I have been hearing back from many of my friends that they want to start saving for retirement, they want to start investing, and they want to gain financial freedom. However, they have no idea where to start. This post is all about how to go from broke and confused, to getting on autopilot in the right direction.

Just a few years ago, I was in the exact same position. When I graduated, I was in a $14/hr job, had to stay with my parents to save money instead of moving out like I so desperately wanted to, continued driving a car that was almost 20 years old, and just thought that it wasn’t possible to start saving anything. Through hard work, I was able to increase my salary dramatically over the following few years, cut my expenses while still enjoying my early twenties, and destroyed my debt. The time had finally come when I could put some money away, the only problem was that I had no idea where to start. 401Ks, 403Bs, IRAs, CDs, ETFs, Stocks, Bonds. My bachelor’s degree was in finance, and I still felt like the world was full of acronyms without direction. I suffered from analysis paralysis (analyzing to the point of not doing anything for fear of taking the wrong first step). In order to help you skip this potentially scary first step, here are my recommended steps for getting started on the investment path.

1. Define Your Current Financial Situation

Before you invest a dime anywhere, it is important to know where you currently stand financially. If you don’t know how much money you are actually bringing home and aren’t aware of your monthly bills, then how will you know how much you are able to save away? You won’t. Your first step is to grab a piece of paper or open up excel and determine your current situation. I prefer to look at this from a monthly standpoint.

You will need to take your monthly income and subtract out all of your monthly expenses. Below is the example that a friend of mine named Brett gave me including all of his monthly expenses, rounded to make the math a little more simple.

You may have noticed that this does not include any food, entertainment, gas, or other variable expenses. Good observation, we will get there next. People are notoriously bad at estimating how much they are spending for things that do not cost the same amount every month.

2. Track Your Spending

Now that you have listed out your recurring monthly income and expenses, we need to determine how much you are actually spending on those variable expenses. The best way to do this is to look at your spending over a period of time and average it out. You can either start tracking every penny that you spend today, or you can look at your receipts/account balances in the past AND continue to track every penny that you spend going forward. Notice how you should be tracking your spending either way? I recommend that you take the second route. Look at your past spending and make sure to track your spending going forward.

You can review your actual past spending by either going to your bank statements and adding up every cash withdrawal and every credit card transaction over a period of time, or find your total spending for a period of time by using a budgeting tool such as Mint or Personal Capital (Note: Personal Capital is more of an investing tool, but it has budgeting features. For a good comparison of these two see this review from Investor Junkie).

When adding up your expenses for prior dates, be sure to use at least 3 months of expenses. For better results, use a longer time frame. I like to use a year because that covers all birthdays, holidays, and a good amount of randomness that can pop up like trips to the doctor. Brett took my advice and added all of these up for a full year and came to a number of $12,000 for the prior year after subtracting out the regular monthly expenses that we already covered in step 1. We divide this by 12 to come up with our monthly variable expense report for Brett. Now Brett’s report will look like this.

3. Review Your Situation

Looking over the prior results shows that Brett has $900 every month that he can be investing. Brett understood the importance of first building up an emergency fund, but when adding these numbers he realized that he was spending $3,100 every month. This meant that he would need to get to $9,300 in his emergency fund in order to survive for 3 months if he were to lose his job. By going through the exercise in step 2, he was motivated to drop that variable expense down to $600 per month, and switched to a lower cost cell phone provider to get down to $35 per month. Just these few simple changes meant Brett only needed to get up to $7,905, plus he was now had $1,335 to invest every month. This is the awesome double benefit of lowering your expenses in action. Brett enacted his plan, and was able to save up his emergency fund in just under 6 months, and was able to find out what his investment options were for that $1,335 every month.

4. Discover Your Options

401K / 403B

After you build your emergency fund, it’s time to start looking at those dreaded acronyms. Your first step is to check with your employer if they offer a 401K or 403B. 401K and 403B plans allow you to invest your money before taxes and allow them to grow tax free until you hit retirement age. It is at that time that you can start taking this money out and paying taxes. The IRS allows you to contribute up to $18,000 per year to one of these accounts at this time. You will want to get two things from your employer in regards to these plans.

First, find out if they have a matching program. Some employers will offer to match your contributions up to a certain amount. For Brett, the employer would match $1 for every $1 Brett invested up to 6% of his salary. Since Brett’s salary was $5,250 / month, the company would match up to 5,250 * .06 = $315. This is the easiest investment return that Brett will ever make. It’s a guaranteed 100% return essentially! If nothing else, make sure that you get the match.

Second, you need to know where to invest the money in the plan. Many employers who offer a 401K or 403B will give you a packet showing you all of the different investment options. Since you’re just getting started, I recommend finding picking out a fund that has an expense ratio of less than 1% and has the words “Target Date” in the title. The Target Date funds will automatically switch more from Stocks towards Bonds as you get older without you having to do anything. If your company doesn’t offer a “Target Date” fund, then look for a fund that is described as a Total Market Index or S&P500 Index.

IRA

Let’s say that you have maxed out your contribution that your employer will match, you’ve completely maxed out your 401K/403B, you don’t have access to one of these, or you’ve maxed out your employer match but they don’t offer anything with expenses less than 1%. Your next step is to try to max out an IRA. The IRS currently lets you contribute up to $5,500 per year to these accounts. You can set up an IRA by going to a brokerage or mutual fund company. I recommend Vanguard due to their low costs, helpful customer support, and the fact that they are owned by the people who buy into the funds. If you go to this link, and click on the “Open an Account”, you can create a new account and get started quickly. There phone support is extremely helpful if you get stuck. The same rules apply here when looking for funds to invest in. Look for Vanguards target date funds and total market funds to put your money into

5. Automatic Contributions

Now that you’ve opened up your first investment accounts, you’re ready to put your investment journey on autopilot. Choosing the same funds you found in step 4, setup an automatic contribution. For your 401K/403B this was probably already taken care of when you opened your account if your employer asked for a contribution percentage. What that means is that they will take this amount out before you pay taxes and invest it for you in your fund choices every paycheck. For an IRA, there is one additional step. You need to manually setup recurring investments through the web interface. On Vanguard, you can go to “My Accounts” -> “Buy & sell” -> “Set up an automatic transaction”. Then follow the onscreen instructions.

Congratulations

Congratulations on starting your investing journey! In future articles we will go over some more advanced concepts, but just know that you have taken an important step in your journey towards preparing for retirement. Even better, your investing is on autopilot. You will be sticking with the program without having to worry about signing in each month to buy and sell any stocks or bonds.

Oh yea, you might be wondering what happened to Brett. Well he took a dual approach. He decided to contribute $450 per month to his IRA with Vanguard in the Vanguard Target Retirement 2055 Fund, and 16% of his monthly paycheck into a target date fund through his companies 401K. This still gives him a small cushion in his budget that makes him feel comfortable.

Continue the Discussion

What questions do you have and what else do you want to learn?