If you don't have an emergency fund yet, at least $10,000 should go into a bank savings or money market account that's highly liquid, so you can withdraw it quickly. That money is your safety net in case of job loss or other unforeseen disasters.
Beyond an emergency fund, you may find other projects, like your own education or that of a family member, to be the best form of investment, if you expect them to bring opportunities or credentials.
If you have an emergency fund, and money won't improve your career path, then you're ready to think about how to invest the money in a way to make it grow. The first lesson of investing is: start early in order to maximize the impact of compounding over time. Compounding means earning interest on top of interest, which will maximize your long-term wealth.
For example, If you want to retire at 65 and anticipate a 6 percent rate of return on your investments then if you start at 20, you'd have over $275,000 when you retire. However, starting at 40 would give you a little under $86,000.
That's an enormous difference, and it shows that how long you invest can be more important than how much you invest. If you're wishing now that you'd started earlier, don't waste time on regrets -- just get started today! It's better than getting started tomorrow.
Short-term investing -- day trading, picking stocks and timing the market -- seems really exciting from the outside, but the superficial excitement conceals the fact that most retail investors lose money with short-term investing. FutureAdvisor believes in long-term investing, and multiple academics with Nobel Prizes support the approach as well:
- 1990: Harry Markowitz wins the Nobel Memorial Prize in Economic Sciences for his work on portfolio choice, which was used in creating Modern Portfolio Theory.
- 2013: Eugene Fama wins the Nobel Memorial Prize in Economic Sciences for research which laid the foundation for building Modern Portfolio Theory.
History has shown that cash has not been a good investment, losing about 2% a year in real terms, while US historical averages show stocks have returned a 6% return. So holding a portfolio with a greater weighting to stocks rather than cash will earn you a better return.
|Time Period||Annual Real Return for Stocks||Annual Real Return for Gold||Annual Real Return for Bonds|
Annual Real Returns from: Stocks for the Long Run, by Jeremy Siegel
If you've decided to invest your money rather than keep it in cash, then the next question to answer is: what kind of account should I invest it in? The answer will depend on whether or not your employer sponsors a retirement account for you and matches your contribution.
If they do, the first thing you should do is invest until you get every dollar of matching funds to your 401k, because matching funds are a 100% return, and you won't find that often in life.
Once you've exhausted the matching funds, maximize your contribution to your Roth IRA, which is $5,500 per year. After the Roth, go back to your employer-sponsored 401k, and invest any extra dollars you have. The most you can contribute per year is $18,000, so that answers any other questions you might have had about your $20,000.
The reason you should maximize your yearly contributions to your IRA and 401k is that they are tax-deferred accounts, which means your investments can accumulate interest, and then accumulate interest on the interest, without incurring taxes on those gains until you retire. That accelerates how fast your wealth grows.
When investing $20,000, it's also important to focus on what you pay every time you buy and sell a security. That's called your trading commission, and it can add up to real costs that sabotage your returns. At FutureAdvisor, we use commission-free investments wherever possible, which cuts the costs eating away at your portfolio.
If you have a 12-asset portfolio for $10,000, you're investing $1,600 per asset, so an $8 trading fee will eat up 0.5% of your investment before you're even started. We work to eliminate commissions wherever we can. That said, low expense ratios (the percentage of your assets you pay to invest them in a fund per year) are also important, and they are measured separately. Numerous studies show that the less you pay a fund in investment fees, the better it performs.
With a $20,000 portfolio, you want to use Exchange Traded Funds (ETFs) to diversify as broadly as possible. Owning every share in the S&P 500 would be very expensive if you bought stocks individually, but with an ETF that tracks the S&P 500, you can own the index through a single security, broadening your portfolio without having to monitor hundreds of individual stocks. ETFs are highly liquid, low-cost investments. Liquidity means they trade on the stock exchange when the market is open (you can get in and out of them easily), and they usually have much lower fees than mutual funds.A few ETFs that you'll want to consider including in a balanced portfolio are:
|Vanguard S&P 500 ETF (Ticker: VOO)||0.05%|
|iShares Trust Core MSCI EAFE ETF (Ticker: IEFA)||0.14%|
|iShares Core MSCI Emerging Markets ETF (Ticker: IEMG)||0.18%|
|Vanguard Total Bond Market ETF (Ticker: BND)||0.08%|
Your investing strategy should include stocks that generally show superior long term returns historically (this will probably include companies will small market capitalization and low price-to-book ratios). It should also include instruments to de-risk the portfolio such as bonds, Treasury Inflation Protected Securities (TIPS) and real estate. While the stock market can be risky, investing for the long term and holding asset classes that may help offset its ups and downs can help manage risk.
If you have $20,000 in a brokerage account or IRA, you can link it to FutureAdvisor now to get a free analysis and step-by-step instructions on how to balance it for long-term growth.
To recap, here are the best steps you can take to secure your financial future:
- Fund an emergency account that will allow you to live without income for a couple months
- Consider 'Investing' in yourself or your family, by using the money on education
- Invest for the long term by appropriately capturing any matching funds from your employer, and maximizing contributions to your Roth IRA and 401(k) in that order
- Keep trading fees low by seeking out low-fee ETFs for equities and bonds
- Diversify your investments to spread your risk widely - that strategy could save your wealth, and it's backed by Nobel Prize winning research! FutureAdvisor can show you how for free