“Got any investment tips?”
It's a common question, but there is no one answer to it. The right investment decision depends on the circumstances, and circumstances change over time. For example, the right way to invest can vary depending on how much money you have available. To look at how the size of the investment should guide your approach, consider the different actions you might take with $1,000, $10,000, or $100,000 to invest.
How to invest $1,000
Nice going! You are no longer living from paycheck to paycheck and have started to accumulate some modest savings. Still, with $1,000 or less an unexpected expense – say, the car needs new tires or you find yourself out of work for a couple months – could put a real strain on your budget. Therefore liquidity, which is your ability to access money on short notice, is a key. Here are some thoughts on where to put your money under those circumstances:
- Safety first. When you are first starting to build savings the last thing you want to do is take a step backward, so safety is a primary consideration. A deposit account at an FDIC-insured bank will give you absolute certainty of not losing money.
- Savings account or CD? Savings accounts (or money market accounts, which are essentially the same thing) are an obvious choice for money you might have to tap into unexpectedly, but don't rule out the possibility of a CD. A savings account allows you to access your money immediately without penalty, while a CD requires a commitment for a specified period. If you need to take money out before the CD's term is up, you will probably have to pay a penalty. On the other hand, CDs (especially longer-term CDs) typically pay more interest than savings accounts. In many cases, as long as you don't have to break into the CD within the first few months, higher CD rates can more than compensate for the potential penalty. What this comes down to is weighing the probability that you will need to tap into the account against the size of the penalty.
- Shop around. Savings account and CD rates vary greatly from one bank to another. With a little shopping around, you should readily find savings accounts offering more than ten times as much interest as the national average. You you can also find CD rates that are significantly above average. Investing the time to shop around upfront can then pay off in higher interest earnings month after month.
- Look at fees as well as rates. Interest rates have traditionally been the focal point of shopping for deposit accounts, but banks are increasingly charging for seemingly standard services like paper statements on some savings accounts, so be sure to consider fees as well as rates when choosing an account. At today's low interest rates, a fee might easily negate all the interest you earn on a savings account. As for CDs, those early-withdrawal penalties also vary from bank to bank, so make this a point of comparison when shopping for a CD.
- Consider online banks. Online banks can help you earn more interest in two ways. First of all, not being limited to your local banks gives you more choices, especially if you live in an area where there are few banking options. Second, online banks typically offer higher interest rates than traditional banks. Having customers bank online represents a cost savings to the bank, because they don't have to staff and maintain branch operations for those accounts. In many cases, banks are willing to pass some of these savings along to their customers in the form of higher interest rates. Don't rule out the traditional bank branch, but be sure to include online banks in your search and let the best rate win!
- Keep building. Depositing $1,000 is a great start but your goal should be to continue to build savings from there. Keep adding deposits regularly, and if possible have your paycheck directly deposited into a savings account. This way you can pay yourself a monthly allowance out of savings to pay expenses, but you will be making sure that every paycheck adds something to your savings.
Related >> Beginners' Guide to Investing
How to invest $10,000
Your saving discipline is starting to pay off! Now that you've accumulated $10,000, you should have more than enough money to take care of emergencies and can start thinking about targeting money to meet long-term financial goals. Here are some steps to take:
- Define your goals. Your investment choices should largely be determined by your financial goals and the time frame of those goals. Are your savings earmarked to buy a car next year, to put towards a down payment on a house in five years, or to retire in thirty years? Determine your priorities so you can make investments that match your goals.
- Invest or pay off debt? Do you have student loan debt hanging over your head, or did you let your credit card spending get a little out of hand in the past? Sometimes, the most profitable investment is to pay off debt. Especially if you have high-interest debt like credit card debt, you could probably save more money by paying it off than you could earn by investing.
- Understand the respective roles of stocks, bonds, and cash. Stocks, bonds, and cash all have particular characteristics that make them suitable for different types of needs. Cash or cash equivalents such as savings accounts don't earn much of a return but they allow you immediate access to your money, so these investments are suitable for short-term needs. Bonds are likely to pay higher interest rates than deposit accounts, but are subject to some fluctuations in value between now and their maturity date. These can be suitable for intermediate goals like a buying a car or putting a down payment on a home if you match the maturity date with the timing of your need for money. Just be advised that there can be a significantly higher default risk in anything other than US government bonds. Finally, stocks subject your money to the greatest risk, but they also have the highest return potential. That return potential can help you stay ahead of inflation over the long run. Because of their variability, stocks are best suited to long-term needs, at least five years in the future.
- Consider tax-advantaged vehicles. If you are saving for retirement, consider a tax-advantaged vehicle such as an IRA or an employer's 401k plan. A 401k plan allows you to contribute more annually than an IRA and may also include some matching funds from the employer, so in many cases this should be your first choice for retirement saving. The tax advantages of these accounts requires a commitment on your part though, because there is a tax penalty if you access the money before reaching retirement age.
How to invest $100,000
At $100,000, your savings can start taking on some heavy-duty tasks, such as funding retirement or your kids' education. Here are some steps to take:
- Segment your savings by purpose. Your savings are now big enough to work towards multiple goals, so you should identify those goals and segment those savings accordingly. For example, you might have a three-year CD earmarked for a down payment on a house, while you also have assets in a long-term mutual fund building towards retirement.
- Consider whether a Roth or Traditional IRA is the right fit. If you set up an IRA, you have a choice between a Roth and a traditional IRA. A Roth is funded out of money you have already paid taxes on, while with a traditional IRA you don't play taxes until you start to draw on the money in retirement. Choosing between the two often comes down to a judgement of whether you are in a higher tax bracket now than you are likely to be in when you retire. If your tax bracket is higher now, a traditional IRA can allow you to defer taxes until you are in a lower bracket. If you think your tax bracket will be higher when you retire, then it might be better to pay the taxes now and put your money into a Roth IRA.
- Build education savings if you have kids. If you have children, you can get some tax advantage by saving for their education via a section 529 plan. Contributions to these plans are not deductible, but you don't have to pay tax on the investment earnings in the plan. Just be sure not to contribute more than you are likely to need, because proceeds from these plans have to be used for qualified tuition expenses.
- Diversify your investments. As your investments grow, it becomes more important to limit your exposure to any one security. This means diversifying your investments – owning multiple asset classes and several stocks rather than a heavy weighting in just one or two. At $100,000, the most efficient way to diversify is via a mutual fund. If you don't want to make a lot of individual investment decisions a life cycle fund can be a good way to get diversification across multiple asset classes suited to your stage of life.
Related >> Investing 101: A Primer on Mutual Funds
Different approaches for different amounts of money mean you should revisit your investment strategy from time to time as you ramp up your savings. An approach that was fine for a $1,000 investment might not be sufficient when you reach $100,000 – but that's a nice problem to have.
Richard Barrington, CFA, is a 20-year veteran of the financial industry, including having served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc.