You've padded your emergency fund,
paid off your debt
and saved up a few thousand dollars – $5,000 to be exact – that you're
ready to invest. But is it best to put it in a mutual fund, certificate
of deposit, index fund or exchange-traded fund?
"If you're asking what's the best way to invest $5,000,
it's kind of like asking what should I have for dinner tonight? Well, it
depends," says Greg McBride, chief financial analyst of Bankrate. "What
do you like? What don't you like? Do you have any allergies? What are
you in the mood for? The same thing [applies] here."
Before you get to specifics, such as how much risk you
can stomach or what to choose off the menu of investments, start with
the basics.
"The first question you need to ask yourself is, 'When do
I need to spend that money?'" says Manisha Thakor, founder and CEO of
MoneyZen Wealth Management. "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. Once you are sure it's long-term money, now
you're ready to really get into the nuts and bolts."
To help you delve into those nuts and bolts, we asked
financial experts for advice on the best way to invest your $5,000. They
suggested options for both the short and long term, if you're hoping to
grow that money for retirement decades down the road.
Short term
Online savings account. The best place for money
you need in a moment's notice is an online savings account, McBride
says. Even though interest rates for online savings accounts are low –
hovering around 1 percent – they "pay the best returns relative to the
savings account offers among all the financial institutions," he says.
The returns currently compare to those of CDs, but without the early withdrawal penalties.
CDs and money market accounts. If your time
horizon is less than five years, Thakor recommends putting the money in a
CD with a maturity date that matches your goal. This option may be
ideal if you have a low risk tolerance, since CDs are insured by the
Federal Deposit Insurance Corp. up to $250,000 per depositor. The
downside? You can't touch those dollars for a predetermined time without
paying a penalty.
Alternatively, money market accounts, which are also
insured by the FDIC, earn slightly less interest than CDs, but you can
withdraw the money at any point. Just keep in mind that interest rates
are generally inversely correlated with access to your money. As Thakor
puts it: "If you want unlimited access to your money, you'll get
slightly lower rates. If you don't mind tying it up for a defined period
of time, which is what you do with a CD, then you can get a slightly
higher rate."
Given their low yields, CDs and money market accounts are
better for shorter-term investments, since they don't always keep up
with the cost of inflation. "Even though on paper it might look like
you're protecting your principal and [your] deposit is growing a little
bit in value, you're actually losing ground because the purchasing power
is not holding," says Paul Granucci, a financial solutions advisor with
Merrill Edge.
Long term
Actively managed mutual funds. Investors with a longer time horizon can afford to take on more risk for a greater return by
putting their money in the stock market.
Mutual funds offer an easy way for investors to gain exposure to a
broad range of stocks. If picking stocks makes you nervous, fear not.
With actively managed funds, a fund manager makes all the decisions for
you, including what sectors of the economy to invest in and which
companies are undervalued or poised for growth. But beware: Mutual funds
come with fees. The average actively managed stock fund charges an
annual fee of 1.26 percent, according to fund tracker Morningstar, and
Thakor advises against buying mutual funds with an expense ratio of more
than 1 percent.
If you do go the actively managed route, Granucci
recommends a globally balanced mutual fund, which is diversified in
stocks, bonds and cash and contains domestic and international
investments.
Index funds. "If the goal is to try to achieve a
lot of diversification and build a portfolio that you can more or less
kind of set and forget, it's hard to beat index funds," says Christine
Benz, director of personal finance for Morningstar.
With index funds, you don't have the opportunity to
beat the market,
but you can keep up with the market, "which is not a bad place to be
given that most active fund managers do not outperform their benchmarks
over long periods of time," Benz adds.
Thakor points out that index funds are the healthiest
option on the menu – without organic food prices. "Index funds are the
financial equivalent of a superfood like chia seeds or kale," she says.
"Depending on what type you pick … you can get exposure to literally
thousands of stock and bond issues at a very nominal fee." The average
expense ratio for stock index funds is 0.75 percent, according to
Morningstar.
ETFs. Mutual funds and ETFs are very similar.
"When you buy one share of an ETF or one share of a mutual fund, you're
buying a small piece of a lot of different investments that make up that
fund," Granucci explains. "The difference is how they are managed."
There's
no active management with ETFs,
so if you're thinking about investing in a handful, be prepared to
rebalance your portfolio at least once a year (mutual fund portfolios
should be rebalanced, too). Advantages include costs that are a lot
lower than those of mutual funds (Morningstar reports ETFs have an
average annual fee of 0.57 percent) and no minimum investment
requirements. While mutual funds may demand initial investments of
$1,000 or $3,000, ETFs – which are traded on exchanges and fluctuate in
price during the day – cost only their current trading price, like
stocks.
ETFs offer exposure to asset classes ranging from bonds
to domestic and international stocks, and even alternative investments
like commodities. "Instead of trying to do one fund that's going to do
it all, you might need to find three or four ETFs that are going to fill
all the different buckets that you want to hit," Granucci says.
Before diving in. You might be ready to put that
$5,000 to work, but before you settle on one of the above investments,
McBride points out three places where your money would be better spent:
- Paying down high-interest debt.
- Saving for retirement in a tax-advantaged account, such as a 401(k) or individual retirement account.
- Starting an emergency savings fund that covers six months of living expenses.
"For the vast majority of Americans, tackling those three priorities is going to more than chew up that $5,000," he says.
And
there's a reason why paying debt is at the top of the list: You'll get a
higher risk-free rate of return by paying down credit card debt than
you will investing in financial securities. As McBride says, "Paying off
a 15 percent credit card balance is like earning 15 percent risk-free."
But let's assume you've paid off your debt, contribute to
a 401(k) or IRA and have enough savings for a rainy day. Now you're
ready to sit down at the table. The experts might have different tastes,
but they all agree on one thing: You have to know what you're ordering.
In other words, if you don't understand what you're investing in, you might make some mistakes.
"The power of investing comes from compounded returns and
time, and if you don't understand what you're doing and you're afraid
to ask questions, when the inevitable hiccup comes in the market,"
Thakor says,
