Congratulations, you've saved $5,000. Now what?
Time to invest those hard-earned dollars the smart way
You've worked hard, eaten out less, counted every penny. And now all those savings are just... sitting there.
When you're trying to build savings, it's easy to let money pile up in a checking account. But at a certain point, that surplus becomes unnecessary padding — when it could be doing something productive. But how?
Say you have a comfortable $5,000 extra. The first thing to do is run a financial health check. Paying off debt, building a rainy day fund, or starting a retirement account are all smart ways to use that money.
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If you have all of the above bases covered, however, it's time to consider putting the money to work by investing — assuming you don't need access in the next few years. "My rule of thumb is investing is something you do for the long run, which I would define as a minimum of five years and ideally 10-plus years," Manisha Thakor, CEO of MoneyZen Wealth Management, told U.S. News & World Report. "Once you are sure it's long-term money, now you're ready to really get into the nuts and bolts."
That said, even if you're operating on a time frame that's less than five years, you don't have to be a total financial couch potato. A savings account at an online bank can net 1 percent interest, which is better than letting the money sit in a checking account or a lower-yield savings account at a brick-and-mortar institution.
Another low- (but at least not no-) interest option is to put your money in a certificate of deposit (CD) with a maturity date that works for your time frame, or in a money market deposit account. Both are FDIC insured up to $250,000. The drawback to CDs is that you can't access the money for a set amount of time without incurring a penalty. Money markets, on the other hand, allow some access but earn less interest than a CD.
As for what to do if that $5,000 is "long-term money," here are three options for beginner investors:
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1. Mutual funds
A mutual fund pools money from many investors to build a portfolio of stocks, bonds, or other types of assets; each investor then gets a slice of the total pie. While you can find mutual funds with minimum investment requirements of $500 or less, more options will be available now that you're at the $5,000 mark.
Mutual funds' diversification is one of their big benefits, since it spreads your exposure around. Sure, you're not going to catch a fortune-making ride on a fast-rising stock — but you're unlikely to crash, either. Another plus with mutual funds: Each is overseen by a professional whose job is to make and monitor investments, buying and selling accordingly (and avoiding the duds along the way). The active management comes at a price, however; on average, between 0.5 percent and 1 percent of your assets go to the portfolio manager. Taxes, transaction costs, and other expenses will eat in to your returns as well.
2. Index funds
An index fund is a mutual fund with shares in all the companies that make up a particular market, or index. For example, the Standard & Poor's 500 index includes a broad cross-section of 500 large U.S. companies, while the Russell 2000 is made up of 2,000 relatively smaller, domestically focused businesses.
Unlike regular mutual funds, index funds are passively managed, meaning there's no buying and trading — just buying and holding on for the long haul. Because of that, the fees associated with investing are much lower. So is the risk, thanks again to diversification. "[The fund] just moves with the market. You don't have to worry about individual fluctuations, like are people buying lots of iPhones this year or what health drugs are coming out," Luke Delorme, a research fellow at American Institute for Economic Research, told Forbes. Even Warren Buffet has sung their praises as a choice for nonprofessional investors.
3. Exchange-traded funds (ETFs)
An ETF is a type of index fund. The twist is that its assets — for example, the shares of stock in the S&P 500 companies — are themselves divided into shares. What you buy are shares of the ETF, rather than shares of the stock, which creates an indirect relationship between you and the underlying investment. These ETF shares are then traded like a common stock on the stock exchange, with the price changing throughout the day as they are bought and sold. This means you don't have to worry about meeting a minimum investment requirement; you just buy into the fund by paying the current trading price. However, you do have to pay a brokerage commission whenever you buy and sell.
There are many types of ETFs. Most track market indexes like the S&P 500 or Russell 2000 — their corresponding ETFs are the Spider (SPDR) and IWM, respectively — though sometimes they only include shares from a representative sampling of companies in the index. Alternately, you can buy a country fund, which invests in the top equities of a particular country, or an emerging markets fund, which invests in a group of countries and the top companies in those markets. There are even ETFs that track the price changes of commodities like gold or silver, and sectors like oil companies and biotech.
ETFs are not actively managed, which generally translates to lower costs than with mutual funds. (In that sense, you may be able to get more bang for your buck by buying more ETFs and achieving even greater diversification.) The downside to the lack of professional oversight is that it puts the onus on you to keep an eye on your portfolio and rebalance it at least once a year.
If the last part makes you nervous, you might want to try robo-advisers: online wealth management services that use automation and computer algorithms to tend to your investments. Some services have account minimums, so you'll have to shop around — but there's plenty of options for the $5,000 crowd. As for management fees, they are typically less than with a human adviser (and sometimes free, though you'll still get hit with other expenses).
Whether you're considering an ETF, index fund, or mutual fund, none require a lot of research into or knowledge of individual stocks — another reason they're good options for starter investing. The key is just that — to get started.
Alexis Boncy is special projects editor for The Week and TheWeek.com. Previously she was the managing editor for the alumni magazine Columbia College Today. She has an M.F.A. from Columbia University's School of the Arts and a B.A. from the University of Virginia.