Investing Small Amounts
by Gary Foreman
I am 55 years old and will begin receiving a small pension from one of my old jobs. The amount will be only $55 per month until I die. What would be the smartest thing to do with it? Pay down credit card debt, invest it, sock it away in the bank as a rainy day fund? I lost 85% of my portfolio when the stock market tanked and have very little left for retirement, so I'm afraid to get back into mutual funds. Does anything else look good these days?
Erica in Sioux Falls, SD
Erica has a good opportunity. While $55 a month isn't a huge amount of money, it can add up. For instance, if Erica manages to save the money and earn just 2%, it will be worth $7,300 when she's 65. Or if she manages to earn 10%, it will be worth over $11,250 in ten years. So it's important to get a good return on the money and not let it disappear each month.
She should consider two factors in making a decision. Her time frame and ability to take risks with the money.
Erica's goal will determine her time frame. If she wants to save for retirement, she'll have a ten-year horizon. However, if she wants the money ready for the next budget crunch, she'll need to think in terms of having the money readily available.
If she takes a longer view, she'll be able to choose a riskier investment without actually taking on more risk. Let me explain. A stock mutual fund is unpredictable in any single year. You wouldn't choose the mutual fund if you wanted to make sure that you could get all of your original investment out at any time you wanted.
On the other hand, a money fund is very predictable. Your principal is always available.
But suppose that Erica's horizon is ten years. The mutual fund becomes much more predictable. That's because ten years is long enough for good years to overcome any bad years. And the mutual fund will average a higher return than the money market fund over a ten-year period.
Erica's willingness to take risk is also a consideration. Some people can't handle a mutual fund loss. Even if past results suggested that it would only be temporary. As a rule, no investment should cause you to lose sleep. If you are not comfortable with an investment, you shouldn't make it.
Now that we've set a framework, let's look at some of Erica's ideas. Using the money to pay off credit cards could be her best option. First, she has access to the money any time she wants. Paying down her balance will leave more credit available for new charges.
The other advantage of paying off credit cards is knowing exactly how much she's earning. Erica will earn the interest rate of the loan that is being paid off. So a credit card that charges you 14.5% will earn you exactly that. If she used the $55 each month to reduce debt, she could eliminate a $14,900 balance over ten years. And that would eliminate over $200 of credit card minimum payments each month.
Erica could invest the money in a variety of places. One problem is that it's hard to invest smaller amounts. Even if she saves up the money and invests it once a year, there's still only $660 with which to work. She'd probably need to select a mutual fund. They're designed to handle small dollar investments.
Erica may think of stock investments when mutual funds are mentioned. Given her stock experience, she might be concerned. But not all mutual funds invest in stocks. Some invest in bonds or a mixture of stocks and bonds.
She also shouldn't confuse her recent stock experience with the performance of most mutual funds. A general purpose stock fund will not lose 85%. Certainly not before you have warning and time to get out.
What "looks good these days" usually isn't a good way to invest. Very few people are able to predict the future well enough to time markets. Most of us are better off taking a slow, steady and predictable path to wealth accumulation.
As a general rule, it's usually advisable to pay off debts before investing. That's because the interest rates for borrowing money are usually higher than those paid for investing money.
One exception to paying debt first is when you can invest in a 401k plan where your employer matches part or all of your contribution. That match significantly boosts the return.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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