I've been an investor for nearly two decades at this point, but as a Certified Financial Planner®, one of the most common questions I'm asked is "How should I get started investing?"
This is a great question. And while there's no one-size-fits-all answer, there are some smart opening moves that could set you up for a lifetime of investing success. So, if I were starting my investing efforts from scratch with $5,000, here are three important things I would do right away.
1. Put the money in the right kind of account
The first thing I'd do with that $5,000, before making any investments, would be to deposit it into the correct type of account. Assuming that I don't expect to need the money for near-term expenses, I would open and fund a tax-advantaged retirement account like an IRA. For most Americans, there are two basic forms.
- Traditional IRA: These accounts allow qualified workers to deduct their contributions annually, up to a maximum level set by the IRS. Eventually, the funds taken out of these accounts in retirement will be considered taxable income in the years those withdrawals are made.
- Roth IRA: Contributing money to these accounts doesn't offer any immediate tax benefit, but your withdrawals in retirement will generally be tax-free.
With both types of IRA, your investments grow and compound on a tax-deferred basis. In other words, if an investment pays you a dividend this year, you don't have to pay taxes on it. And if you sell an investment within your account at a profit, you won't have to pay capital gains tax, so you can reinvest the entire amount.
Here's why this matters. Let's say that you're in the 22% tax bracket and you have $5,000 to invest. If you contribute it to a Traditional IRA, this translates to $1,100 in current-year tax savings, in addition to the long-term benefits of tax-free dividend and capital gains reinvestment.
2. Create a "base" for my portfolio
After depositing $5,000 into the tax-advantaged account that makes the most sense, I would then use the money to construct a "starter portfolio."
There are several ways to achieve this, but the general idea is that you want to begin with a broadly diversified investment approach. Once you've established that as a base, you can start putting more money to work in individual stocks and aiming to beat the market over time.
My preferred way to create that base is to buy a few exchange-traded funds (ETFs) that track the performance of certain benchmark stock indices. A low-cost S&P 500 index fund like the Vanguard S&P 500 ETF (VOO 0.74%) is a fantastic starter investment, and one that makes sense for virtually every novice investor to own.
Beyond that, here are some other excellent examples of low-cost index funds (all run by Vanguard, which has some of the best low-fee ETFs in the market) that could be excellent choices for new investors establishing their portfolios:
- Small-cap stocks: Vanguard Russell 2000 ETF (VTWO 0.01%)
- Growth stocks: Vanguard Growth ETF (VUG 1.39%)
- Income stocks: Vanguard High Dividend Yield ETF (VYM -0.08%)
- Real estate stocks: Vanguard Real Estate ETF (VNQ 1.22%)
- Fixed income (bonds): Vanguard Total Bond Market ETF (BND 0.66%)
If I were starting my portfolio today with $5,000, I'd put about half of it into an S&P 500 ETF and divide the rest among the other five index funds listed here. But as I said, there are numerous ways to achieve that diversified base. The goal is to create a portfolio that isn't tied too closely to the performance of any single stock -- or even to any single sector -- before you start branching out into individual stocks and/or more focused index funds.
3. Make future contributions to your portfolio automatic
The first two steps are the basic idea of how I'd invest my first $5,000. But it's important to go a step beyond to set yourself up for long-term success. And one of the best ways to do that is to automate your future investment contributions.
For example, it might be a smart idea to set up an automatic $400 monthly deposit to your investment account ($4,800 per year). That way, you won't have to remember to make contributions and you won't be able to make excuses for skipping them. If you're just starting out, this can be one of the most effective ways to build a substantial retirement nest egg over time -- not to mention a great way to save money on your taxes.
Generally speaking, it is a good idea to max out your contributions to tax-advantaged retirement accounts before you start investing money via a taxable brokerage account. For 2022, the IRA contribution limit is $6,000 per person ($7,000 if you're 50 or older), so keep this in mind when deciding how much you want to route each month into your retirement and non-retirement accounts.