Let's address a common problem facing many new investors who want to start investing in the stock market: money.
As in, how much money do you need to start investing? And if you don't have a lot of money to start with, how should you invest what little you have in order to make more? Let's start with a nice, round number: What is the best way to invest $1,000?
In my opinion, a new investor can start investing in the stock market with only $1,000. It's not easy, but it's not impossible. To make it work, you just need to defy common wisdom a bit. How? I think you should take your money and split it into two piles, $500 each, and invest one pile of that cash in an index fund such as the SPDR S&P 500 ETF Trust (NYSEMKT:SPY), and the other in a stock of your choosing.
And now I'll tell you why.
The trouble with (too little) money
The biggest problem with investing a small sum of money in the stock market is that seemingly tiny "transaction costs" can make up a large proportion of your investment, making it hard to benefit from a rising stock market. I'll give you one example.
Here at The Motley Fool, we recommend that you spend no more than 2% of your investment on investing commissions. Why? It's simple, really. Say you buy $100 worth of a stock, and it goes up 10% in a year (the average for the S&P 500 over long periods of time). If your broker charges a $10 commission to buy the stock, then at the end of that year, your net profit from this investment is...zero. The stock goes up $10, but because of the commission, you started out $10 "in the hole." That ate up your later profit, leaving you with absolutely no benefit from the stock's gains.
How do you avoid this unhappy scenario? First, use a discount broker that doesn't charge a lot for trade commissions. (Many online brokers charge $5 or less these days.) And second, you can also keep the cost of trading low relative to the investments you make by buying more stock each time you buy. The more stock you buy at a fixed commission rate, the smaller the commission (when measured as a percentage of the investment).
Here's a rule of thumb: To ensure you pay no more than 2% in commission costs, multiply your broker's commission by 50. Only buy stocks in amounts of that value or greater. For example, if your broker charges a $5 commission, make sure you buy at least $250 worth of stock each time you trade.
Two piles of money
So why does this math lead me to recommend that you break your $1,000 investment into two piles of money? There are three reasons.
First, if you buy $500 worth of a stock for a $5 commission and later decide to sell your stock for another $5 (so, $10 total), your total transaction cost, round-trip, is only 2%. (If you buy and hold, on the other hand -- something we recommend -- then your total transaction cost will be only 1%.)
Thus, a new investor can use $1,000 to make at least two separate $500 investments in the stock market while keeping transaction costs on each of them at 2% or below.
Time is an asset
And now the second reason: An investor with only $1,000 to invest might ordinarily want to wait until she had $5,000, $10,000, or even more before investing, which would allow her to buy a diversified bundle of investments all at once while keeping transaction costs low. However, while waiting to amass the necessary funds, she'd be losing one of the most valuable assets a new investor possesses: time.
Simply put, the sooner you start investing, the more time your investment has to grow exponentially. So, even if $1,000 isn't the ideal amount of money to start investing with, it's better than losing valuable time in the market.
Knowledge is an asset, too
Time lost is a tragedy in another way, too. In my view, the sooner you begin learning how to invest, the wealthier you'll end up in the long run. $1,000 split into two investments may not be much to start investing with, but it's something. It's enough for you to, for example, buy $500 worth of the SPDR S&P 500 ETF Trust, buy another $500 worth of stock in a specific company that you want to learn more about, and then see which kind of investment you're more comfortable owning.
Covering essentially the entire "stock market," the SPDR S&P 500 ETF is inherently more diversified, and less volatile, than an individual stock. Over time, you'll notice how the individual stock's price fluctuates much more wildly than the "Spyder" -- and you may get an idea whether you're comfortable seeing the value of that investment go up and down a lot over the course of days, weeks, and months -- or whether you might prefer the more steady ride that comes with index investing.
As an investor in individual stocks, however, you'll have the learning experience that comes with owning a piece of a business. As a part-owner, you'll naturally pay more attention to the company's quarterly earnings reports, industrywide trends, changes in management, and macroeconomic factors that affect both the company itself and the broader market.
In the end, this learning experience may be the greatest "return" you get from investing your first $1,000 in the market.