Many investors spend all their time thinking about which stocks to buy. But for most of them -- and especially those who are just starting out -- how they invest makes much more difference than what they invest in.
Recently, a graduating college student asked me what someone in his situation should do with a few thousand hard-earned dollars. If he'd asked me to name one stock to invest all his money in, I couldn't have told him -- there are just too many choices.
That's one of the big frustrations newcomers face when they start thinking about finance. It takes a lot of time and effort to master the ins and outs of investing. Most people don't have that time -- they'd be happy with a simple answer that gets them most of the way there, even if it means they don't squeeze every last percentage point out of their returns.
When it comes to deciding on a single way for a young novice investor to start, it's a lot easier to come up with a good answer. The best thing for a new graduate to do with between $1,000 and $4,000 or so is to open up a Roth IRA account.
The perfect way to start
Here's why Roth IRAs are a great way to save:
- Never pay tax again. As long as you follow the rules, your Roth IRA will be tax-free forever. New grads generally don't pay a lot in taxes, so this doesn't get you much value initially. But over time, the taxes you'll pay on investments outside a Roth -- whether it be in regular accounts where you pay tax every year, or in retirement accounts where you pay tax when you take money out -- are huge. And as you get older, those taxes tend to rise as well. With a Roth, you never have to worry about that.
- Avoid penalties. Roth IRAs actually let you withdraw the money you initially deposited without any taxes or penalties. You don't have as much flexibility to withdraw the earnings on that money, but at least you know you can get at some of your money if you need it. That's a nice feature, especially if you're not sure you want to put all of your savings toward retirement.
- Get lots of choices. It's easy to open a Roth IRA. You can invest in nearly anything: stocks, bonds, bank certificates of deposit, mutual funds, or even some unusual things like gold bullion. And you can start accounts nearly anywhere -- banks, fund companies, and brokers routinely offer them.
As for what to buy, I'm a big proponent of stock index mutual funds. Many fund companies offer low minimum balances for Roth IRA accounts, and it's easy to keep adding to your account over time while remaining diversified. For young adults, being aggressive with long-term money makes sense, so consider going beyond large domestic stocks to add small-cap and international exposure.
With limited money, funds are the best way to diversify. You don't have to decide whether Microsoft (Nasdaq: MSFT ) will beat back Google (Nasdaq: GOOG ) in the battle for the Internet, or whether ExxonMobil (NYSE: XOM ) or Chevron (NYSE: CVX ) is the better energy stock -- you'll own bits of all of them.
But for those who want to follow specific companies more closely, a discount brokerage account is a good way to go. Doing your own research and picking some stocks to follow is a great way to start your education as an investor. But if you can't commit to paying attention and spending the time to follow your stocks, you'll be better off sticking with mutual funds.
In general, it's more critical to your investing success to get started doing something than it is to pick the perfect stocks or funds. As long as you find reasonably good investment choices, you'll probably do fine. The key is getting the nerve to get started. With a Roth IRA, that's easy to do.