Dollars and Sense
Investing from Scratch
by Maya Iginla
A couple months ago, I went to get my hair done at my regular salon. I was eagerly anticipating a relaxing morning filled with pampering products and juicy celebrity gossip when I got a piece of advice I hadn’t bargained for.
“You know, Maya, you should really think about putting aside some of your savings to invest. It’s never too early to start!” my hairdresser exclaimed enthusiastically as she slathered my head in deep conditioner. I was shocked – I had never seen this side of her before. Usually our conversations were limited to important topics like Jennifer Aniston’s love life and debates over whether or not Apple was an acceptable baby name. I laughed.
“Thanks, but I’m not that smart with my money.” I wasn’t lying. I had exactly one checking account and would have happily kept my money in a shoe box under my bed if that was at all possible. Investing was something that old white guys did on Wall Street. It involved Armani power suits and convoluted hand signals, neither one of which I had. To be honest, I wasn’t even sure what the difference between stocks and bonds was.
But my hairdresser wasn’t going to give up that easily. She went on to explain that investing isn’t as intimidating or hard as most people think, and by the time my 15 minutes under the dryer were up, I was actually starting to believe her. At the end of my appointment, she wrote down a few Web sites for me and urged me to check them out.
So I did, and a significant amount of reading combined with my hairdresser’s advice gave me a good overview of the extraordinary potential behind today’s money market.
Why should we invest? Because, let’s face it – even if we’re not into Prada bags or exotic Caribbean getaways, we want to make more money. Everyone does. And investing is a great way to make more money. It helps us stay ahead of inflation and achieve long-term financial goals.
It might seem risky to invest now, when our economy is at an all-time low, but believe it or not, our current recession actually has some benefits. Since no one has any money, stocks are dirt cheap, which makes this the perfect time to “buy low, sell high” – one of the basic principles of successful investing. Plus, because we’re young, we don’t have to freak out as much if we lose money in the market. We have plenty of time to gain it back!
For the first time, I’m actually excited, not intimidated, by the concept of investing. I’ll share some of my newfound financial wisdom with you here. This investment strategy is pretty straightforward and simple, but it is can be a smart choice, especially for young people. So read on for the simple steps you can take today to start saving money for the future.
Getting Started
1. Make some money. A common misconception about investing is that you need considerable savings to do it, but that’s just not true anymore. If you have some kind of steady income for at least a few months out of every year (summer counts!), no matter how meager it might be, then this plan is perfect for you.
2. Open an IRA account. Say what? Don’t worry, it’s not as scary as it sounds. An IRA is an Individual Retirement Account that functions like the grown-up version of a piggy-bank. It provides a safe space for your investments to accumulate and gather interest. The two most common kinds of IRAs are traditional IRAs and Roth IRAs.
In this article, I’ll focus on Roth IRAs, since they’re generally a smarter choice for young investors with limited funds, but traditional IRA accounts have their benefits as well. They’re a good option for older investors who are already well-established in the working world. If you’d like to find out more about traditional IRAs, try the article “Roth vs. Traditional IRA – Which is Better?” on Cashmoneylife.com. It compares both types of IRA in depth and helps break down the important differences between them.
Now on to the good stuff: According to Erin Burt, a contributing editor for Kiplinger.com, a Roth IRA is an Individual Retirement Account that allows your interest earnings to grow completely tax-free. You’ll pay taxes on the contributions you make to the Roth, but when you eventually decide to retire and withdraw your money, you won’t owe the IRS a penny. That’s right – unlike traditional retirement accounts, anything you withdraw from the Roth after age 59 and a half is tax-exempt.
You can invest the money you contribute to your Roth in anything you want – stocks, bonds, mutual funds, even real estate companies. Although it is a retirement account, you’re free to withdraw your contributions, tax and penalty free, at any time. If you’ve had your Roth for five years, you can even withdraw up to $10,000 to help buy your first house! And after age 59 and a half, you can withdraw your contributions and your interest earnings tax-free. “When you're just starting to invest, the Roth should be your first stop,” Burt says.
There are a couple requirements for contributing to a Roth. You can’t contribute over $5,000 per year (somehow, I don’t anticipate that being a problem for most of us). Also, the money you contribute to a Roth has to be money you’ve earned – not money your parents give you or random savings you have lying around. That’s why you need some kind of income for this plan to work.
Want to open a Roth IRA? It’s easy. There are countless different places to do it, from banks and credit unions to mutual fund companies and discount online brokers. In fact, the hardest part of this plan is choosing the place that will best fit your needs. If you’re serious about opening a Roth, I’d recommend researching the specifics on your own, but I can help you with the basics here.
If you have at least $1000 on hand to invest and/or are able to make year-round contributions at a minimum of $50 per month, a mutual fund company that invests in stocks, such as Vanguard (Vanguard.com), T Rowe Price (Rroweprice.com), or Fidelity (Fidelity.com) might be your best bet. Mutual funds are a smart choice for new investors because they invest in a wide variety of stocks rather than putting all their eggs in one basket. These companies also have fund managers that invest your money in stocks they think will do well, so you barely have to do any of the nitty-gritty work. Vanguard, T Rowe Price and Fidelity even offer “No-Load” funds, which don’t charge commission for services. The only drawback is that you need to have a decent amount of money available to open a Roth IRA with a mutual fund company. And some of us don’t have that. So what options are there for us broke folks?
If you have less than $1000 to invest and can’t make steady monthly contributions, consider opening a Roth with a discount broker like Sharebuilder (Sharebuilder.com), TradeKing (Tradeking.com), or Zecco (Zecco.com). Unlike large mutual fund companies, these discount brokers have no minimum account balance requirements and charge much smaller fees for their services. You pick the stocks you want to invest in and go from there. The downside? Discount brokers don’t offer mutual funds or professional help, so they can be more risky and require much more involvement on your part. If you want to go this route, I’d recommend doing some serious research beforehand and finding a relative or trusty adult you can rely on for sound financial advice.
These mutual fund and discount broker companies all have simple, step-by-step applications you can fill out online if you want to open an account. You’ll need your Social Security number and current bank account information on hand. Don’t freak out! If you’ve ever filled out college or job applications, the Roth application will be a breeze.
For more information about where to open a Roth, check out the article “What is a Roth IRA and Why Should You Care?” on Getrichslowly.org. It does a fantastic job of breaking down all the different options that are out there and provides links to other useful online resources.
3. Watch your money grow. Have you ever heard of compound interest? Let me explain: Think of your original deposit in the Roth as two pet hamsters. After a year, these two hamsters mate and produce 10 more hamster babies. The year after that, these babies breed and produce about 50 more babies. The pattern continues, and soon you have more hamsters then you know what to do with.
OK, so this analogy isn’t perfect. In real life, hamsters die, and by dying they control their populations. But money never dies – it just sits in your Roth IRA, happily accumulating. Scott Burn describes this process perfectly in his article, “Start on your first $1 million at age 16.” (Read it yourself at Moneycentral.msn.com.)
Say you’re 16 when you open your Roth. You work over the summer and earn $2,000 at your job, but instead of spending this money on shirts from American Eagle and Dairy Queen Blizzards, you put it all in a Roth account. And you do the exact same thing for the next three summers. After that, you never make any additional contributions to the Roth. Assuming a 10.7% compound annual return rate, which is average for large-capitalization U.S. stocks, you’ll have $1,114,423 by age 67. That’s right – you’l be a millionaire. If you don’t believe me, do the math yourself on the Financial Calculator (Dinkytown.net/java/CompoundInterest.html).
Most of us aren’t quite as diligent as this particular 16-year-old. It can be hard to stomach putting 100 percent of the money you earn into savings. If you want to, go for it! I envy your commitment. But there’s also hope for the rest of us. This 16-year-old might have contributed $2,000 every year, but she only did it for four years. What if you put $25 into your Roth account each month? That’s about five frappucinos’ worth of money. Will you really miss it? Probably not. And then, instead of quitting after four years, what if you keep contributing to your Roth for 10 or 20 years? Hopefully you’ll start to make more money and pay off those student loans somewhere along the way, so you’ll be able to contribute even more. As long as you don’t go over the $5,000-per-year limit, you’re golden.
It might seem like age 67 is a long way off – and it is. Why should we care about retirement when we’re still decades away from gray hair, wrinkles and bad joints? Shouldn’t we be living in the moment?
Sure we should. But we can easily do that with $25 less per month. The key to taking advantage of compound interest is to start investing when we’re young. And when we do start getting older, we’ll be thankful that our younger selves helped us to adequately prepare.
Personally, I plan on opening a Roth IRA as soon as I’m out of college and have a steady income. In 40 years or so, I’ll be the stylish old lady cruising around Florida in a diamond-encrusted wheelchair. I hope to see you there.