A recent Money magazine tidbit on Twitter caught my eye. Someone asked how they should invest a small amount, in this case, $3,000. The response suggested a target-date retirement fund. However, I don’t think that is a very good answer in this case, or in most cases.
How To Invest a Small Amount
When I was a Certified Financial Planner, I would come across people all the time who wanted to know how to invest a small amount. It isn’t hard to see why. We are constantly reminded that we should be saving and investing money. Books like The Richest Man in Babylon (the single best book for beginners in personal finance) extol the virtues of investing some of everything you earn and letting the power of compound interest turn that on-going investment into millions of dollars. However, this very simple concept is actually very misunderstood.
First, remember that compound interest is NOT fast. If you invested that $3,000 and were able to earn 8 percent per year you’d have just $4,408 in five years and $5,141 after a full seven years. That isn’t to say that you shouldn’t invest that money, you should just understand what your realistic expectations should be.
Second, understand what your time frame is. One of the difficulties of financial planning is getting all the terminology right, and not just the technical stuff. Even some of the most simple terms are often misunderstood.
For example, when it comes to personal finance, professionals talk about short-term, medium-term and long-term. For the short-term, you should save your money, not invest it. For the medium-term, you should only invest if you have a high risk tolerance as it can take several years for the law of averages to turn in your favor. Long-term financial goals should be funded by investing in a portfolio that matches your risk tolerance.
Many people have their own ideas about what those words mean, however, for professionals, those financial phrases mean less than five years, five to ten years, and more than ten years, respectively.
- Short-term < 5 years
- Medium-term 5 years to 10 years
- Long-term 10+ years
That may or may not square up with how you use those terms, but you can see how many people end up doing the wrong thing with their money just by not connecting on this one simple thing. If you are thinking you won’t need this money for four or five years, and consider that “long-term” you’ll be looking to invest when you should be looking to save.
Which brings us to another terminology problem. Saving money does not mean shoving it under your mattress. Saving still means earning interest. Granted, these days that interest is pretty puny, but it earns it just the same. More importantly, it never loses any money. Any true investment involves risk, and that means the possibility of loss.
Use Designated Accounts for Long-Term Investing
Assuming you truly mean long-term, that is over 10 years, then most investing questions are easily answered by using the specialized accounts designed for that type of investment.
If you are talking about investing for retirement, then you should invest in your 401k or an IRA. In this case, an IRA is the answer because there is no real way to drop a lump sum into your 401k. In fact, another $2,000 could still go into an IRA for the year based on the 2012 IRA limits.
If you are talking about investing for a child’s education, then you should invest in a 529 plan.
After that, if you are still talking about money you are 90 percent sure you will not need for at least 10 years, THEN you can talk about investing elsewhere. However, if the dollar figure is small – less than $10,000 — then, you should first ask if you already have sufficient savings and emergency funds. For most people an emergency fund should be at least three months of your typical monthly expenses, and six months is ideal. If you don’t already have that money socked away, the answer is that the $3,000 belongs in your savings account, or a money market account.
All of this brings us to the unacknowledged trick in this question. If you are already maxing out your 401k contribution limits, and your IRA contributions — inlcuding spousal IRA contributions, and sufficiently funding any 529 plans for your child’s education, then there are not very many scenarios under which you have only a one-time amount of $3,000 to invest, making the question completely different. (If you are going to have an extra $3,000 on a semi-regular basis, that is an entirely different question.)
If, on the other hand, you are not maxing out your 401k AND contributing the maximum to an IRA, and investing adequately for your child’s education, while still sufficiently funding your short and medium-term goals with SAVINGS, then the answer is obvious. Put the $3,000 towards retirement or your kid’s 529 plan.
In other words, there is rarely a situation where anyone needs to know where to invest a “small” amount of money.
(Oh, and while we are at it, most professionals consider a small amount to be somewhere between under $10,000 and under $50,000, depending upon the circumstances.)
Don’t Forget the Fees
If you are going to take the advice to invest $3,000 (or whatever amount) in a target-date fund, don’t forget about the fees. If you invest in funds with a load, you’ll be losing nearly six percent off the top in the case of a front-load mutual fund. If you invest in a no-load fund, be sure that there are no annual fees for “small” accounts, or any inactivity fees if you aren’t making ongoing trades.
Those hits can eat up any investment returns you might earn along the way.