Here, I’ll add to this thread to head off some of the daily “what should I do with this $$?”
As the OP said, take a solid look at your financial position currently and also at your goals.
You need an EMERGENCY FUND. Start off with $1000. Put it in a money market account or a high-yield savings account. Here are a few links. I am endorsing none of them because I have USAA and therefore no experience with these:
http://www.bankrate.com/brm/rate/mmmf_mmaratehome99.asp?params=WA,1092&sort=2&product=33 <-- Bankrate.com lets you compare
So again STEP ONE: Put $1000 in a high-yield account. This is your EMERGENCY FUND. You will not use this money for buying a stereo or for going to dinner. You WILL use this money to replace your alternator when your car takes a crap (for example.)
Step TWO is to pay off your debts. There are a lot of ways to do this and I will not get into them in this post unless I get requests to edit this. The point here is that you will nearly always PAY higher rates than you EARN, so if you have debts that takes a serious bite out of your investment income.
Step THREE is to contribute to your emergency fund until it is large enough to cover 3-6 months of your necessary living expenses. This still goes in that same high-yield savings-or-money-market account. You want the money there because it needs to be readily accessable if something comes up, and that rules out CDs & etc. If you are in a more volatile career, you might consider having 9-12 months in the emergency fund instead of 3-6; but I think 6 is a good number.
Those are the BASICS. It will take most people a while to get through Step Three. You should not proceed to step four until you are done with step three.
Are you done with step three yet?
At this point you’re going to begin investing. If you are reading this post then like a lot of us you are an investing n00b. This means you are not ready to pick stocks yet. Picking stocks is sexy and glamorous and requires a lot of time to do it right. (Some of you old-timers are going to say this is an over-simplification, and you’re right, but this is for teh n00bs.)
Mutual funds are “where it’s at.” At least for most people. When you contribute to a mutual fund, a “fund manager” takes your money and buys lots of stocks and/or bonds with it. This is is full-time job and he’s had a lot of training. He can do it better than you, almost certainly.
When thinking of mutual funds, there are a two basic types:
- Managed funds
- Index funds
MANAGED funds attempt to “beat the market” through active trading. THEY can be broken down into a few more types:
- Bond funds
- Blended funds
- Stock funds
Bond funds invest in bonds. Generally they will have a lower rate of return in a bull (up) market, but a better one in a bear (down) market. Many bond funds are tax-exempt because they invest in municipal bonds. USTEX and USATX are two tax-exempt bond funds I am currently looking at.
Blended funds look to take a middle ground: they will invest in stocks AND bonds.
Stock funds purchase stock in different companies and return the most in a good market. Stock and Blended funds can be further subcategorized:
These can also be of two types:
The “cap” type just has to do with how big the companies the fund invests in are. A large cap fund will invest in companies like General Motors or IBM or Anheiser Busch or CitiBank. A small-cap fund will invest in startups or other smaller companies. Mid-cap funds obviously invest in medium-sized companies.
VALUE funds are those where the fund manager looks for companies where their shares are trading below what they should be. Let’s say company X has a fantastic product and very little debt and few competitors, but maybe there was a little scandal in the news about one of its executives sleeping around, so the stock price is down. Well a value fund will buy that stock, expecting it to go back up to it’s normal level.
A GROWTH fund will look for companies that are growing, building market share, increasing their value on the economic stage, etc etc, and invest in THOSE companies.
If you look at this example:
The Calamos Growth Fund (CVGRX) is a large-cap growth fund. (Frequently these funds will have “Growth” or “Value” in their name.) Scroll down to the bottom of that page and you can see the grid that shows the category.
There are several things to consider when picking a mutual fund:
- Historical return
First of all, you never want to buy a mutual fund because it turned in 37% last year. That is AWESOME for the people who owned it, but the fund manager could have just gotten lucky, too. Look for a fund with a 5-10 year (or more) track record of returns you like. Sticking with the above example, CVGRX has a 10-year average of 18.75% before taxes and fees. That’s pretty darn good.
Next, look at the fund management.
Nick P. Calamos has been the fund manager since 1990. Clearly he knows what he is doing. But if you go to invest in this fund, and you see that last week he turned over the reins to someone else… well then it’s a whole new ballgame and all of the history with Calamos is out the window.
Next, you want to look at the fees a fund charges, because the return of a fund is reduced by fees. If a fund (for example) returned 10% last year, but they charged 2% in fees, then the real return was 8%. After taxes it might only have been 5%, which is silly. Low fees are important.
(Fees, BTW, generally go to cover things like trading expenses, the salary of the manager, utilities for the fund company, rent, etc etc. The fees are teh fund corporation’s income.)
In the case of CVGRX, fees are 1.19%. If we subtract that from the 18.75% 10-year average, we get 17.56%. Then take out taxes and you’re still above 12%, which again, is not too shabby.
“BUT! BUT! BUT!” some people will shout. “BUT 80% OF MUTUAL FUNDS DO NOT BEAT THE MARKET!!! YOU SHOULD BUY INDEX FUNDS!!!”
Index funds? What are index funds?
Index funds are a fabulous invention. It’s true that beating the market is difficult to do on a regular basis. Index funds are built on the premise of “if you can’t beat 'em, join 'em.” They simply buy all of (or a statistically representative sample of) all the companies in a certain index. So an S&P 500 Index fund (like FSMKX: Fidelity Spartan 500) doesn’t have to spend a lot of money on managment salaries because the amount of management required is very small. As such, the expenses for FSMKX are only 0.1%; subtracted from the 10-year average of 8.07%, that gives a 7.97% average return before taxes.
A final “category” of mutual funds are “international funds.” These invest in companies around the world. Some are worldwide funds whereas others invest in just one area, like Asia or Western Europe, etc.
“Dang,” I hear you say. “These taxes sure are getting up in my chili.”
NOT TO WORRY. If you have “earned income” (a Job) then you can contribute 100% of your after-tax income (up to $4000/year) into a “Roth IRA.” This Roth can be any kind of investment, but most people pick a mutual fund. The growth of the fund is then TAX FREE, although you can’t take the money out (with rare exception) until you turn 60. BUT THEN your withdrawls are TAX FREE, you can pass it on to your spouse when you die TAX FREE, and on to your youngest child when your spouse dies TAX FREE. The Roth is such a wonderful product it’s amazing that it came out of our government.
Some companies offer a 401(k) plan. Depending on what funds they make available for your investment purposes, this can also be excellent. 401(k) contributions are subtracted from your AGI, reducing your tax burden; but they do not grow tax free. Therefore, for retirement purposes, here is the best way to handle your accounts:
FIRST: IF (and only if) your company has MATCHING 401(k) contributions, contribute to max out the match. This is because the match is an instant 100% return on your money. Do not contribute a penny more than the maximum match, however.
SECOND: Contribute to your Roth IRA which you wisely opened in a good mutual fund.
THIRD: If you have maxed out your matching 401(k) contribution and your $4000/year Roth contribution and you still have money to save for retirement then put that into your 401(k) plan again.
Overall, in your mutual fund portfolio, you’re going to want to have a good mix between the fund types. You’ll want small-, mid-, and large- cap funds, as well as international funds; approximately 25% in each category.
Researching funds is easy and fun for a lot of people, but if you don’t want to put forth the effort, then index funds are definately the way to go.
If you have kids or are still in school yourself, you can contribute to a 529 college savings plan; I’m not super familiar with this, but my understanding is that it’s kind of like an IRA but you use it for educational purposes. Significant tax advantages over just keeping it in a fully taxable account.
Also, in many cases people are eligable for a medical savings account. I am not so I don’t know a lot about this either, but it seems like you would use another high-yield savings account or MMA for this, and it has tax advantages as well.
IN CONCLUSION… “I have $$$ to invest, what should I do with it?” I hope you’ve found the answer in the above. Start with step 1 and work your way down.