Help a Reader: Starting to Invest

Here's a question I recently received from a reader:

I'd like to tell you a little about myself. I'm a 22 year old college student who is currently working on completing his undergrad degree in Psychology with hopes of continuing on to graduate studies within the next two years. Thanks to my parents and scholarship money, I pay nothing to attend school. My parents also take care of most of my other large expenses (e.g. car insurance, medical). More importantly, when I was young I was diagnosed with Crohn's disease, and while I am currently in remission, that is only so because of a ridiculously expensive medication called Remicade. Thank goodness for health insurance.

So, I started saving any money I came in to... I opened an online MMA at HSBC bank which, at that point in time, offered a special 6.06% APY (regularly ~5% APY) for "new money"--which I was. However, for economic reasons beyond my comprehension the APY is now 3.05%; I have saved about $2,500 in this account. At work I take home about $260 a week (though it fluctuates during the semester) and have started putting away as much as I can [in to the MMA]. I am a very, very picky spender.

Anyway, I believe it is time to invest. I'd like to move everything in my MMA to something with a higher return; I'd like to keep the money "somewhat liquid" in case of a rainy day. I was thinking of opening a Roth IRA at some point; however, not being able to touch that money until I'm 59 1/2 unless I'm buying my first home or become disabled worries me. So the Roth IRA is in my not-to-distant future, but I was thinking maybe my first investment should be something else. If Index funds are the way to go, how do I go about choosing the right one? Should I start with the Roth IRA as my first investment, and then continue on to riskier territory? I'd like some advice, especially while I can afford to put away as much as I can!!

I usually don't comment on these questions so I won't influence the responses from readers. But I do have to say one thing on this one: "somewhat liquid in case of a rainy day" and Roth IRA/index funds are contradictory statements. A Roth IRA is a long-term investment as is placing money in an index fund. Yes, you can get your money back out if you HAVE to, but you will never know the value of it when you do as the market could easily go down and you'll only have a fraction of what you put in. So if you really want the money available and truly liquid, then a money market or something of the like is the best option. If you want to invest for the long-term, both a Roth and index funds are good options to consider.

I'll leave the rest of the suggestions to you all.

Comments

[Rod Ferguson]

Remember that higher return usually equals higher risk. 3% isn't bad, although I'd agree it isn't great. About the only think I can think of to keep your cash somewhat liquid that could give a higher return than 3% that isn't a money market would be stock investment. Pick something like ING's Sharebuilder (for the low trading fees), spend a month learning about investing in general, another month or three researching a particular industry then a month after that researching individual stocks and then invest. Be advised that the low fees for Sharebuilder are offset by limited investment options.

Upsides: a brokerage account ties into a bank account, so it's usually no more than 48 hours to take a stock and turn it into cash in the bank and vice versa. With the right stocks in the right industries, you can easily gain 10% or more; I have had two companies in my portfolio double in price and one quintupled (three others are under water, but my overall net is up).

Downsides: any gains are subject to taxation, so keep a record of how much of what you bought at what price when. There is absolutely no guarantee whatsoever that you'll make money - if you don't do your research well enough, you stand a good chance of losing some if not all your money; even if your research is spot on, the market might just decide to dump all over your stocks anyway. It can be very frustrating.

Random advice: DO YOUR RESEARCH. Don't listen to anyone offering advice on a particular stock - even from people you know and trust. If *they* haven't done their research, it's your money being lost. Don't be a day trader; stocks go up and down, so if your research says company A is good and it's had a 3 week downturn, then just sit or add to your position. Remember that you only take a profit or loss when you sell. Diversify; a loss in one stock could be offset by a gain in another. Stick with what you know; if you, for example, work at Subway part time, then focus your research on food service and hospitality companies. You have a better understading of the fundamentals of a company or industry if you work it. Companies that give dividends are better than companies that don't, although the potential for large price gains are generally lower.

Now, if you just want to save the money, you're going to have to give up some of your liquidity. If you are willing to wait up to a year before you can touch your savings, then you might want to split your cash into CDs that mature at different rates. $2,500 should be able to net you five 6-month $500 CDs; rotate the maturity dates so that every 2 months one matures giving you access to part of your savings. If you don't need it, roll it over. If you do, well then you do.

[Matt]

I strongly disagree with Rod Ferguson. Investing in individual company stocks is completely inappropriate for the reader.

He or she is looking for more liquidity than is appropriate even for index funds, which in general are much, much lower risk than individual stocks.

The only people who should even consider individual stocks are those with millions of dollars to invest who can make it a full time job. And even they will usually lose out long-term to index investors.

Unfortunately, right now interest rates are very low and even the best online savings accounts will cause spending power to be eroded by inflation and taxes. But as long as you anticipate a short-term need for the money, you can't do much better.

If one of the things you might want to do with your savings is buy a house a couple years after you finish grad school, I'd recommend starting a Roth with a bit of your money, because you need to have a Roth for 5 years before you can access that money for anything. So you might as well start the clock. In fact, if you're pretty sure you can live without the money for those 5 years, you could put everything in there and pick a low-risk asset allocation like 70% bonds/30% stocks. In your situation it might be a really good way to save for a house without having to pay taxes on your gains.

I would keep at least $1000 in the money market as an emergency fund "for a rainy day." I would also keep a couple thousand in there for short term savings. Think about what you will need to buy in the next 2 years (a car? furniture for an apartment?) and aim to be able to pay for those with cash.

After that, you should focus on investing. I would put half into a Roth IRA and half into another fund. You should research companies like Vanguard, Charles Schwab, Fidelity, and see what their minimum balances are. Then work on saving that much in the MMA and then opening an account. Start the Roth as soon as you can. Then I would work on starting another fund (S&P 500 index is a good place to start). This money can be used as a down payment on a house later on, or whatever other long term goals you have other than retirement.

[sow]

If you don't know what to invest in, invest in yourself. Increase your financial IQ before you start anything. Read books on money and biographies on individuals who were/are wealthy. Then copycat. If you haven't heard it: "There are no such things as risky investments, just risky investors." Best of luck.

[Kevin]

Keep what you have in the money market for your emergency fund. Yeah, the return isn't that great, but it is steady and will be there if you really need it.

If you want to start investing check out an index mutual fund that lets you start off with $50 a month or so recurring contributions - put it into a Roth. I now T. Rowe Price for one does this, but I'm sure there are others as well.

[Mark]

Matt,

You said only people with millions should invest in individual stocks...I had 2 questions for you. I don't think these apply to the initial reader, because I agree with others that with his time frame his best bet is CD's or money market funds.

1. What about the theory of taking 5-10% of your investments and using it for lack of a better term as 'play money'? So if you had $10,000 in index funds and another $500-1000 to spare, maybe investing it in a few stocks?

1a. I don't mean this for day-traidng purposes, but still more for buy and hold purposes. For example, a strong value company might not be a bad company to get one's feet wet if they really wanted to try investing in stocks.

[Rod Ferguson]

Matt - millions of dollars? For $5 you can buy stock. Full time maintenance? I'm not saying he should day trade; I specifically stated that day trading was a bad idea. He wants a return above his current interest rate and he wants to keep his liquidity (he probably wants a return higher than the nominal interest rate, based on his wording). That pretty much means stocks. Index funds are great - I have some - but the return potential isn't as great as one can get with individual stocks. I also hold metals, for which there is no return but have no counterparty risk.. another good thing to have as part of your portfolio. But his question was about return and liquidity, and a money market (which would have been my initial suggestion) was already nixed. A better answer to a slightly different angle to the question would be to leave that $2500 in savings as an emergency fund to offer a buffer against job loss, homelessness, rampant inflation, etc, and not worry about his insterest rate on it; instead look at doing something with a better return on new money coming in. But that wasn't the question.

[Matt]

Mark: I have no problem with a little play money. Just treat it the same as money you would take to Vegas, the track, or a poker game with your buddies. It has nothing to do with investing though. Don't delude yourself that you're planning for the future by buying individual stocks.

Rod: "the return potential isn't as great as one can get with individual stocks." POTENTIAL is the key word there. The LIKELIHOOD, on the other hand, is that index funds will do better in the long run.

With that greater potential for gain comes a disproportionately larger amount of risk. Based on the question asked, does the reader strike you as someone who has a huge appetite for risk? The other problem with individual stocks is you have to own quite a few different ones to properly diversify. After all, the market won't reward you for risk you could have diversified away. Unless you have a lot to invest, the transaction costs of buying a sufficient variety of individual stocks will be a problem. That's why I advised not bothering with it unless one has millions. If the reader needs to maintain a high degree of liquidity, but wants the risk/reward of investing in the stock market, an ETF like VTI would be a good choice for the stock portion of the allocation.

Reader: There is simply no alternative to educating yourself about economics and finance. You can't just rely on the help of a financial professional, because unless you have some understanding of what they're doing, you won't know whether they're investing your money sensibly or enriching themselves at your expense via commissions. Unfortunately, the bad advice is more plentiful and more heavily marketed than the good advice.

Actually, as a psychology major, I bet you'll find learning about economics and finance pretty interesting. Behavioral psychology and economics, for instance, share a basic tenet: incentives matter. Psychology also makes a big contribution to the field of behavioral economics, which has a lot to say about personal finance. There's a popular book out now called Predictably Irrational that introduces the concepts.

Here are a few resources to get you started learning about investing and financial planning:
The Wall Street Self Defense Manual by Henry Blodget
The Intelligent Asset Allocator by William Bernstein
Buckets of Money by Ray Lucia

That's enough to get you started, but there are other great books and resources out there too. A Random Walk Down Wall Street is a classic book. Also check out the 12 Step Program at www.ifa.com

[Rod Ferguson]

I'm not going to answer Matt, as I think we're talking cross-purposes; I was trying to answer the question, and he is trying to offer the best advice he can for investing. Index funds, on average, return about 1-2% above the average money market interest rates, and have maintenance fees associated with them - hardly a windfall (yes, I know some return far more; I'm talking averages here). Index funds should be a part of any portfolio, just not the entire thing. The same can be said for stocks, metals, land, etc.

But, Matt (and sow) are absolutely correct about educating yourself. My suggestion earlier about taking a month to learn about investing could be expanded to take a year to learn about finance and economics in general. Pick a single area that you might be interested in, like currencies, the stock market, macroeconomics, whatever, and start there; you'll naturally branch out to the other areas. Once you can get a firm understanding of the fundamentals, you can begin to make educated decisions about your wealth. You are still young; losing a few points of return while you better prepare to make your decisions will not hurt you in the long run.

[Jim]

Do you have any credit card debt by chance? If you do then I'd say pay that off first. From the sound of it I doubt you do, but just wanted to cover this.

You say you want the money 'somewhat liquid in case of a rainy day'. Is this more of a generally short term investment or is this something you plan to be invested in for years but just don't want locked up out of reach entirely?

If you're concerned that you may need this money in short term (within a year or 2) then how much risk do you want to take? If you invest in stocks like index funds it is very possible that your investment could loose 10%, 20% or more within a given 1-2 year period. If you're looking short term and aren't OK with potentially losing a chunk of the money then I'd stay in something SAFE like the MMA.

If you plan to invest long term timeline (5 years plus) then I'd recommend an index fund. Index funds are diverse so your risk is spread around. Look into ETFs from Vanguard or Fidelity. These are diverse funds that are traded like stocks so you can sell them quickly and easily. They have pretty low expense ratios too.

I think you should avoid investing in individual stocks. Don't put all your eggs in one basket. Picking individual stocks is almost a crap shoot. Sure you might luck out and find a Google on its early days but I think its more likely you'll invest in the next Enron. And its very easy for individual stocks to drop 20% or more in short time frames.

Just my $.02

Jim

[rwh]

One educational point I would like to make is the importance of starting an IRA now, at age 22 versus waiting 5 or 10 years. A quick savings calculation yielded the following:

At age 22, saving:

100/mo for 5 years at 8%, then never adding another penny for 35 years until age 62 will yield 119,712.61.

Wait until age 32 to start saving and save 100/mo for 30 years at 8% will yield 149,035.94 at age 62.

Wait until age 27 to start saving and save 100/mo for 35 years at 8% will yield 229,388.25 at age 62.

And of course: if you start saving 100/mo at 8% at age 22 and keep it up for 40 years until age 62 the final amount will be 349,100.78.

So by all means educate yourself, keep an emergency fund and as you get older diversify and allocate your assets in different areas, but the important thing is don't delay starting that Roth IRA. Do it this month with any number of mutual fund companies that will allow a low initial balance with monthly automatic purchases. At age 22 you have time on your side. Take advantage of it.

[Thomas]

Three recommendations:

Best financial book ever: "Millionaire Next Door".

Start a ROTH as soon as you can. I wish I had started mine earlier.

Go with Vanguard, they are a great company to invest with.

Just my 1.5 cents

[Jon]

I feel something of a kinship to the reader. I too was diagnosed with an IBD (Ulcerative Colitis) while in college - also controlled with expensive medications (Asacol/Lialda/Ursodiol) and also very lucky to have good insurance. I'm 24 now, a recent grad, and have been saving a number of ways since I graduated.

Straight out of college, my priority was to pay off my CC debt, which I did quite quickly once I found a job.

I opened up an account with Sharebuilder investing in index funds. I've had that account for almost two years now. It's done alright, and I've been putting about $100/month into that account.

Second, I opened up a interest bearing online checking account with ING Direct and a high interest online savings with HSBC. HSBC was offering 5-6% when I opened the account, now they're down to 3.05% as the reader mentioned. My ING Checking also earns about 2.5-3.0%. I keep all of my needed cash for bills in checking, and transfer surpluses to savings. I was transfering $100/month into savings. I recently suspended my sharebuilder transfers to build a stronger emergency fund so I diverted that $100/month to my savings account until I reach a point where I'm more comfortable.

Third, I've had two employers offering retirement plans. I opened a 401k at my previous employer and a 403b and 452 (for govt employees) at my current employer. I'm putting about $200/mo into my current 403b/452 accounts. I haven't started an IRA yet since I have these accounts. I may if I need to further diversify in the future.

The retirement fund is obviously a long term investment. The checking and savings earn interest for short term while keeping my cash very liquid. Bank to Bank transfers usually take 2-3 days. My sharebuilder account was intended to be a medium to long term account, and I haven't taken anything from there yet.

As a caveat for sharebuilder, trades are $4 apiece. At two trades a month for me, that was $8 off the top, and that's for a basic account. If you move up a level and pay $15/month, you get some extra features including a gain/loss tracker, and a few free trades each month.

I wouldn't consider myself all that savvy with savings and investments, but i probably have a better understanding than many. One commenter suggested CDs which isn't a bad idea, except that right now the interest rates on those are pretty low too - unless I'm looking in the wrong places. I looked into it, and locking my money up wasn't worth the slight interest rate bump right now. Granted, interest rates could sink even lower, but I'll take my chances.

[Jenny]

I haven't seen this clarified, so I'm going to jump in here. A Roth IRA is NOT a type of investment. It is a type of account. A Roth account can hold stocks, bonds, index funds, CDs, or any other type of investment. As such, it is not inherently "safer" or "riskier" than any other type of account, nor is the expected return any different. The benefits of a Roth have to do with your expected tax bracket at retirement compared to your tax bracket now.

One other clarification. If the money you currently have in your savings account is your "rainy day fund" for emergencies, or money you're expecting to need in the short term (within five years), keep it in savings. The return is low because the risk is low. If you invest in index funds, you will risk losing some of your money in the short run, though history has shown that long-term the return is very good.

I agree with what others have said. Do lots of research before you jump into the stock market. Understand why returns are different among different types of investments. Understand the choices you have when it comes to accounts, and the benefits of each. Keep reading FMF. Index funds are indeed a great way to get started, and a wonderful foundation for your portfolio. But if the interest rate on your savings went down due to "economic reasons beyond [your] comprehension", you are not ready yet.