Al Jacobs

Article Summary:

How can you start investing when you have very little money?

How To Invest When You Don't Have Much Money

A recent request from a newsletter subscriber was short and to the point: “Would you please give us some suggestions on how to invest when you don’t have much money?”  This sounded like a challenge I’d enjoy tackling.  But as I wrestled with it, I realized the question involved far too many variables.  Among them: How old is the individual?  How little money is available to invest?  What assets are currently held?   I sensed that nothing less than a massive treatise could do justice to the subject.  So I’ve narrow it down to something manageable, with the question becoming: I am single, 35 years old, possess few assets, and set aside $250 in surplus funds each month.  How can I sensibly invest?

Before I suggest how these funds might best be utilized, I’ll risk irritating 95 percent of investment advisors by suggesting how they should not be invested.  These monies should not go into the customarily recommended mutual funds, whether they be managed, index, balanced, sector, exchange traded, hedge, or any combination thereof.  To the further displeasure of insurance company representatives, none of the cash should find its way into annuities of any sort.  And lastly, the prospect of dabbling in precious metals, such as gold or silver, dare not even be contemplated.  The reason I avoid conventionally promoted investments is because they are subject to market vagaries.  The appropriate goal for this individual will be a measure of assured financial security upon retirement age.  With only modest funds available, all of which must perform productively, there is no room for uncertainty.  

With the parameters established, the logical question becomes: What can $250 monthly be invested in that will predictably generate a sufficient return to guarantee financial self-sufficiency for a person in thirty years?  I’ll offer what some persons may regard as an unconventional reply.  The assets should be placed into sound interest-bearing vehicles such as certificates of deposit, treasury notes, or corporate bonds.  Though such a strategy may seem unglamorous, value can grow remarkably over a long period, with thirty years being sufficient time for favorable maturity.  The secret ingredient is compound interest, which is as close to magic as you’ll ever experience.  To give you an appreciation of the potential, consider how $250 monthly will grow if it can be invested at a reasonably obtainable 7½ percent return, compounded semi-annually, over 30 years.  At the end of that time, it will become $341,500.  What occurs, simply, is that when paid, the interest earns interest, which in turn earns more interest, which in turn . . . I think you get the picture.  This multiplying effect resembles a geometric progression—a sequence in which the ratio of a term to its predecessor is always the same.  Perhaps it passed over your head when first exposed to the principle in high school math, but as a get-rich-steadily device it is a winner.

Although the investment technique I’ve just described is valid, there nonetheless is a fly in the ointment, for we’ve ignored an important element.  The numbers I’ve calculated do not take into consideration income taxes.  As all interest generated will be taxed at the top of the taxpayer’s marginal bracket, a portion will be unavailable to benefit from the compounding effect.  We must contemplate what this will mean in dollars available at retirement.  We’ll presume this individual receives enough salary and other revenue to fall into a combined state-federal tax bracket of about 33⅓%.  In a state like mine—California—it doesn’t take much income to get there pretty quickly.  Losing that one-third translates to lowering the 7½% annual rate of return to 5%.  The effect on the size of the retirement stockpile after thirty years is disheartening.  Instead of the $341,500 we previously anticipated, there will only be $214,700 in the pot.  That $126,800 reduction can mean the difference between a comfortable retirement, as opposed to just scraping by.

Before we throw in the towel, let’s consider whether there’s some way of fixing things, for much of success in life is analyzing our options and carefully selecting from among the choices available.  Luckily, just such an opportunity presents itself, thanks to a tax provision that first became available in 1998.  It is the Roth IRA, a type of retirement account, available to certain taxpayers, from which all income is forever tax-free.  By opening a self-directed Roth IRA account with a brokerage firm—preferably a discount one with minimal fees—all investments are held as IRA assets with the interest income accruing to the account free of taxes.  Withdrawals in any amount, with neither tax nor penalty, are allowed from the account when the taxpayer reaches the age of 59½.  By taking advantage of this type of account, we fully restore our 7½% annual return, subject only to a modest administrative charge.

There is a final factor we must consider in this analysis—that of increased cost of living.  Just what buying power will $341,500 actually command in thirty years?  It’s my belief that there’s a correlation between inflation and interest rates.  Most likely the dollar’s decline will reflect the bond interest obtainable.  Other economies usually perform this way; a hefty interest rate compensated for the 68 percent per year average decline in the Russian ruble during the period 1992 through 1999.  Thus if thirty years of inflation results in a dollar with greatly diminished purchasing power, the obtainable interest rates, together with the corresponding multiplier effect, should greatly increase the total number of dollars.  In short, there will likely be a trade-off.

Al Jacobs has been a professional investor for nearly four decades. His business experience ranges from real estate, mortgage, and securities investment to appraisal, civil engineering, and the operation of a private trust company. In addition to managing his investments on a day-to-day basis, he is a featured financial columnist for both online and print publications. He is the author of "Nobody's Fool: A Skeptic's Guide to Prosperity". You may subscribe to his financial Newsletter, "On the Money Trail," at no cost or obligation, by visiting On The Money Trail.

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