In the last three articles, we have looked at some of the steps a new investor should take to start making wise financial choices. In the previous article we covered making choices in your employer’s retirement plan. This article concentrates on investing in other accounts such as IRAs and brokerage accounts, where your choice of investments are virtually limitless.
In your retirement plan through your employer, you likely have a list of funds from which to choose your investments. The funds are normally categorized into equity funds, fixed-income funds, international funds, etc. This makes it relatively easy to decide which funds you wish to own. However, when you make a contribution to your IRA, or when you have additional taxable savings that cannot be added to a retirement account, there’s no list from which to choose investments. You can pick whatever investment you choose – mutual funds, stocks, bonds, or other more exotic investments.
In your IRA, we suggest you first consider an equity fund such as an Index Fund based on the S&P 500. Many funds of this type exist, such as the Vanguard Index 500. Initially, you will need to make some minimum investment in the fund, typically $500 inside IRA accounts, and then you should be able to dollar-cost-average the remaining contribution over a period of time. For instance, if you contribute $5,000 to your IRA this year, make the initial $500 contribution into an Index Fund, then invest $450 monthly for 10 months until all the cash is invested. In future years, you will be able to dollar-cost-average your entire contribution over the course of the year, if you continue to invest in the same fund. You likely won’t need more than three or four mutual funds in your IRA. One large-cap, one mid-cap and one small-cap are often enough to get you well diversified across the whole spectrum of the equity market.
If you still have additional savings available after you make an IRA contribution and maximize contributions to your retirement plan, you should consider opening a brokerage account. Determine whether you plan to spend the funds in the account in the next 10 years. If so, you then should compare interest rates on U.S. Treasury bonds, CDs from local banks, and money market rates. You should choose one of these, depending on which choice offers you the highest after-tax return. We believe that any funds needed within 10 years should be invested in one of these vehicles.
If the funds are not needed within 10 years, consider either individual common stocks or mutual funds that invest in common stocks. You should dollar-cost-average funds into equities, investing approximately equal amounts each month during the year. For instance, if you assume you will be able to save $5,000 during the year, you could invest around $417 each month into an equity mutual fund.
You should only invest in mutual funds until you have approximately $50,000 invested. At that point, you should consider buying shares of individual common stocks. By holding common stocks, you should be able to better manage the tax consequences of the account. For instance, if you are holding a stock that has lost value during the year, you may choose to sell the stock and take the realized loss to offset other taxable gains you may have. Holding individual common stocks generally takes a little more work on your part than holding mutual funds does. Therefore, if you don’t want to put in a little time and learn about the companies in which you invest, you should consider continuing to invest in equity mutual funds.
We suggest that people avoid more exotic investment vehicles such as options and futures contracts. These investments are often very volatile and in many cases, your entire investment could easily drop to zero. While some professionals are able to make money trading these instruments, we believe it is best for the individual investor to avoid them altogether. We also suggest that day trading, or short-term trading, should be avoided as well. Day trading increases taxes and transaction costs, even when you are able to make money doing it. In most cases, people who attempt to day trade do not make money.
Hopefully, you now feel a little more prepared to enter the world of investments!