Stock market investing isn’t something you do because you’re bored and investing seems more interesting than playing online Solitaire. Nor is it an activity that you should jump into without careful preparation.

Investing in the stock market should be a purposeful activity, carried out with clear financial goals in mind. In order for it to be so, you’ll need to identify your goals and figure out what sorts of investments make sense in order for you to meet them.

In this chapter, we’ll look at some common financial goals, the time frames necessary to achieve those goals, and tax regulations that could affect different types of investments. Once you understand those topics, you’ll have a better idea of what type of investments make the most sense for working toward your financial goals.

We can’t predict what our future holds, but we certainly can plan for what we hope it holds. As you formulate financial goals, you’ll need to look into the future and identify just what it is you anticipate needing money for, and how much you think you’ll need. Once you’ve done that, you can figure out when you’ll need the money to fund particular events.

When you’ve identified what you’ll need to pay for, estimated how much you’ll need to pay for it, and have a time line in place regarding when you’ll need to have the money, you can begin selecting the investment vehicles that make the most sense for you. Let’s start by looking at some of the most common reasons people invest their money, either in stocks or something else.

Building savings for retirement is one of the most common reasons that people invest in the stock market. With an average life expectancy in the United States of 77.9 years, according to the Centers for Disease Control and Prevention, and an average retirement age of 62, according to the U.S. Census Bureau, the average length of time spent in retirement is 18 years. Eighteen years is a pretty compelling reason to have some money available for when you’re no longer working, don’t you think?

The mistake many people make is waiting to start saving for retirement. When you’re 22 or 23 with your first “real” job, chances are you’re stretched a little thin with paying for a place to live, repaying college loans, making car payments, and handling other expenses. Besides, who can think about retirement when you’re just starting out?

By the time many people do start to think about getting some retirement savings together, they’ve lost years of opportunity to invest even small amounts that would have had the potential to result in significant savings. Of course, stocks aren’t the only option for retirement investments, but many people do invest in the stock market, often in addition to other options, such as 401(k)s and individual retirement accounts. If you’ve already got some retirement savings and are thinking about adding stocks to your portfolio, give yourself a pat on the back.

Everyone knows that the cost of a college education has skyrocketed during the past decades, meaning that investing for your kids’ education is a really smart idea. The College Board, a not-for-profit organization based in New York City that offers resources and tools for connecting students with colleges and universities, tells us that tuition at American colleges and universities has increased faster than inflation for the past 30 years, with the average tuition between the 1979–1980 school year and the 2009–2010 school year increasing more than 175 percent for private schools and more than 220 percent for public colleges and universities.

This means that parents need to be more aggressive—not to mention creative—about saving for their kids’ education. There are some relatively new college savings vehicles out there and, while they offer some tax advantages, socking large amounts of money into Education Savings Accounts (ESAs) or Section 529 plans (also known as qualified state tuition plans) can decrease your child’s chances of qualifying for financial aid. Whether or not the savings will affect financial aid depends on who is designated as the custodian for the accounts. Ask the investment firm that guides you with these accounts to set up the accounts to your child’s best advantage.

If you have any hopes of qualifying for federal or state financial aid (and don’t think you need to be impoverished in order to do so), it’s generally best to minimize money saved in accounts in your child’s name, which decreases the chance for aid, and do your homework before investing in ESAs or Section 529 plans. The Complete Idiot’s Guide to Paying for College by Ken Clark is a good resource if you’re looking at making the most of your dollars. (See Appendix B for more information.)

Investing carefully in stocks and bonds, beginning when your child is young, may be your best shot at maximizing college savings. The trick is in achieving the proper allocations of stocks and bonds, with greater emphasis on stocks when your child is young, and moving more toward bonds as the college years get closer.

Investing in stocks in order to generate a down payment on a home can be tricky because it’s generally a shorter time period than investing for retirement, although many people have been successful in doing so. However, because your time frame is compressed, you’ll need to pay close attention to how your investment is allocated, keep an eye on risk factors, and be prepared to be nimble about making changes, should that become necessary.

Maybe your financial goal (or at least one of your goals) for stock market investing is just to grow your money and create wealth for yourself and your heirs. If so, you find yourself in a good position, assuming that you’ve already planned for other, more immediate goals and have met them or are on your way to meeting them.

Wealth creation is a long-term investment, meaning that you’re able to tolerate more risk than you could with a short-term investment. Wealth occurs by building net worth through capital (assets). Most wealthy people don’t have a lot of cash lying around. They own stocks, real estate, bonds, and other investments. And remember that “wealth” is a relative word. To some people, wealth is a comfortable retirement. To others, it’s multiple homes, a private jet, and millions of dollars to leave to heirs. Truly rich people understand that one can be wealthy by simply having enough.

If you’ve achieved all your other financial goals, you may just be looking to invest in the stock market because you enjoy it and are looking to generate some fun money. This may be an even more enviable position than investing for wealth creation, which sounds far more serious than investing for fun money. As with any sort of investment, however, buying stocks to generate extra funds for vacations, a second home, or whatever should not be taken lightly or entered into inadvisably.

Once you’ve identified your financial goals, you’ll need to give some thought about the time frame in which you’ll need the money you’ve invested. Money that you’re going to need in three years should not be invested the same way as money you won’t need for 20 years. Investing in the stock market is not without risk, a topic you’ll learn much more about in Chapter 5.

Some stocks, however, are riskier than others. So if you’re investing money that you’re going to need in the short term, you can’t afford to take a lot of risks with it because you need to be able to depend on having the money when you need it.

If you’re not going to need the money you’re investing for 30 or 35 years, however, you can mix it up a little more, combining some higher-risk investments with some less risky ones. That’s because if you lose money with a risky stock, it has time to recover and make up for the loss.

There are varying schools of thought on what constitutes long-term investing, but it is usually defined as an investment that you’ll keep for longer than three years. If started early on, retirement funds are long-term investments. A college education fund can be a long-term investment, depending on how long before it’s needed that it is started, as can a home down payment fund.

Long-term investing has many advantages, and offers the best opportunities for achieving your financial goals. The real beauty of long-term investing lies in compounding . With compounding, the interest you earn gets added onto the money you’ve invested, earning you more interest, which in turn gets added to what you’ve invested.

For example, if you invest $100 at 5 percent interest, you’ll have $128 after five years. If you leave that money alone and it’s compounded over 15 years, it becomes $208, meaning you’ve more than doubled your initial investment. In another 10 years, 25 years after your initial investment, that $100 will be worth $339. And while you may not get too excited about $339, think about what your account would look like if you’d invested $1,000 or $5,000. That’s why it’s so important to get started early when you’re saving for retirement or other long-term goals.

Another advantage of long-term investing, especially for those who have diversified portfolios, is that it affords you time in which to make up losses. When you invest in the stock market, there are years you’ll earn more than you expected to, and other years in which you’ll wonder why you bothered. Investing for long periods allows you to recoup money lost.

A possible complication when you invest for the long term could occur if you find that you need the money you’ve invested for an unanticipated event, and your investment is in a down period at that time. You could be forced to cash in your investment for less than your purchase cost.

Short-term investing is usually defined as an investment that you’ll keep for less than three years. Some short-term investments are for as little as a couple of months.

Short-term investments usually have low risks and low yields, depending on the type of investment you make. Despite that, they’re an important portion of your total portfolio, including your long-term investments, because they fund financial needs that crop up.

You might consider buying short-term investments to generate funds for a down payment, a vacation, or a business investment. However, unless you are very sure of what you’re doing, investing short term in stocks is very risky business, and you just might find yourself broke and out of luck if you depend on it to fund short-term goals. We are fans of the stock market, but other, less risky investments such as treasury bills, certificates of deposit, or money market accounts also have their place within your total investment portfolio.

Tax implications also figure into your investment goals and time frame. One reason that people like retirement accounts so much is because they offer really significant tax advantages.

For instance, funds put into a 401(k) plan are both pre-tax money and tax-deferred money, providing a double win for investors. Contributions to a 401(k) plan are taken out of an employee’s salary before the salary is taxed for federal income taxes. That means that the employee owes less current income tax. Plus, because the money contributed is also tax deferred, the employee doesn’t have to pay any tax on it or the money it earns until he or she withdraws it. Other types of retirement savings programs, such as individual retirement accounts (IRAs), also offer tax advantages. Chapter 22 discusses tax considerations in depth.

Investments held for less than one year are considered for tax purposes as short-term investments. Short-term gains and losses are netted against each other, meaning that losses offset gains, and the other way around.

If you end up with a short-term gain, it will be taxed at the same rate as your regular income tax rate. For example, if you’re in the 28 percent tax bracket, 28 percent of those short-term gains will go to the federal government, and tax will also be due to your state. So instead of coming out $5,000 ahead on your initial investment, you’ll get to keep only $3,600 or less.

If you lose money on another investment, however, you can use the loss to offset your gain. So if you lose $2,000 on your initial investment, you’d have to pay the 28 percent tax on only $3,000 instead of $5,000.

Investments held for more than one year are, for tax purposes, long-term investments, with long-term gains and losses. Long-term gains and losses can also be netted against one another, but it’s done differently than with short-term gains and losses.

If you’re in a 15 percent tax bracket, net long-term gains are taxed at 10 percent. If you purchased the asset after January 1, 2001, and held the asset for more than five years, the 10 percent capital gains tax falls even farther to 8 percent.

If you’re in a 25 percent or higher tax bracket, your long-term capital gains are taxed at 15 percent. If you purchased the asset after January 1, 2001, and have held it for more than five years, the capital gains tax liability would have fallen from 15 percent to 10 percent. The taxes you avoid paying on long-term gains add up, making it desirable to hang on to your investments for longer than a year.

Another tax aspect to consider is that once you’ve figured out long- and short-term gains and losses, you can deduct short-term losses from long-term gains, or long-term losses from short-term gains.

You’re probably getting the feeling, and correctly so, that taxes can be confusing. You’ll read more about taxes in Chapter 22, but if you’re feeling overwhelmed, consider consulting a tax professional to keep you on track.

Most dividends, money paid to stockholders of companies that realize profits and vote to share them with investors, are considered income and may be taxed at an investor’s regular income tax rate. You can assume that any dividends you receive are considered ordinary, or taxable, dividends, unless the corporation distributing them tells you differently.

Dividends that are not taxed as ordinary income are called qualified dividends and they’re taxed at a lower rate, typically not higher than 15 percent. Qualified dividends, which were established as part of the Bush administration’s tax cuts, include most dividends earned through mutual funds. Requirements concerning the length of time stock has been held also factor into whether dividends qualify as qualified dividends.

While it’s important to keep tax implications in mind, you should never decide to buy or sell stock solely on the basis of tax considerations. Taxes are just one part of the bigger, overall investment picture.

When determining what kinds of investments make the most sense for you, you should consider your investment goals, your time frame, and tax considerations. Factors such as your risk tolerance, your ability to remain unemotional about your investments, and how much time you plan to invest in your investments also will play a role in what and how you buy.

Generally, long-term investing in the stock market is considered to be much safer than short-term, so if you want to invest but are going to need the money you’re investing within a short period of time, understand that your risk of losing the money is much higher than it would be if you were investing for the long haul.

Beginning investors usually do well to sit down with a broker or financial consultant to discuss their goals and investment opportunities before jumping into the stock market. Having a clear understanding of your investment goals, however, and knowing when you’ll need to have money available to meet those goals, will help you decide which investments make the most sense.

The Least You Need to Know