Unless you own a business, the most likely way that you will become a multimillionaire in your lifetime is to invest a portion of your income into the stock market. In fact, people who buy $5,000 used cars every five years and invest the money they would have been spending for car payments with new cars in stocks will gain more than a million dollars over their lifetime just from that decision. Investing allows you to multiply the money you earn, which makes it a lot easier to gain enough money to become financially independent than it would be to simply earn the money through work and save it. Paying cash and not paying interest for the things you buy also helps because it lets you keep more of the money you make.
To get started in investing, about $3,000 is a reasonable sum. The easiest way to invest is to put your money into mutual funds. These invest in a large number of different stocks, can be purchased by setting up an account online and then using a few clicks of a mouse, and have a performance that bests many professional investors. $3,000 would allow you to buy into several high-quality, low-fee index mutual funds. Once you take the initial position, you can send in smaller amounts to buy more shares of the fund. You can even set up auto-draft to send the money from your bank account to the fund automatically each time a paycheck is deposited.
As an example of mutual fund strategies you could use, let’s look at one of the best families of funds, Vanguard . For $3,000, you can get into the following funds:
Vanguard S&P500 Fund
Vanguard Explorer Fund
Vanguard Mid-Cap Index
Morgan Growth Fund
Vanguard Small-Cap Index
Windsor II Fund
The first fund invests in the stocks contained in the S&P500 Index, which is a group of large, well-known companies. The second fund invests in small US stocks and generally makes risky, potentially high profit investments. The third fund, the Mid-Cap Index, buys medium-sized companies contained in an index of medium companies – some of which will be tomorrow’s leaders. The Morgan Growth Fund is a managed fund that tries to invest in companies the managers believe will grow earnings more rapidly than the average stock. The Small-Cap Index buys stocks in an index of small companies; a very volatile group but one that has the largest potential for growth. The last fund, the Windsor II Fund, invests in stocks the managers feel are good bargains relative to expected earnings and other factors.
There are two different types of funds on this list – managed funds and index funds. The managed funds will have larger fees than the index funds, averaging about 0.40% of assets (or $4 for every $1,000 invested) versus about 0.20% of assets (or $2 for every $1,000 invested) per year for the index funds. Note that this is low for managed funds, where many funds charge 1% or more, but still costs more than unmanaged index funds because you need to pay a group of managers to select stocks, where an index fund just buys whatever is prescribed by the index it is tracking.
If you decided to go the managed route, you might select the Morgan Growth Fund to start, then save up another $3,000 and buy into the Windsor II Fund. In doing this, you would be using the two main stock picking strategies – momentum and value. Momentum investors buy companies that are doing well and going up in price with the expectation that they will continue to do well. Value investors find companies that have been beaten down and therefore are good bargains compared to that for which other companies are selling. Over long periods of time in the past, value investing has done better than momentum investing, mainly because less is lost during market downturns, but both strategies have been in the lead during different periods of time. By buying into both funds, you’ll cover both bases and make sure a portion of your portfolio is getting the best returns possible at any given time.
If you decided to go the index route, you might first invest $3,000 in the Small-Cap Index Fund, then save up another $3,000 and buy into the S&P500 Index Fund. In this case you’re buying both momentum and value stocks in each fund. You’re also buying equal positions in large and small companies. Overlong periods of time, the Small-Cap index will do better than the large stocks because the companies have more room to grow, but it will be a bumpier ride. Because the large companies have dividends and multiple product lines in multiple countries, they will be hurt less during market downturns. Over periods of a few years, there will be times when large stocks will do better, and others where small companies will do better. Once again, if you buy into both you’ll ensure yourself of having money in the best performing sector at any given time.
Once you have made your initial purchases, the two most important things to do are to 1) leave the money alone and never try to trade to beat the market and 2) be constantly investing more, buying whichever fund you have less of at the time you’re ready to invest.
You must accept that you will never be able to guess where the markets will go next because all available information is already priced into the price of the stocks. Most of the big gains made in the markets that result in the high returns compared to bank accounts are made during a period of a few days or weeks that occur randomly over a period of many years. If you pull your money out thinking that you’ll miss a downturn and then jump back in, you might miss out on a big rally and only make 5% for the year when the mutual fund you were investing in makes 40%. You’ll also be paying taxes on any gains if you are investing your money outside of a tax-advantaged account such as an IRA. Not only will you be paying money in taxes, but you’ll miss out on the compounding that the money you pay in taxes would have generated.
You must constantly be buying more because you need to build up a large position to really make the life-changing gains that investing can provide. Buying in periodically also allows you to get a better price on the funds you buy because you’ll be buying more shares when prices are low than when they are high. This means that during periods where the fund price remains essentially unchanged you’ll still make money because you’ll have bought shares on dips in price and lowered the average price you paid for the shares. If you had dropped all of your money into the market right before the 1929 market crash, it would have taken about 15 years for you to get back to even. If you had investing right along, putting money into the market every few months, you would have made a ton of money during those 15 years despite the crash.
To learn more about investing and how to manage the money you earn to become financially independent, check out the SmallIvy Guide to Investing, Book 1: Investing to Grow Wealthy. In there I go through a lifelong strategy of money management, plus give all sorts of information on different investment options and the risks involved. It also explains how individual stock investing can be used as a way to possibly outperform the market averages for those who want to use individual stock investing to add to their mutual fund investments.
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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.