When I was 13, I worked all summer and saved up a little money. I needed to find a use for the money that was left over after my baseball card and candy spending sprees. My grandfather/financial adviser suggested putting it all into McDonald's stock. One year later, I made 40% on my investment (by being extremely lucky) and decided it was time to finally buy that amazing new 5 disc Sony CD changer I had always dreamed about (at least, I had dreamed about it for the better part of a month). Last week my cousin was talking to me about how he has some money that he wants to invest and was wondering what advice I might have. I started composing an email to him but then figured there may be other people out there with the question:
Early in life, with a little bit of extra money, what are my options for investing? This isn't a guide to making your life savings plan or retirement advice. This is a guide on what to do with a few hundred or thousand dollars that you don't plan on spending in the next few months (instead of putting it into a savings account). It's not a guide on how to double your money. Unless that guide is called "Getting Extremely Lucky" or "Breaking and Entering 101", that guide doesn't exist.
As a quick side note, I realized after writing this, that it may be a bit long and more than necessary for answering a quick question, but I wanted to try and explain as much as possible. If all this starts to make your eyes cross, you can skip to the summary at the end for brief thoughts on what you can do.
I'm going to assume for this article that all of your investments will be in stocks. Alternative investment options to stocks are bonds, CDs, savings accounts, etc. Stocks have more risk and thus greater chance for monetary reward (and loss). The alternatives are generally safer investment options, commonly with relatively fixed returns. For example, a CD (certificate of deposit) is an investment in which you give an investment company (such as a bank) your money for a certain amount of months in exchange for a certain amount of return (such as 6 months for 4% return).
The first question you'll need to decide is what vehicle to use for investing in. This can be split into two categories: a fund (or collection) of stocks or single stocks.
A fund can either be a mutual fund or an exchange traded fund (ETF). Either option is an investment in a collection of stocks (sometimes including bonds as well) for a single price. For example, the Vanguard 500 Index contains 500 of the largest stocks to mimic the return of the largest (in terms of capital) publicly traded companies (the S&P 500 Index). For $120 dollars (as of this writing), you can own a sliver of 500 stocks. Your money can go up and down the same amount (approximately) as the 500 largest stocks. By purchasing shares of a fund, you lessen the amount of risk of losing money, but also the chances of gaining money quickly. For example, if you invest in a fund and one company in that fund loses 10% of it's value in one day, it's very unlikely for the other companies to do the same. However, if you just owned the one company stock, your money would go down the full 10%.
Mutual Funds and ETFs are very similar in terms of how they work. There are two big differences worthy of noting right now. One is the cost of the funds and the second is how they pick the stocks.
There are two costs associated with funds, the cost of buying shares and the continual cost of running the fund. When mutual funds are purchased through the company that runs them (such as Vanguard or Fidelity), there is no fee to buy shares. ETFs, on the other hand, are purchased like stocks, which charge a fee for each time they are purchased or sold. The fee for buying and selling can range from $0 to over $20 per transaction. Mutual funds purchased through a financial adviser or 3rd party can also have a cost known as a load. A load is either a fixed amount or a percentage of the purchase price. Mutual funds with loads are becoming less and less common (thankfully), and there should always be a way to not get funds with loads. If you find a financial adviser that only offers load funds, it may be time to find another adviser (or do some research and invest on your own).
The second cost of funds is the operating expense. The operating expenses can range from under 0.1% to over 2%, with 1% being the average (that I've seen). When comparing a mutual fund to an ETF with the same collection of stocks, the ETF will be cheaper. This is because ETFs are on auto-pilot (explained soon) and mutual funds have someone controlling the stocks included. So, when deciding between ETFs and mutual funds (or the same collection of stocks), you need to compare the initial cost of purchasing the fund with the ongoing operating expense.
For example, lets say an ETF has a .25% operating expense and the mutual fund has a .5% operating expense. Let's also say that purchasing the ETF will cost $10 and the mutual fund will be free. You plan on investing $2,000 for 1 year. The mutual fund will cost you $10 for the year in costs (.005 X 2000). The ETF will cost you $15 for the whole year (.0025 X 2000 + 10). Therefor, holding the fund for 1 year will cost you more with the ETF. If you also add the cost of selling the ETF (another $10), the mutual fund comes out at less than half the price. As you raise or lower the amount you're investing or the amount the shares cost to buy and sell, the winner will change.
The second difference is how they pick stocks. ETFs are the easiest to explain and understand. They pick stocks using an index. It doesn't matter what's in the index, as long as it is in an index. The index can be anything from the top 500 stocks (such as the S&P 500), the price of oil, or the exchange rate of euro vs us dollar. If someone can create an index for it, it can become an ETF. ETFs use indexes created by a party other than the one selling the ETF, and because of this, they don't need to manage the index. Thus, the operating price of the ETF is lower than a mutual fund (which manages the stock list included in the fund).
Mutual funds can either be actively or passively managed. Passively managed mutual funds are generally index funds. Actively managed funds have a team of analyists decided what to buy and sell and when. Because of this, passive (index) funds have cheaper operating expenses than active funds. Put another way, the goal of an index fund is to follow the return of the market. The goal of the active funds is to beat it.
The second way to invest is just to pick out one or more stocks and buy shares of them. Picking individual stocks can be a lot more exciting, stressful, or overwhelming, depending on your attitude. I won't speak too much on purchasing individual stocks except to mention a few things.
Choosing the stock - simplified, you can pick one of the larger, more established "Blue Chip" stocks, such as McDonalds (my first pick), IBM, Exxon, etc or one of the other companies.
The Blue Chip companies have been around a long time, don't move too quickly in either direction (usually), and are generally safe bets. They are boring, but reliable. Depending on what's going on in the world, some of these companies will move much quicker than others. For example, oil companies have been moving up and financial companies down recently due to what's been happening in the US and the world.
The other companies can be split into many different types, but for simplicity I won't go through them all. These will generally move around much quicker, and have a much greater chance of making (and losing) lots of money overnight.
With stocks (and ETFs), the purchasing and selling price isn't the current trading price. The selling price (bid) is below the current price and the purchasing price (ask) is above the current price. The more traded a stock is (such as the Blue Chips), the closer to the current trading price the bid and ask are.
Lastly, the amount you pay to buy and sell a stock (called a trade) can vary greatly. Companies with very low expenses on mutual funds like Vanguard also have very high expenses on stock trades. Other companies, like Zecco, offer trades for free if you have at least $2500 invested with them, and $4.50 if you have less. Other companies will give you a certain number of trades for free to start with.
If you want to find out more on your own, a couple of good books that I highly recommend for starting investers (whcih should be available from your library) are:
Investing for Dummies (all of Eric Tyson's Dummy's books are a great source of beginner's information)
The Boglehead's Guide to Investing (written by fans of John Bogle, the founder of Vanguard; a great resource explaining index investing's benifits)
The Four Pillars of Investing (definitely a harder book to read, but much more in depth on strategies and reasons for investing)
Basically, if you want to invest in a bunch of stocks with a little bit of money, mutual funds and ETFs are the way to go. Opening an account with Vanguard and buying a mutual fund is relatively simple. The funds have minimums between $1000 and $3000. For an ETF, you can start with very little amount of money. Otherwise, you can buy individual stocks for a riskier chance at making or losing money. The larger companies usually offer safer bets but less chance to increase or decrease your money quickly.