How to Invest X Dollars in Y Years
Investing is a tricky business. We talk about some investment strategies for different amounts of money. Let’s figure how some ways to make the most of your cash investments.
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Say you got a spare bit of cash lying around. If you have been paying attention to anything we have been saying in our other articles, you probably know it’s a good idea to invest money that would otherwise just sit and collect dust. If you have never invested before, you are probably wondering;
How, exactly, should I invest my money?
This is a good question but it can’t be answered on its own. It is missing some critical components. When deciding investments, there are three major criteria you need to consider:
- Amount invested
- Risk tolerance
The first thing is figuring out the amount to invest. The initial invested amount determines the general return you will get. All other things being equal, the more you invest, the greater your returns will be, assuming an average market return.
The amount you need to invest depends on your specific investment goals. If you just want to play around with investing, a small amount should be fine. If you are trying to save for retirement, you will need to invest more.
This second critical component is time. The fertility of a particular investment not only depends on the initial invested amount but on the length of the investment. Over a long period of time and with some luck, a $10,000 investment can really grow.
Conversely, in a short period of time, that $10,000 could do poorly and lose value. So when you are making decisions about what to invest and where, you need to determine what your investment timeline trajectory is.
You also need to consider how much risk you are willing to expose yourself to. Different people have different risk tolerances. If you have a high risk tolerance, you might be OK investing in more high-risk securities like stocks or currencies.
On the other hand, if you have a low-risk tolerance, you may want to allocate a greater portion of your investments to stable investments like bonds and mutual funds.
The structure of this article is as follows: First, we will talk about the different classes of investments, their respective risk/reward ratios, and over which time periods they do the best.
Then, we will talk about specific investment strategies for 4 ranges of money: $5,000-$10,000, $10,000-$50,000, $100,000+, and $1 million+
Sound fun? Let’s get started.
Types of Investments and Their Risk/Reward Ratios
There are four major investment classes:
- Mutual funds
Each of these investment types have different expected returns and different levels of risk. There are many other investment types and subtypes, but the majority of traders traffic in these four securities.
Risk/Reward Ratio: High-risk, high-reward
Stocks represent a share of a company. When you purchase shares of stock, you become part-owner of a company. As the company grows in value, your shares increase in value.
People make money buying stock and selling later once the value has increased. Stockholders usually have some voting privileges regarding the structure of the company. Common stocks may also entitle you to a portion of the company’s profits, which are paid out quarterly in dividends.
In general, individual stocks have the highest risk of all security classes. This is because stock performance is directly tied to the performance of a specific company.
If the company does well, your shares increase in value but if the company does poorly, your shares decrease in value. It is possible to lose your entire investment in stock if the company does poorly.
At the same time, stocks have the highest potential for growth and reward of all securities. Theoretically, share value can increase infinitely and the only real limit on how much stock you can own is how much capital you can invest.
(This is theoretical; in actuality, companies might have specific rules about how much stock an individual can own.)
Stocks generate value in 2 major ways; capital gains and dividends. Capital gains are the increase in value of the shares.
Capital gains are realized when the asset is sold. Dividends are shares of company profits distributed to shareholders at specific intervals.
Stocks can be both a good short-term and long-term investment. With stock, there is the potential to rapidly make gains if you take advantage of market swings or by selling short. You can also invest in stable dividend-producing stock to get a regular payout over the long haul.
Risk/Reward Ratio: Low risk, low reward
A bond is essentially a loan you make to a company or the government. When you purchase a bond, you are loaning money to an institution with the promise they will pay it back plus interest.
When you buy a bond, you agree to have the loan paid back by a specific date. The company pays you periodic interest payments as well, usually twice a year.
The bonds maturity is the date by which the principal will be paid back. The maturity date is an important factor to consider in your investment strategy and goals. There are three bond maturities:
- Short term: 1-3 years
- Medium-term: 5-10 years
- Long term: 10-30 years
Bonds usually have a lower risk than stock. This is because companies are mandated by law to pay out interest payments to bondholders before shareholders. The only real risk with a bond is, like with any loan, the borrower could default.
Government bonds are backed up by the “full faith and credit” of the US, which means there is no risk of defaulting (assuming the government does not dissolve, that is). There is also interest risk which gets magnified on longer time scales.
As a consequence of that low risk, bonds have a lower reward than stocks. According to CNN, since 1926, bonds have an average return of 5%-6%, compared to a 10% average for stock.
This lower reward is balanced by the predictability of bonds. They can be a way to secure a stable source of income later in life.
Risk/Reward Ratio: Depends on the fund
Mutual funds are collective investments in which investors pool their funds to buy several securities. Mutual funds are a way for investors to buy a large number of securities all at once. You can think of mutual funds as if you were buying a pre-built investment portfolio that is managed by a fund.
Mutual funds can consist of many kinds of securities. As such, the risk/reward ratios of mutual funds vary based on their composition.
Funds that invest in volatile sectors might have a higher risk/reward ratios or lower if they invest in more stable sectors. When a mutual fund gains money, the fund managers distribute a proportion of that amount to investors.
There are two main kinds of mutual funds: index funds and exchange-traded funds (ETFs).
Index funds passively track an index like the S&P 500 and adjust allocations according to index performance. Index funds have lower management fees and are relatively stable as index performance is relatively predictable
Exchange-traded funds are a special type of mutual fund that also tracks a specific index. Unlike index funds, ETFs are traded via brokers – like stocks – and their value can fluctuate day-to-day. Index funds are priced once at the end of the day. ETFs have more risk than index funds but higher chance of reward.
Risk/Reward Ratio: Varies
An option is basically a contract that gives the holder the right to buy or sell a security by a specific date. When you buy an option, you are claiming the right to buy or sell a security at a specific price before the contract expires. Options are flexible as you are not obligated to buy or sell the security by the target date.
Trading options can be a bit tricky to understand, so here is a quick sketch of how they make money: If you buy a call option, you claim the right to buy an option at a specific price, called the strike price, by a specific date. If the sock value rises above the strike price, you can profit.
Alternatively, you can buy a put option to sell some security at a strike price. If the value of the security remains above the strike price, you can make money.
When buying and trading options, you need to decide which direction the market is going to move. Market movement determines if you should buy a call option or a put option. If you think some stock is going to rise, you would buy a call option. If you think it is going to fall, you buy a put option.
You also need to determine the time length of the option. Typically, options with longer expiration dates are more secure as you have more time to see if your market predictions pan out. Daily and weekly options can be very risky and should only be used by experienced investors.
How to Invest $5,000-$10,000
$5,000-$10,000 is not that much money in the grand scheme of things, but it can be used as seed money to jump-start your investing career. The biggest thing you’ll want to watch out for at this monetary range is brokerage fees. Even a 1%-2% account fee can be upwards of $100 a year and that’s not including transaction fees or advisory charges.
At this level, your best bet is to use a low-cost broker and start with small investments. Let’s look at some options.
Use a Robo Advisor
Robo advisors are a great way to get into the investing world because of their low-barrier for entry. Robo advisors usually have low investment minimums and no transaction fees on normal stock trades. The average annual management fee is around 0.25%-0.35% of total assets under management.
Robo advisors use cutting edge algorithms based on the latest economic science to diversify your portfolio against risk. Robo advisors seem to perform just as well as traditional advising services as well. Most of the best robo advisors give access to a wide range of securities to pick from.
Open an IRA or Contribute to a 401(k)
It’s never too early to start saving for retirement. If you don’t have one already, $5,000-$10,000 makes a good starting investment in an IRA.
IRAs get special tax-deferred status so they are used to withhold paying taxes on money you gain until you actually access the funds. The annual IRA contribution limit is $6,000, so $5,000 is right at the maximum.
If you have a work-sponsored 401(k) your company will match contributions. Most companies will match half or even all of your contributions. If you have not already maxed out your annual 401(k), this decision is a smart one.
Mutual funds are typically the best kind of investment to make and they have minimum contributions in the $3,000-$5,000 range. ETFs let you buy-in directly at share price which is usually lower than the average minimum for mutual funds.
Several online brokers have a selection of commission-free ETFs you can invest in. All ETFs have an expense ratio (an annual fund management fee) so you want to make sure you find ETFs that have no commission fees on transactions.
Invest 10% in Stocks
We would not recommend putting your entire sum into individual stocks. The reward is just not worth the risk at this point. We would recommend initially allocating no more than 10% of your funds into stock.
The rest should be invested in low-cost funds. Investing 10% in stocks gives you a way to experiment with trading without incurring too much risk.
How to Invest $10,000-$50,000
What if you have a bit more cash to invest; say in the $50,000 range? Once you hit the $50,000 range you can build up some serious momentum with investing.
Investments grow exponentially, so the more you invest now the faster it will grow and the more you will have later. Here are some ideas on how to invest $50,000:
Max Out Retirement
The first thing you should do with that money is max out any annual retirement contributions. The annual 401(k) contribution as of 2020 is $19,500 and the maximum IRA contribution is $6,000, which comes out to $25,000 in total. Trust us, you will appreciate that large contribution down the road.
Diversify, Diversify, Diversify
Now that you have a substantial sum to invest, you need to focus on properly diversifying your portfolio. Most modern investing is based on Harry Markowitz’s Modern Portfolio Theory (MPT). According to MPT, there is an optimal way to diversify your portfolio investments that maximizes reward while simultaneously minimizing risk.
Investing in target-date funds is a good way to diversify your portfolio. These special mutual funds rebalance your assets to meet your pre-determined investment goals. It is also a good idea to invest in an index fund like the S&P 500, which lists some of the largest companies in the US.
Open a 529 College Plan
If you have children then $10,000-$50,000 is a solid amount to start saving for your kids’ future education. 529 contributions are subject to gift tax-exclusions. You can deposit up to 5 times the yearly contribution at once—$70,000 or $140,000 for a married couple—without having to pay a gift tax.
Invest in a House
It might also be time to expand your investment opportunities beyond the stock market. A house is technically not an investment, it is an asset. But buying a house lets you build up some equity that you can access one day, much like an investment.
You will have to put a down payment down on the house first. Traditional wisdom holds that you should put at least 20% of the value of the house as a down payment, but the actual average is around 7%. The average value of a house in the US is around $200,000, which comes out to a little more than $14,000.
Keep in mind that a house is not as lucrative as an investment as stock in terms of potential returns. Stocks have a higher average annual return and they are more liquid than real estate.
Further, a mortgage is a least a 10-year obligation. However, a house is much more than a store of value and is worth the investment for the non-financial benefits.
Get an Advisor
At $50,000, it is probably time to get the help of a professional. Most advisors have yearly management fees in the 1%-2% range and they will help you handle all the technical aspects of managing your money. Getting a good financial advisor is kind of like an investment in itself as a good advisor will help you build more wealth in the long term.
How to Invest $100,000+
First off, give yourself a hand. Whether you save $100,000 from your paychecks or got that money in another way, $100,000 is a fantastic amount to invest. At the $100,000 mark, you can really start to take advantage of what the investing world has to offer.
At this point, you need to decide what kind of investor you are going to be. $100,000 is a lot of money and you need a clear plan going forward.
If you are a DIY kind of person, managing your funds on your own is cheaper but takes a lot of work. There is also still the option of automated robo advising. Many robo advisors offer some kind of human assistance so you won’t be totally on your own with a machine.
Alternatively, you could find a full-service financial advisor if you don’t trust yourself investing or don’t have the time to manage things personally.
P2P lending platforms have emerged as a way for traders to borrow money directly from one another. Lending money to traders is a good way to make money off of interest. Higher risk loans carry a greater return but you can also make smaller safe loans to borrowers with good credit.
Most P2P lending networks have minimum salary nets and you need to have a sizable net worth. $100,000+ is just around the cutoff to qualify for P2P lending programs.
With more money, you might be a bit more comfortable trying higher-risk strategies. Forex trading involves investing in global currencies to make money. The average amount that trades hands on the forex market daily is an estimated $4 trillion.
Forex trading is inherently risky as innumerable things can affect the valuation of a currency. Exchange rates change in seconds and can vary by as much as 40% a day. You should only attempt forex trading if you are comfortable with high risk and have experience dealing with volatile investments.
There is also the option of trading virtual currencies. Virtual currencies like Bitcoin or Litecoin are extremely risky, but unlike national currencies, the performance of cryptocurrencies is not directly tied to the economic condition of any particular nation.
Real Estate Investment Trusts (REITs) are companies that own and operate properties that generate income. Investing in REITs is a great way to build wealth as they have very high returns above the market average. The only problem is that REITs also hit major depressive swings.
Given that REITs are tied to the value of real estate, if the real estate market performs poorly, the REIT will as well. Most REITs specialize in properties in a specific industry, like retail or office spaces.
How to Invest $1 Million+
Here is a question: If I gave you $1 million right now and said I wanted it back in 6 years with 7% interest, would you accept?
If you are thinking “no”, then you probably don’t realize just how much you can make from investing $1 million. In 6 years, you can make a much larger return than 7% with a solid million.
$1 million is an amount that most people never see in their entire life and if you have managed to accrue $1 million whether through saving every last penny or lucky inheritance, you are in the best financial position you could possibly be.
At these levels of money, investing really becomes all about the long haul. When invested wisely, $1 million can generate returns that will keep you comfortable for the rest of your God-given life.
When you have $1 million to invest you will likely not have the time to manage that sum all on your own. That is just too many investments for a person to handle on a non-full time basis. That is where money managers come in.
Money managers are individuals or firms that manage individual investor’s finances. Money managers handle portfolio balances, financial statements, taxes, and things like planning for retirement and setting up wills and trusts. A money manager is basically like an all-in-one financial manager.
Money managers have a fiduciary duty to wisely manage investments for clients. In exchange for a fee, money managers handle all securities issues.
Most money managers charge between 0.5% – 2% of assets under management, depending on portfolio size. Since money managers charge advisory fees based on portfolio size, rather than on a per-transaction basis, both them and the client have the same interests.
Along with the asset fee, money managers for high net-worth clients might charge a performance fee which compensates them for good portfolio performance. Performance fees normally fall in the 10-20% range of the fund’s profits.
$1 million can act as seed money to set you up with a steady stream of income for the rest of your life. At those levels of capital, you might want to consider investing in high-dividend stock. Dividend stock might have lower returns than other kinds of stock but they generate reliable dividends that can function as a regular source of income.
When looking at dividend stock, the key yield ratio to look for is 4%. If, for example, you dump $400,000 in 4% dividend stock, that is a $16,000 annual dividend payout at the very least. Keep in mind that the share value and dividend payouts will rise over time so the amount you get will likely be larger.
It is true that dividends are not guaranteed, so finding the right securities can help make sure you get consistent payments. In general, utilities stock is a solid investment for dividends as utility companies have a predictable revenue model, large revenue base, and high cash flow.
Utility companies tend to also be relatively resistant to economic recession so they are stable. A solid chunk of the best dividend stock in the market comes from utility and infrastructure companies.
A third smart way to invest $1 million is to purchase an annuity or two. Fixed annuities can be paid into with a large lump sum of cash so you start receiving benefits immediately or on a deferred basis. If you are trying to set up a reliable stream of income for retirement, then setting up a deferred annuity and paying into it over the years is a solid plan.
If you invested $500k of that $1 million you could collect almost 40k$ annually, and that is not accounting for growth. If you invested the entire $1 million, you could tap into an annual steam of $75k, a great amount for retirement when supplemented with other investments.
Things to Keep In Mind When Investing
No matter how much money you’re investing, here are a few key things to keep in mind.
- Draw a financial roadmap: You should never be investing without a goal. Every investment decision you make should be oriented toward those goals. Without a drawn-up plan, you run the risk of backing yourself into a corner and squandering your investment potential.
- Figure out your risk tolerance: All investing involves some risk, so you need to figure out how much risk you are willing to expose yourself to. The more risk you are willing to tolerate, the more possibility for big returns, but also the more chance for something to go wrong.
- Long-term or short-term?: Make sure you have a clear investment timeline. Try to set goals with definite dates like “I will have $50,000 in energy stocks by X date.” Once you establish your timelines, It’s much easier to draw out plans to reach your goals.
- Find your niche: If you are going to be an expert investor then you’ll need to find your area of investing expertise. Pick an industry that you are familiar with or are interested in and try to become an expert in it. The more specialized knowledge you have about a particular sector, the more smartly you can choose investments.
- Don’t panic: Every investment will do poorly at some point. You never want to get scared and sell when you should have held. Patience can beat out a market downturn 9 times out of 10.
The above strategies are meant to be taken as suggestions and are not gospel advice. At the end of the day, the way you invest your money is up to you. We have merely given a couple of options available with different amounts of money to invest.
Perhaps the single most important thing to keep in mind is that building wealth from investing takes time. Unless you are extremely lucky, there is generally no way to get rich quick with investing.
Investing large amounts of money takes patience, discipline, and a kind of practical wisdom you can only gain from experience. You cannot get scared and pull out when some investment does poorly and you can’t let your emotions get the better of you.
We will close out on this note: No matter how you choose to invest your money make sure it lines up with your long term financial goals. You’ll need to sit yourself down and ask yourself questions about what you value and how to get there.