Friday, July 6, 2007

"I have a Sum of Money to Invest. How do I invest it?"


I have a sum of money to invest. How do I invest it?


Before you can think of investing this sum, let us go through these questions:

1. Do you have high interest rate credit card or card loan debt? For example, credit card debt greater than 10%? If so, you can use this money to payoff the debt. If you hold a balance on a credit card that charges you 15%, then if you pay off this debt, you are getting a 15% RISK-FREE return! If you invest in the stock market, expect to gain 8-10% average per year over a very long time (yes, you can gain 20% in a year, then next year, lose 10%), with risk. The better deal is paying off your high credit card debt.

2. Do you have a three to six month emergency cash fund in case you lose your income? If not, you may want to start that fund, by putting the money in a high yielding savings account (getting at least 5% at this time). If you have a safety net (such as having supportive parents), then maybe you can have a smaller emergeny fund.

3. Do you need the money within five years or less? For example, you need the money for a downpayment on a house. Then maybe you shouldn't invest the money in a stock market. You may want to put this money in a high yielding savings account as mentioned above. If you can take a bit more risk, and you don't need the money for 3 years (but need it by 5 years), you can look for a good no load, no transaction fee, Balanced Mutual Fund. A Balanced Mutual fund is a mutual fund that often has a 60% weighting in equities and 40% in bonds.

4. If you don't need to use the money within 5 years, then you can be more aggressive and go with a higher percentage of equities (stocks or stock mutual funds). The next question is whether you have saved at least $1000. If you have not saved at least $1000, start saving using a high yielding money market or savings account until you reach $1000.

5. If you have $1000 or more, start learning more about the stock market and investing.

6. Once you are comfortable with at least a primer on investing, Exchange Traded Funds (ETFs) and the stock market, you can now open a Brokerage account from brokerages such as E*Trade or Ameritrade.

7. Do you have between $1000 and $5000 to invest? Then I would recommend investing in diversified mutual funds or ETFs. ETFs are Exchange Traded Funds, or mutual funds that are often indexed, that trade just like stocks. For example, you can buy and sell DIA ETF from any broker. DIA represents the 30 stocks in the Dow Jones Industrial Average. One company which provides ETFs that are sold by almost any broker is Barclays Ishares.

A Sample ETF portfolio:

  1. SPY: S&P 500 ETF representing approximately the largest 500 US Stocks.
  2. IWM: IShares US Small Capitalization ETF representing the smaller capitalization US Stocks.
  3. EFA: IShares International Developed Markets including Europe, Japan and Australia.
  4. EEM: IShares International Emerging Markets including Korea, Taiwan, China, Mexico, Brazil, India, Russia.

8. Do you have at least $5000 to invest, and do you have the time an inclination to study stocks and learn more about the market? If you do not, then you can continue using the mutual fund and ETF strategy mentioned above.

9. If you have at least $5000 to invest, and you do have the time and inclination to study stocks and learn more about the market, then you can now invest in individual stocks. You have to continue reading and learning and go deeper in the recommended book list.

10. Once you've studied enough about individual stocks, you can aim to have a 5 to 10 stock diversified portfolio (as recommended by Jim Cramer in his Book, "Real Money: Sane Investing in an Insane World"). Each stock has to be in a different sector for true diversification. Expect to spend one hour each week studying each position. That's why it is difficult to have a portfolio of more than ten stocks because you won't have time to keep track. Of course, you can choose to have a mixed portfolio of ETFs and individual stocks. Also, if you can keep track of more stocks, you can have a portfolio of up to 20 individual stocks.

11. EXCEPTION: If you are very young (college aged or early 20s), and you have at least $3000, and you have the time and inclination to invest in individual stocks, then go ahead an invest in individual stocks. You are young and you can take more risks than someone who is close to retirement. If you only have $3000, you can start with three positions at $1k each, and as you save more money, you can continue adding money until you have a 5 stock portfolio.

12. NOTE ON COMMISSIONS: Be careful about commissions. If it costs you $10 to buy a stock, and sell a stock, then if your position is $500, then that means it costs $20 per $500 position, or $20/$500 = 4%. That means, for every transaction, you are spotting the market 4%! This is not acceptable. You should have larger position sizes but make sure that you have enough diversification (at least 5 stocks in 5 different sectors). The exception in point #11 above still holds.

Don't forget to continue reading and learning! I hope you enjoy the journey and make lots of money in the process.

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