Go to a standard advisor, or read an article from a magazine on how to invest, and you will likely get the standard advice:
1) Buy mutual funds (individual stocks are too risky)
2) Diversify as much as possible (to limit volatility risk)
3) Don’t try to pick individual stocks or time the market.
4) Find stocks with good dividends to supplement growth.
5) Have a portion of your account in bonds (usually a percentage equal to your age, or your age minus 10).
This advice is perfectly good and will nearly ensure that you preserve your money and do better than inflation. If you properly diversify and rebalance correctly, you should receive around the market average, minus fees on the funds you own. Long term averages have been around 10% using that strategy.
But what if you only have about $2,000 to invest? Maybe you’re just out of college, have graduated with no debt and have no credit cards, and you’ve just started your first job. After a year of careful living you’ve saved up a good, $10,000 emergency fund, and now have a couple of thousand dollars left over for investing. You’ve also allocated 15% of your paycheck directly into your 401K, which is invested in mutual funds using the standard advice above. If you put that $2,000 in mutual funds, you would only be able to buy one fund, and then probably only after agreeing to automated payroll deductions.
Let’s say instead that you decided to buy an individual stock with that money. What is the worst that could happen? The company you bought could go bankrupt and your $2000 would disappear. You’d only be left with a worthless stock certificate to frame and put on your wall (if you even sent for the certificate). You’d have a $2,000 piece of art work.
You could probably re-earn that $2,000 in a few months. In fact, you could start directing a portion of your paycheck to investing, and come up with a few thousand dollars every 3-6 months. In that case the loss of the $2,000 would become a distant memory after a few years. Just a war story to tell.
So what kind of stocks would you buy with your $2000? Many people get caught up in the dynamics of the market. If they used that $2000 to buy 100 shares of XYZ stock and $20 per share, they would sell it if it went to $22 per share. After all, that was a 10% profit. They might also look at the fluctuations in price, see that XYZ traded between about $18 and $23, and decide to sell at $22.50, hoping the stock would then drop to around $18 so that they could buy the shares back and do it again. People who did this might make a small gain here and there, but they would never really make a lot of money. Not as much as they should.
What if you could go find a professional business manager. The kind who went to a fancy Ivy league school, and invest your $2000 with him. Maybe with a whole team of fancy managers. Or maybe you could find someone who has a great idea and invest with him. Let him take care of running the business. You’d just be a silent partner. But wait – those sorts of people are only interested in people with hundreds of thousands of dollars to invest. They wouldn’t be interested in you and your lousy $2000, right?
In fact, that is just what the stock market allows you to do. If you stop following the prices and really look at the companies, you can find all sorts of businesses out there to put your $2000 into. These are all businesses with great ideas and professional, battle-scarred managers. You could be part of the next Google, or Apple, or Ford Motors.
You’d want to approach it just as you would if you were putting your money into a business. You would find a business with great prospects and a great management team. A company that had room to grow for years to come. Maybe one that had just started to make it big, but was not so big as to be high in price yet.
You would then invest your money and expect to leave it there for years while the business grew. You would expect up and down years – after all you have no control over what the economy will do or what people will decide to price the company at on any given day. You would plan to stay with the company though as long as it still has the promise of growth.
Because you could not be sure that your first pick was right – after all, things happen even to great companies – you might want to put your next $2000 into another company. And then your next $2000 into yet another company. That way you would have three chances of picking a big winner instead of just one.
Eventually, if you picked the right company, your meager $2000 would be worth tens or hundreds of thousands of dollars, and you’d be receiving a huge dividend. Maybe you’d get paid back your $2000 every month in a dividend. Hopefully as the business grew you would have sold off part of your interest. After all, if you owned $50,000 worth of a company, you’d hate to see something happen and get nothing out of it. Maybe you’d sell of $10,000 worth every now and then, and use the money to pay your house off early or buy some mutual funds.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Picture Credits: Jorge Vicente, downloaded from stock.xchng