To Invest or Not to Invest: “How” Is the Question

Wednesday, May 12, 2010 - 04:54 PM

If you’re like a lot of people, the idea of investing seems overwhelming, mysterious and downright frightening. The wild ride, you reason, just isn’t for you. That argument may make sense for money you know you’ll need to get your hands on within the next ten years. But for money you don’t plan to touch for longer, it can be riskier to keep your cash in a savings account that does not keep up with inflation.

After you pay off high-rate credit card debt, put money into tax-favored retirement plans (particularly those with company matches) and save six months’ worth of living expenses in a bank savings account (to bail you out if you lose your job or have a major emergency), you should consider investing at least a portion of your money. Some steps to consider:

  1. Always diversify. Investing in just one company is placing a bet on just one company. To avoid putting yourself at the mercy of one company’s success (or failure), spread the risk around. Choose a mutual fund, which pools your money with that of other investors into a large basket of stocks, bonds and cash.
  2. For stock mutual funds, I like stock index funds. There are two types of mutual funds: “active” and “passive.” Passive funds, or index funds, are in my opinion the no-brainer best choice. Active funds need to pay a fund manager to pick and choose which stocks to invest in and thus these funds pay the manager high fees to do this (on average 1.27% per year). Index funds don’t pick and choose in the same way. Instead, they are made up of the very same stocks that make up some popular indexes like the S&P 500 (a barometer that tracks 500 of the largest companies’ stocks) or the Wilshire 5000 (a very broad index that measures the performance of all U.S. equity securities). Index funds tend to charge consumers much less to invest in them. The interesting fact: On average, active managers don’t always beat the market. In fact, more than 70% of active managers have failed to beat benchmarks over the last 5 years, according Standard & Poor’s most recent scorecard report! Read Burton Malkiel’s book (he’s my hero!) The Elements of Investing, which makes strong arguments for choosing index funds over actively managed funds.
  3. Check out index funds through Charles Schwab and Vanguard. When shopping for an index fund, look for the lowest expense ratios. The lower the expense ratio, the lower the cost to you. Both Charles Schwab and Vanguard offer super-low-cost index funds. The Schwab S&P 500 Index Fund (SWPPX) has an expense ratio of 0.09% and a minimum investment requirement of $100; that’s the best deal around right now. The Vanguard 500 Index Fund Investor Shares (VFINX) has an expense ratio of 0.18% and a minimum investment requirement of $3,000. Go to Schwab.com or Vanguard.com to browse their offerings. (One note: Schwab also offers more expensive mutual funds, so stick with the index funds, which are inexpensive.) For even more diversification (which in my opinion is likely even better) the Schwab Total Stock Market Index Fund (SWTSX) tracks the Wilshire 5000 and also has an expense ratio of .09% and a minimum investment of $100. Vanguard’s Total Stock Market Index Fund Investor Shares (VTSMX), which also seeks to track the overall stock market, has an expense ratio of .18% and a minimum investment of $3,000.
  4. Get to know ETFs. There’s another way to invest in an index that you may have heard about called exchange traded funds, or ETFs. And the good news is that the expenses are often even lower than expenses for index funds. But if you want to continue to make regular investments, or think you’ll want to in the future, ETFs might not be for you, because you’ll be charged a transaction fee every time you contribute money to the account. Bottom line: Specifics tend to change, so you need to compare costs, and make sure you’re getting a fair price if you go with ETFs.

In the end, there’s no guarantee that you will always make money or even keep up with inflation with stock investments. But it’s the best guess of most experts going forward that you’ll want to have at least some of your money in the stock market for the long-term. And for that money, I’d vote on index funds.

 

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