The last couple of posts have dealt with investing – arguably the most challenging aspect of personal finance. We talked about the importance of starting an investment program as soon as possible in order to take advantage of the amazing power of compound interest. And we talked about the fact that asset allocation is more important to your investing success than the actual investments you choose.
Once you’ve committed to get in the investment game and you’ve figured out the right asset allocation for you, now it’s time to pick your actual investments.
Two Key Steps Toward Simplified Investing
My recommendations? First, invest in mutual funds instead of individual stocks. A mutual fund is a pool of money from lots of investors. It’s a less risky choice than investing in individual stocks because mutual funds are inherently diversified. Each one typically holds many different stocks, bonds, or other investments.
However, if you were going to implement Morningstar’s recommended asset allocation (scroll down to “Investing” and click on “Asset Allocation Guidelines from Morningstar”) using mutual funds, you’d still have plenty of work ahead. You’d need to choose a U.S. stock fund, a non-U.S. stock fund, a U.S. bond fund, a non-U.S. bond fund, and a fund that invests in commodities. And there are plenty of funds to choose from in each category.
The Simplest Investing Solution
Fortunately, you can invest in a single mutual fund that is set up to provide you with your ideal asset allocation. And even better than that, this single mutual fund will change its asset allocation automatically as you get older, becoming more and more conservative, as it should.
This type of mutual fund is called a target-date fund. The target date refers to the year of your intended retirement. Most of the big brokerage houses offer such funds – Fidelity (scroll down and see the funds listed under “Target Date”), T. Rowe Price, Schwab, Vanguard, and others. You just choose the one that has the year of your intended retirement as part of its name, and you’ll know that it’s set up with an asset allocation the company believes is right for you.
If you are going to use a target-date fund, you need to be aware that they don’t all use the same asset allocation, even those that are aiming at the same retirement date. Some are more aggressive than others.
They also use different “glide paths,” which has to do with how conservative they become as you get closer to your intended retirement date.
The Impact of Mutual Fund Fees
One important factor when choosing a mutual fund is its fees. All mutual funds charge fees to cover their expenses. You don’t pay them up front (as long as you use “no-load” funds, which I recommend), but they impact investment returns. Of the four companies mentioned above, Vanguard has the lowest fees.
The Financial Industry Regulatory Authority offers a free online calculator in which you can compare the impact of fees from one mutual fund to another. For example, let’s assume you decide to put $10,000 into a target date 2035 mutual fund and you earn eight percent per year for 20 years. If you had chosen Vanguard’s 2035 fund, you’d end up with $34,872. If you had chosen Fidelity’s 2035 fund, you’d end up with $29,958. Obviously, a fund’s fees matter a lot.
Minimum Required Investments
Another factor to consider is the minimum amount needed to invest in such funds.
Vanguard requires a minimum initial investment of $1,000. When making future investments, if you do so by check, it needs to be for at least $100. However, if you set up an automatic monthly investment, there is no minimum. You could do that with as little as $1 per month.
T. Rowe Price requires a minimum initial investment of $2,500, or $1,000 if you invest through an IRA. Each additional investment needs to be for at least $50.
If you have less than these minimums, Fidelity or Schwab may be good choices. While Fidelity requires $2,500 as an initial investment in its target date funds, if you invest through an IRA, you could get started with just $200, as long as you commit to an automatic deposit each month of $200.
Schwab offers the lowest minimum required initial investment I could find – just $100 to get started and $1 for additional investments.
It May Not Be Interesting, But It Is Important
By now, some people reading this article have a thick glaze covering their eyes. I know that for a lot of people investing is not the most interesting topic in the world. But hopefully the idea of one day having enough money to provide for your family’s needs without a paid job is exciting, so it’s important to know about the core principles of wise investing and to start investing as soon as possible.
Before you do, though, there’s one more thing you should know about investing: the benefits tax-advantaged investing, which we’ll look at in the next post.
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