It is often said that it takes money to make money. Really it takes a plan and committment, since all of us start small and build wealth with time (unless you are fortunate enough to start with a lot of money, which is few of us).
So first of all, what is a small amount of cash? Well, if you have less than a few thousand dollars, you really aren’t ready to start investing. You do not have the minimum required from most mutual funds and if you invest directly in individual stocks you’ll be paying too high a percentage to fees. Keep saving up money until you have maybe $3,000-$5,000. Some mutual funds will allow you to start with less money, however, provided you also setup direct deposit to put a portion of your paycheck each month in the fund as well. They know that over time your position will grow, so they are willing to accept losing money on your account, since their administrative costs will exceed the fees they collect, for a while.
So once you have $3,000 to $5,000, what do you do with it? A common choice is to invest in a mutual fund since this allows you to buy a large basket of stocks, thereby reducing your risk of a significant decline. (Significant in this case meaning 90%. You’ll still see drops of 10-20% from time to time.) It is also virtually impossible to lose one’s entire investment in a diversified mutual fund. The entire economy would need to collapse. By contrast, people lose their entire investment in a single stock fairly often, perhaps one in twenty times. In other cases the stock you select may only decline slightly, but then sit there doing nothing for years. You may not lose your investment, but you do lose the money that you would have made if it were left in a bank account or invested in a mutual fund during that period. This is called opportunity cost, and can be just as detrimental as seeing a stock decline.
When investing in mutual funds, I like to use index funds. These funds do not use a manager or try to beat the market. Instead they buy stocks to match a particular index, say the S&P500. Because there is no active management, the fees are a lot lower. Given that about 90% of managed funds fail to beat the market over time, it makes sense to just try to get the market return. Good index funds to start with are those that invest in a large cross-section of the market. Examples are a large cap fund like an S&P500 fund or a small cap fund like a Russell 2000 fund. The latter will be a lot more volatile than the S&P500 fund, meaning that the price will fluctuate a lot more, but over longer periods of time it will provide a greater return. Once you have a significant amount of money you should have money in both, since typically one will outperform the other over any given period and you won’t know which in advance, but to start choosing one will be fine.
An alternative to index funds are exchange traded funds, or ETF’s. ETFs are like a mutual fund, but they trade like a stock. This means you buy them on the open market using a broker rather than by sending in money to a mutual fund company. Their fees are also really low, like an index fund would be. There are a huge number of ETFs that focus on different sectors fo the market, but to start choose something like one that follows the S&P500, the Dow Jones Industrials, or the Russell 2000.
A final consideration is investing in single stocks directly. With $3000-$5000, you can buy 100 shares of most stocks, which is enough to start to be cost-effective. The danger here is that you could lose the whole position or trail the market for years. If you can find a good company like the next Microsoft or Home Depot, however, you can do really well.
In buying individual stocks, you want to think like an owner of the company and not like a trader of the stock. This means you find a company that you would like to own for a long period of time (like 10-50 years). You need to be willing to hold onto it through the ups and downs in the economy. You want a stock with lots of room to grow, since as it grows the value of your investment will grow. You also want a company that will live through downturns while the competition goes out of business.
If you follow this strategy, you must accept the risk that you’ll pick a few losers. You must be constantly adding money to investments, picking up shares of good stocks while they are down. You should also be cutting back on positions that do so well that they take over your portfolio. As your balances grow, you should also be diversifying some of your money into mutual funds to protect against losses.
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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.