We all start somewhere.
I remember the day I had $1,000 and thought it would be a good idea to invest it in the stock market.
I had a 401(k) and a Roth IRA, so I was familiar with the mechanics of the stock market, mutual funds and index funds, and how everything fit together. I stayed away from the public markets in a taxable brokerage account because I didn't want to deal with the taxes (they're near trivial, just keep records). I don't know if this is why so few Americans own stock but I do know it held me back.
By the time I was ready to dip my toe into the market, I had about $3,500 and wasn't sure what to do next.
If I were giving my 20-year-old self advice on how to proceed, here's what I would tell him…
Don't get scared off by the financial jargon. I'll try my best to explain them as we go!
My Investing Approach
Everything in life is about having a consistent, repeatable approach. If I don't explain the philosophy and approach, it's easy to get confused if the steps don't line up.
When you don't have a lot to invest, you need to find cheap and low (time) maintenance investments. You want cheap investments, which cost little or nothing to buy or sell because you have very little cash. You can't afford to pay even $5 a trade because one round trip (buy and sell) will cost you $10, or 1% of your assets. It's like another tax, one that will be charged even if you lose money.
You want low maintenance investments because you should be setting and forgetting. At this stage, your time is better served to accumulate more assets to invest, rather than “managing” the investments you have. For now, skip real estate, tax liens, angel investing/private placements, hard money loans, and any of the non-traditional investment options.
With $1,000, it's just not worth your time. There's plenty of time for that later.
Before you invest a penny, get your financial affairs in order.
At a minimum:
- Fully fund your emergency fund.
- Pay off all high interest debt.
- Contribute to a Roth IRA and/or 401(k) with an employer's match.
- Save for other short term savings goals (but put them in safe short term investments).
#1 and #2 are “defensive” moves. You need an emergency fund to protect yourself and paying off high-interest debt is the highest risk-free rate of return you'll ever see.
#3 is an “offensive” move and both types of investment vehicles offer an advantage you don't get with a taxable investment. With the Roth IRA, you get tax free growth. With a 401(k) and employer match, you get an immediate risk free return on contributions. Use both.
#4 speaks to the idea that investable assets should be left alone for at least five years. If you need it in a year or two, it should not be invested in anything risky.
My approach is informed by these guiding principles:
- Keep costs low. Investing with just $1,000 is challenging because transaction costs can be expensive. Nowadays, plenty of brokerages offer free trades. I use Ally Invest and they're now free for U.S. stock, ETFs, and options. If you pay $4.95 per trade then each buy and sell will cost you $9.90. $9.90 on $1,000 is 0.99% of your total assets. That means every investment has to appreciate at least 0.99% before you break even and you're paying $5 to add to the holding. Here are brokers that do not charge sales commissions.
- Your biggest asset is your time. If you don't have a lot to invest, you shouldn't be spending your time looking for investments. You should still try to learn as much as you can, but you shouldn't be analyzing opportunities. You should be earning more money to invest. Grow your nest egg.
- Don't gamble, this is a long game. When you have a little in the market, there's a tendency to want to be risky and gamble more. Fight that temptation because this is a multi-decade game. Doubling your money on a hot stock tip might feel great but how many times can you do that before you get crushed? Probably not enough to last 40 years. And remember, the best performing accounts at Fidelity were the ones that were forgotten!
OK, so you have $1,000 — what now?
Three Options for Beginning Investors
- Treasury Securities – Bills, notes, bonds, TIPS – these are offered by the United States Treasury and are fixed income investments. You buy the bonds and they pay you a regular interest rate on a regular basis. They're backed by the full faith and credit of the United States Government.
- Certificates of Deposit (CD) – A CD is offered by your bank. It's backed by your bank and the FDIC, up to $250,000.
- Public Markets – Essentially “everything else” that is regulated by the government to include stocks, bonds, etc.
The first two are conservative, risk-free investment, but they get your money into something while you accumulate more capital. In the current interest rate environment (Dec 2015), they won't get you much.
The third is where we will spend most of our discussion.
These are Treasury Bills, Notes, Bonds, and Treasury Inflation-Protected Securities (TIPS). They're all debt instruments backed by the “full faith and credit” of the United States. They're also going to give you very little in terms of interest.
Sometime in the future, when rates are better, give Series I Bonds a look. Series I bonds are 30-year bonds whose interest rate is determined by a fixed and variable rate. The fixed-rate is set when you buy the bond and the variable rate changes every six months based on inflation (CPI-U) data. The equation is public information but I always turn to Jonathan at MyMoneyBlog for his bi-annual updates on Series I Bond interest rates.
You buy these through the Department of the Treasury's website – Treasury Direct.
Certificates of Deposit
These are the ones you get at your bank. If you chose this route, just get one at your bank. While it's generally prudent to research CD rates, the difference for this small of a balance won't matter. You're better off using this time in some other way.
Now we're getting to the sauce.
To invest in the public markets, you have three options. You can invest directly with a single company, work with a brokerage, or use a “Robo-advisor.”
Direct Stock Purchase Plans
Direct stock purchase plans are exactly what they sound like – you buy shares of a company's stock from the company. Not every company offers this but the ones that do often go through the Computershare Trust Company.
For example, Coca-Cola is available under these terms. One time purchases have a minimum of $500 but ongoing automatic investments can be as low as $50. The fees are lower than a brokerage and will get you into individual stock positions, so it's often better than a brokerage if you have a specific stock in mind.
A traditional stock brokerage account can be a challenge with $1,000 because of the commissions. Every purchase (learn the different types of order types) will come at a non-trivial cost relative to your assets. In the beginning, I recommend skipping individual stocks and going with funds. There's nothing wrong with individual stocks, I hold a lot of dividend stocks, but the costs are too high at this point. I would go with a mutual fund company that won't charge me to accumulate more shares of their funds.
If you open an account with a large mutual fund company like Vanguard or Fidelity, you can get commission-free access to their ETFs. All account holders at Vanguard can buy and sell Vanguard ETFs absolutely free. Fidelity account holders can buy and sell many iShares ETFs and Fidelity ETFs for free.
If you want free trades and don't want to use a smartphone only brokerage, consider Ally Invest. I have an account with them and have long been a fan. Free trades with no minimums and a suite of useful tools. If you want to get into stock options (not recommended if you have just $1,000), they're a good brokerage for that as well.
A “robo-advisor” is a relatively new creation within the last few years. They act as a computerized financial advisor and determine your asset allocation using an algorithm. You deposit your funds with a robo-advisor company and they invest it, charging you a small advisory fee on top of the underlying fund/etf fees.
We'll go in greater detail on investing through funds/ETFs and Roboadvisors.
Do It Yourself with Funds
If you want to do it yourself, go with a big mutual fund company like Vanguard or Fidelity. Vanguard has no account fee if you opt for electronic statements and has a minimum of $1,000 if you use their Target Retirement Funds or their STAR fund ($3,000 minimum otherwise). Fidelity will not charge you an account fee and has a minimum of $2,500. If you only have a thousand dollars, Vanguard is your best option here.
With Vanguard, you still pay fees in the funds themselves, expressed as an expense ratio. The Target Retirement 2050 Fund has an expense ratio of 0.15% and the Vanguard STAR Fund has an expense ratio of 0.31%. Both are higher than Vanguard's index funds (the 500 Index Fund has a ratio of 0.04%), but those two funds have low minimums.
If you have $3,000, I'd go with an index fund and my money is in Vanguard funds.
Vanguard also offers a Personal Advisor Service where you can speak with an advisor to come up with an asset allocation to help you mean your financial goals. It's an affordable service that only costs 0.30% on top of the underlying Vanguard fund fees.
The three most well known advisors are Future Advisor, Wealthfront, and Betterment. (see a head to head comparison between Betterment and Wealthfront) As always, fees are important and these companies charge an advisory fee on top of the investments they put you in. In all cases, they are cheaper than a human advisor.
Here's how they break down fee-wise with just $1,000 to invest:
- Betterment: If you're willing to automatically deposit $100 per month, it's just an 0.35% advisory fee for assets under $10,000. If you don't auto-deposit, it will cost you $3 per month. The fees drop to 0.25% when you exceed $10,000 in assets. It drops to 0.15% when you exceed $100,000 in assets. Zero trade fees, transaction fees, and rebalancing fees. (pricing page)
- Wealthfront: They do not charge a fee on the first $10,000 in assets (we have a promotion with them that will give you the first $15,000 of assets managed for free), then it charges 0.25% annually on amounts over $10,000. This is an advisory fee on top of the fees of the underlying ETFs, which they say average 0.12%. No transaction or trade fees either. (see our Wealthfront Review)
- Future Advisor: Recently acquired by BlackRock, the world's largest investment manager, FutureAdvisor charges 0.5% advisory fee on top of the underlying fees of the investments.
Should you use a Robo-advisor? That's up to you. These didn't exist when I first started investing so I went with Vanguard and their low $1,000 minimums. I've stuck with them, though I've mixed in some dividend stocks at Vanguard during the market crash.
These are incredibly cheap services. Wealthfront is free up to $10,000 in assets (with our promotional link, you get $15,000 managed free). Even if you chose Betterment and paid 0.35%, that's just $35 a year on a $10,000 balance. $35 for an algorithm to take away the stress and headache of picking your asset allocation (and tax loss harvest for you) might be worth it.
If it were me, I'd stick with something simple and focus on accumulating more assets. Simple means go with a robo-advisor or a target retirement fund from Vanguard/Fidelity. Once I hit $10,000 in investable assets, I re-evaluated how I want to invest. The goal would be to have an account at one of the big mutual fund companies and be invested in low fee funds/ETFs.
What about other investments?
I'm sure you've considered other investments, here are the ones I've done and my thoughts about them:
- Angel investing: It's gambling. You'll probably lose your money. Don't invest in your friends unless you're willing to lose it (and think it won't affect your relationship). My friend once told me he invested in his friend's company as a way of hedging his own envy — if his friend did well, he'd share in it and not be envious. If it tanked, well his friend would've lost his company and he would've just lost a little money, can't really be bummed about the relative outcomes. Not a bad way to think about it.
- Hard money loans: Risky but can be pretty lucrative, it's hard to find good folks to loan to so it's harder to scale.
- Real estate: Not low maintenance and there's a steep learning curve. Good way to build wealth but not when you have just $1,000 to start. There are plenty of resources that will teach you how to invest in real estate with no money down or flipping houses, but unless you plan on going gung-ho into this arena, I'd work on something else. (an exception to this might be crowdfunding real estate sites, but even that I'd stay away from initially)
- Tax liens: I only researched tax liens, I never went to any auctions or went through the process itself. The returns seem good but there's something about the potential negative karmic energy involved.
For now, stick with the public markets, accumulate more assets, and then re-evaluate.
What About Strategy X, Y, or Z
If you read enough financial literature, you've probably seen a variety of strategies. Some of them are based on looking for leading indicators, others require you to try to follow momentum or use other technical indicators – should you be paying attention?
I wanted to get the expertise of someone who knew more so I turned to Professor Sina Ehsani, Assistant Professor of Finance at the College of Business at Northern Illinois University. He co-authored a paper with Juhani Linnainmaa, Professor of Finance and Business Economics at USC Marshall's School of Business titled “Factor Momentum and the Momentum Factor” which studied momentum factor.
1. Most experts suggest investors put their money in a simple mix of low-cost index funds but can individual investors do better by adjusting their strategy given what you've researched?
Thanks for your interest in our research! We don’t see our findings as a substitute for the “mix of low-cost ETFs.” Low-cost ETFs is perhaps the best advice to give to the individual investor. Factor momentum can become a part of the (diversified) portfolio for the sophisticated investor who already trades factors. For that investor, our main advice is to invest more in winner factors because winner factors tend to do better than other factors in near future. We also show that investing in winner factors is, after adjusting for risk, a lot better than investing in winner stocks.
2. What are some tools an individual can use to identify some areas of opportunity?
I think your question here is related to the implementation of factor momentum. Invesco issues a “factor snapshot” report every month. There may be other resources that I am not aware of.
Page 4 of this file displays a chart that ranks some selected factors based on last year performance. For example, low vol and quality were the outperforming factors of the past year by the time of the report. We predict that, on average, the winning factors (in this case low vol and quality) will outperform others in near future. I think there are ETFs for all of the factors of the chart. Small (IWM) vs. large (SPY, IVV,…), value (IVE) vs. growth (IVW), low volatility (SPLV), and quality (SPHQ). The active part of the portfolio can allocate more to the ETFs that track the winner factors.
Is there risk in following the herd? The rise of ETFs has increased volatility in their underlying stocks, as you discovered in your 2014 paper, so does investing in them increase risk?
Once again, this advice is for active portfolios that trade frequently. The “buy and hold low-cost ETFs” is still the best advice to give to retail investors.
It's interesting to note that the experts still advice low-cost ETFs but there are factors that can help improve your returns if you are willing to put in the study. Factors that outperformed last year are more likely to perform well this year. Picking the winning factors is a better strategy than trying to pick the winning stocks – a powerful insight.
That said, it also shows you the level of detail the experts are using. If you aren't willing to go this deep, best stick to low-cost funds!