors achieve broad diversification and cut risk is by purchasing shares of index funds or various exchange-traded funds.
RELATED: 5 tips for better adulting with your money
6. Having tax-advantaged options.
Stock market investments aren't the only ones with potential tax benefits. However, it's super easy to own them inside tax-advantaged accounts, such as retirement plans, health savings accounts (HSAs), and 529 college savings plans.
Most people build their wealth by purchasing shares through an employer-sponsored retirement account, such as a 401(k), 403(b), or 457 plan. Or if they're self-employed, they use an account for small businesses, like a solo 401(k) or SEP-IRA. Retirement accounts allow your investments to grow tax-deferred in traditional plans or tax-free in Roth plans.
Sarah, if your employer offers a retirement plan, that’s the best place to invest. You typically have a menu of investment options, such as index and exchange-traded funds. I recommend choosing an after-tax Roth option if it’s available at work or using a Roth IRA (individual retirement account). That allows you to skip taxes on decades of growth because you can make tax-free withdrawals in retirement.
To sum up, there isn't another investment that makes earning a healthy return as easy as buying funds in the stock market. The benefits I've reviewed here aren't the only ones but are the primary considerations if you want to build wealth as simply as possible.
But it's also critical to remember that investing in the stock market, especially in individual stocks versus funds, involves risk. The value of your investments will fluctuate, particularly in the short term. So, you should only invest once you have a healthy emergency fund and will likely be fine without the invested funds in the next few years.
Before we go, here's a quick reminder to subscribe to The Money Stack, my weekly newsletter, when you visit LauraDAdams.com. It's filled with money tips, tools, news, challenges, and things I enjoy! You can subscribe for free or become a paid member with access to live educational events.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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